Portman Holdings LLC, which has built high-profile properties such as San Francisco’s One Embarcadero Center, plans to break ground in June on its first U.S. office development without tenant commitments in more than 25 years.
Portman’s project is in Charlotte, North Carolina, while builders such as Houston-based Hines and San Antonio, Texas-based USAA Real Estate Co. are also looking beyond the biggest U.S. cities and starting projects in smaller markets, even without tenants lined up. Such speculative ventures were shunned by developers after the 2008 property crash.
“Everything in major markets like San Francisco, New York and D.C. is fully priced with low returns, high land costs and peak sales prices,” said John Portman IV, chief operating officer at the Atlanta-based firm. “It’s almost too late for any investors and developers to participate.”
The dearth of development in secondary markets, coupled with employers seeking to cut costs and young workers searching for affordable living, is buoying demand for office buildings.
In Charlotte, Portman’s 370,000-square-foot (34,400-square-meter) building is one of two spec projects planned for the area, the city’s first such developments in five years, according to the company.
The cost of doing business in Charlotte is 86 percent of the national average, while the city’s millennial population -- those between the ages of 20 and 35 -- grew 23 percent in the past five years, the most of 75 U.S. markets in a 2015 study by PricewaterhouseCoopers LLP and the Urban Land Institute. That increase was more than double the U.S. average.
“More jobs are being created in lower-cost markets,” said Mitch Roschelle, a partner at the U.S. real estate advisory practice of PricewaterhouseCoopers. “These markets are going to be hot in terms of investments and new developments, markets where urban population growth is considerably higher than the national average -- Houston, Austin, Atlanta, Phoenix.”
In Atlanta, Hines has three office developments planned or under way, the first such projects in the area for the company in eight years, according to John Heagy, senior managing director at the Atlanta office of Hines. At least one of the developments is speculative, he said. The company also has a spec office project in the works in Denver’s Union Station neighborhood and plans to break ground in three months on another one five blocks away.
“Denver is one of those areas that are on the front lines of office spec development,” said Jay Despard, managing director for Colorado of Hines. “In places like Denver, as opposed to San Francisco or New York, employers can maintain an employee base at a lower cost. And, alternatively, when younger individuals are coming out of graduate or undergraduate programs, they move somewhere with a lower cost of living.”
Spec office development in second-tier markets fell out of favor after the crash because bigger cities tend to fare better during downturns, with their larger, more diverse pools of employers, Roschelle said. Atlanta’s office space was almost 18 percent vacant in November 2011, a record high for the city, according to CoStar Group Inc. At the end of last year, the rate fell to 14.3 percent, still the eighth-worst among the 54 largest U.S. markets tracked by the real estate research firm.
“In most markets, there is still less need for new space,” said William Glazer, president and chief executive officer of Keystone Property Group, a Conshohocken, Pennsylvania-based commercial developer. “Look at law firms. All the law libraries are now online. The space requirement per lawyer can be dramatically reduced, the support staff has been dramatically reduced.”
Still, office developers are gaining confidence as demand for space has risen across the U.S. Last year, total occupancy gains in central business districts reached 23.2 million square feet, the highest level in 15 years, according to a January report by brokerage Cushman & Wakefield Inc. Atlanta had the fourth-biggest gain, after Manhattan, Chicago and San Francisco.
Southern California’s Inland Empire, New Haven, Connecticut, and Portland, Oregon had the biggest declines in office vacancies last year from 2013, Cushman said. Across the U.S., rising demand is driving office construction, which is likely to jump to 36 million square feet this year, up 65 percent from 2014, with the majority of projects planned for suburban markets, said Maria Sicola, head of research for the Americas at Cushman.
“Companies are being priced out of the big markets and are moving all or portions out,” she said. “Markets that are developing their own urban centers and are becoming their own brands are especially attractive.”
Technology-related jobs were the key driver of office demand last year, according to Cushman. Smaller, lower-cost markets may benefit from the emergence of new companies in that space, according to Roschelle of PricewaterhouseCoopers.
“More and more investors in startups don’t want them to be in Silicon Valley, where everything is super-expensive,” he said. “They want them in places like Cleveland, where operational costs are very low, and that means more demand for office space in those places.”
Such prospects are luring even foreign investors to smaller markets as they search for better returns, according to Will McIntosh, USAA’s head of research. Overseas investors historically have preferred large, gateway cities.
“Asian institutional investors are finding it more difficult to get reasonable returns in major U.S. markets,” Kye Joon Lee, who oversees institutional investments from Asia into the Americas for New York-based Clarion Partners LLC, said this month at an Information Management Network real estate conference in Laguna Beach, California. “They are more willing to go to non-major markets.”
USAA raised a $700 million fund to invest in office developments, including those without committed tenants, in growth markets, according to McIntosh. More than 70 percent of the USAA fund is cash from a mixture of foreign and domestic investors. The fund plans to deploy all the money within three years, according to McIntosh.
“We’ve had Korean investors that have come to the U.S. over the past year looking to invest,” he said. “We do take them to see assets in cities they know, but also take them to secondary markets to help them understand.”
Even with rising demand for newly built offices, getting financing for speculative projects remains challenging. That issue, combined with a glut of old buildings and increasing construction costs, are leading some companies to redevelop existing structures, Roschelle said.
“Even though there may be cranes, a lot of construction is often for a specific user,” he said. “Otherwise, many developers are still more focused on repositioning existing assets, which is less costly for the landlord and often more viable for the tenant due to lower rent -- or a combination of the two.”
To keep luring tenants and developers from major urban markets, secondary cities have been investing in public projects, such as the Atlanta Streetcar transit system and similar initiatives in Seattle and Cincinnati. Denver raised taxes and issued bonds to help convert the old rail land around the city’s Union Station.
As the job market continues to improve -- 2014 was the best year for the U.S. labor market since 1999 -- smaller markets are likely to continue to lure more developers who have focused on top-tier cities, John Portman said.
Portman’s Charlotte development will have an elevated green plaza, two-story corner balconies, floor-to-ceiling windows, a fitness center and a conference facility.
“There should be a volatility decline in these markets as they get larger and attract more capital,” he said. “They will become safer and safer down the line.”
(An earlier version of this story corrected John Portman’s title.)