by Brianna Crandall — June 12, 2015—”There’s no space like ‘trophy’ space,” according to a report from global professional services and investment management firm JLL (Jones Lang LaSalle). The premier office towers that make up the skylines of North American cities boast—by far—the most expensive office space to rent, garnering 77% more than non-trophy space, according to JLL’s 2015 Digital Skyline online market report.
Average trophy rates in the first quarter of 2015 were $57.97 per square foot compared to $32.70 per square foot in non-trophy buildings. This gap between trophy and non-trophy space reportedly represents a seismic shift from historical spreads: 10 years ago, the difference was just 20.8%. The gap is most pronounced in markets that are only just beginning to see expansionary tenant activity, like Atlanta and Orange County, California.
“The flight to quality in earlier recovery years coupled with an improving economy today have led to significant supply constraints in the country’s highest-quality office buildings, and the rent gap has widened significantly,” said Julia Georgules, vice president, JLL Research.
Trophy tenants can expect little relief in rental rates in the near future, in spite of nearly 29 million square feet of new office space under construction in the skyline markets, says JLL. Nearly three-quarters (75%) of the new development is concentrated in only nine cities, which means most tenants will have little negotiating leverage in their office agreements.
In addition, the chasm in vacancy rates is also considerable: 10% vacancy rates for trophy properties, while rates for non-trophy assets within the 43 markets that make up JLL’s U.S. Skyline stand at 15.1%.
A diminishing “home-team” advantage
If office rental rates are fierce, the price tag to buy an office building is even more so. Economic growth, business expansion and improving market fundamentals have resulted in a second consecutive year of plus-20% pricing gains, pushing skyline buildings more than 9% above peak prices and driving cap rates 10 basis points below the 2007 peak.
The sheer volume of foreign capital chasing skyline office deals is having a major impact on pricing. Of the $35.3 billion transacted over the past five quarters, 34.6% was driven by international buyers. In Houston and Seattle, every office deal transacted during this time period had a foreign buyer, while in Washington, DC; Boston and New York, offshore capital led more than 50% of office purchases.
“International capital is making a long-term impression on the U.S. skyline. We predict foreign buyers to invest $50 billion into U.S. commercial real estate in 2015, and they appear to be buying for the duration. This will have a major impact on future skyline liquidity, particularly for trophy assets in primary markets, where more than half of foreign capital is being invested,” said Steve Collins, international director with JLL’s Capital Markets.
Collins continued, “Going forward, domestic institutional investors will be forced to evolve their strategies, increasingly partnering with foreign investors and diversifying into non-core and non-CBD assets.”
A redefined skyline
As investors begin to diversify beyond the trophies for investment opportunities, a growing segment of tenants are also turning away from skyline buildings in favor of non-core Class A and Class B buildings, inside and outside of traditional central business districts (CBDs), according to JLL’s research. The perception of an “address” has been replaced by the desire for highly customized office space, particularly among fast-growing tech and other creative companies.
But the trend does not stop there: today, many other companies are trying to mimic tech whether through business strategy, people strategy or even real estate strategy, points out JLL. The growing Millennial workforce and their employers are increasingly drawn to architecturally significant Class B buildings located in dense neighborhoods packed with amenities. Among scientific and technical companies over the past three quarters, Class B office leasing surged above trophy leasing, representing 25% of total office leases over 20,000 square feet. Those same companies only leased 6% of trophy space during that same time period.
“Tech users and other creative firms want unique space—they’re mostly indifferent to building quality as long as they are able to design attractive, creative environments for their employees,” said JJ Shephard, managing director with JLL’s Agency Leasing in Seattle. “They have shown a preference in recent years for leasing lower-cost space in well-located historic buildings or converted warehouses because they can spend more on their space’s interior and less on rent. It allows them to create their own identity.”
Among the notable transactions fitting this trend are Buzzfeed’s 200,000 square-foot lease at 225 Park Avenue South in New York’s Midtown South submarket and Pinterest’s nearly 98,000 square foot lease at 651 Brannan Street in San Francisco’s South of Market District.
Georgules added, “A lot of these B-buildings are on the perimeter of the traditional high-rise CBDs in areas that have more of a neighborhood feel. In turn, they like the idea of adaptive reuse and contributing to neighborhood revitalization. As the gap between trophy and non-trophy space continues to grow over the short-term, we actually could be reaching a peak inflection point based on future demand patterns favoring space over building.”
About the Skyline Review
For the first time, investors and tenants can now access JLL’s 2015 Digital Skyline via a digital platform. The fully interactive Web site will feature JLL’s proprietary market insights regarding supply, demand, rents, leverage and investment into 47 markets across the United States and Canada, with the ability to compare and contrast individual markets or multiples of markets. In addition, the site will offer videos and infographics. All information will also be available via mobile access.
