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February 22, 2001

Office market slowing, but future looks good

  • No, the last one doesn’t need to worry about turning the lights off. The market is changing, but has great depth from a variety of tenants that will emerge, grow and absorb the current vacancies.
    • By DOUG HANAFIN
    Washington Partners

    Over the last 30 months, the Seattle office market has experienced unprecedented demand for office space, with net absorption of approximately 6 million square feet. The size of the office market has grown from 28 million to 32 million square feet, and the vacancy rate has declined from 4.33 percent to 1.21 percent.

    When accounting for increased rental rates and a reduction of landlord concessions, rental rates for Class A space has more than doubled over this relatively short period. Keep in mind that the 10-year historical net absorption prior to 1999 was approximately 1.2 million square feet per year.

    High-tech companies account for an estimated 80 percent of the net absorption in the Seattle office market. In other words, fast-growing high-tech companies leased approximately 5 million of the 6 million square feet absorbed in the downtown market over the last 30-months. The sidebar shows a list of noteworthy firms that have leased large amounts of office space.

    Remember, downtown Seattle absorption before 1999 (pre-high-tech demand) was 1.2 million per year. Yet 1.5 million square feet has been put on the market within the last 90 days.

    Just as important as the firms listed above are the start-up firms that have leased 5,000 to 30,000 square feet, filling the nooks and crannies throughout the Seattle central business district. These smaller firms have not been large enough or well-enough capitalized to justify constructing new buildings.

    Because these smaller firms have leased space in existing buildings — thus reducing existing supply — they are largely responsible for the rapid increase in rental rates that has caused most of the pain for existing tenants facing lease renewal. Trust me, this has been painful for long-time Seattle tenants.

    In contrast, most of the above-mentioned firms have not affected demand for the pre-1999 office market because they leased space in new buildings rather than existing ones. (Internap, Avenue A and Amazon.com are exceptions.) In essence, these megafirms have expanded the supply of office space in Seattle by approximately 5 million square feet over the last two years.

    Who’s getting hurt?

    Lenders that lost fortunes during the 1986-to-1990 real estate boom still remember it. Consequently, lenders maintained extremely strict underwriting conditions for new construction during the most recent boom. Typical preleasing requirements were in the 50 to 70 percent range, and large security instruments were required from new tenants, such as 12 to 24 months’ rent in the form of an unconditional letter of credit.

    Also, tenants were required to invest in the landlord’s new building by paying for a large portion of tenant improvements. Although landlords normally provide a tenant improvement allowance of $30 per square foot, the cost to build out the space typically ran from $60 to $75 per square foot. To put this in perspective, a landlord would end up securitizing the lease for a 100,000-square-foot tenant by approximately $8 million through a letter of credit and additional improvements provided by the tenant.

    Over the last 90 days, the shakeout in the high-tech industry has returned over 1.5 million square feet. The first wave of sublease space, approximately 250,000 square feet, was absorbed surprisingly quickly, and many real estate “experts” predicted that the market was in fine shape and there would be no fallout due to the dot-com giveback.

    Major high-tech
    space-holders
    Amazon.com

    RealNetworks

    Internap

    F5 Networks

    Getty Images

    WatchGuard Technologies
    Avenue A

    Go.com

    Onvia. com

    RivalNetworks

    Network Commerce (formerly Shopnow.com)

    Now “experts” will tell you that the market is softening rapidly. Remember, historical downtown Seattle absorption before 1999 (pre-high-tech demand) was 1.2 million per year. Yet 1.5 million square feet has been put on the market within the last 90 days.

    The previous post-boom softening in the market occurred when landlords built on a speculative basis. During that downturn, it was landlords who were most immediately affected because they had no security for speculative space. Although landlords will be affected by the current “softening” to a large extent, most of them will be protected from this current “giveback.” However, landlords will have to retreat from their projections of ever-increasing rental rates in order to keep their buildings full.

    Most buildings in the downtown core are in relatively good shape, with few vacancies. Washington Mutual Bank has backfilled the Financial Center, and continues to expand in Wells Fargo Center, 1111 Third Avenue, Second & Seneca, Washington Mutual Tower and Century Square. Most high-rise buildings are enjoying occupancy rates over 98 percent. Unico’s Metropolitan Tract is also 98 percent leased, along with U.S. Bank Centre.

    However, not all buildings will escape this downturn. For example, Bank of America Tower has been hit particularly hard, having lost major tenants such as Preston Gates, Heartland, Oles Morrison, Cairncross Hempleton, Willis Corporation and Adams & Associates, representing approximately 275,000 square feet. Additionally, around 150,000 square feet of other tenants in the Bank of America Tower will soon be deciding whether to relocate or renew. If these tenants choose to vacate, Bank of America Tower will need to backfill over 500,000 square feet — a third of its space — in a softening market.

    Tenants seeking sublease space will need to lower expectations about the rents they receive from subtenants. When a select number of short-term sublease spaces were available, the sublandlords were in good shape, often receiving rents from subtenants exceeding rents sublandlords were required to pay.

    But with 1.5 million square feet available for sublease, sublandlords wishing to reduce unneeded expenses will have to battle for tenants. This battle, which will largely include only sublandlords, will intensify until a majority of such space is leased.

    No return to 1990

    The Seattle office market will experience a great deal of intensity during the next 12 months, with tenants shifting to new spaces and sublandlords competing fiercely for subtenants. Landlords will have to back off from their projections of ever-increasing rental rates and tenants will get some short-term relief.

    Rental rates, however, will not retreat to 1990 levels — it simply won’t happen. We likely see a slight reduction in rental rates, though landlords will provide more tenant improvements to maintain and attract tenants.

    There’s no question Seattle will experience a setback from the rapid growth it has seen over the last 30 months. Yet there are a tremendous number of tenants looking for space and a large number of start-up firms, particularly in the broadband and wireless sector, experiencing strong growth.

    No, the last one doesn’t need to worry about turning the lights off. The market is changing, but has great depth from a variety of tenants that will emerge, grow and absorb the current vacancies.

    Prediction: we will be back to a super-tight market within 12 to 18 months, and we will not see a significant new supply of space for 30 months.

    Douglas Hanafin is a principal at Washington Partners, a corporate real estate advisory form. Hanafin has represented tenants in the Seattle market for 15 years. Washington Partners represents tenants such as RealNetworks, Amazon.com, F5 Networks, and Heller Ehrman.


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