The winners and losers in Philadelphia’s post-COVID office market

Just past the midway point of 2023, Philadelphia’s office market is caught in limbo, and stakeholders are figuring out how to adapt to a post-pandemic normal with few precedents.

The essential problem, of course, is that companies are broadly using less office space as hybrid work has come to dominate white-collar professions.

Kastle Systems, which monitors swipes into office buildings, showed a slight decline in local single-day occupancy in the second quarter of this year — from 50.8% to 50.1% — the first such decrease since 2021. Second quarter analysis from real estate services company Jones Lang LaSalle (JLL) shows a 17.3% vacancy rate in Philadelphia and 20.6% in the suburbs.

“When you get to 20% vacancy, that’s significant, and that takes a long time to get it down to a level where you have a strong market,” said Tom Weitzel, managing director with JLL in Philadelphia. “Buildings really need to be at about 12% vacancy to be considered healthy … It’s going to be pretty ugly.”

Other market analysts try to highlight the positive side. For those seeking to buy office buildings, for their current use or something else, valuations could drop soon. And for those who want higher end office space, now is the time to lock in a deal.

“A lot of our clients are looking at this as a generational opportunity on the buy side,” said Les Haggett, first vice president with the real estate services company CBRE. “And its the same thing for companies trying to get into some of the best spaces in Philadelphia and the suburbs at lower rent.”

The reshuffle has already begun. In the last month alone, Independence Health Group announced it wants to sublease 224,000 square feet of space at 1900 Market, the law firm Fox Rothschild revealed it would be reducing its footprint by 40% in Center City, and Wells Fargo ended its tenure at 101 N. Independence Mall for smaller quarters on West Market Street.

Office leases often last for 10 years, if not longer, so many pre-COVID leases still have time left. Lenders, owners, and developers are furiously evaluating their next steps. Many incumbent tenants are trying to sublease some of their pre-COVID office space as they figure out exactly how much room they will need in future.

Office brokers report being inundated with valuation requests on buildings across the region. Everyone wants to know what their holdings are really worth. Is leasing strong? Is residential conversion a possibility? Are there cases where it makes sense to demolish a building to make way for something new?

“It feels right now there’s just a lot of planning and not a ton of action,” said Ashley DeLuca, who co-leads a newly created team at the law firm Ballard Spahr that evaluates how to handle distressed properties. “We’re doing a lot of talking with clients about their assets. Lenders, especially, are spending a lot more time than they historically have on understanding the asset.”

Much has been made in the COVID-era of the “flight to quality.” If companies are asking their workers to come back a few days a week, they want the newest or most centrally located offices with the best amenities.

“Both in downtown Philadelphia and in the suburbs, trophy office buildings posted significantly lower vacancy rates than the market at large, standing at just over 13% as compared to 25%,” reported the real estate services firm CBRE in its second quarter office market analysis.

Brandywine Realty Trust, a Philadelphia company with a national portfolio of more than 24 million square feet of office and other space, noted in its second quarter earnings call that its core holdings in Center City, University City, the Philadelphia suburbs and Austin, Texas, were 91.2% occupied and 92.7% leased.

That means the office market isn’t dead, but it’s increasingly polarized. Of the 1,300 buildings JLL reviewed for its second quarter analysis, 457 of them have no vacancy. But certain buildings are in serious trouble. JLL found that just 28 buildings across the region account for a quarter of office vacancy.

As the Philadelphia Business Journal reported, the owners of three Center City buildings — Centre Square, the Wanamaker, and One South Broad — together owe $530 million while facing sharply declining tenancy. Property owners facing high vacancy and imminent loan repayment have few palatable options.

Submarkets also have winners and losers. Western Montgomery County has the worst overall total vacancy in the region at 27.8%, and much of the rest of the county isn’t faring much better. Both Horsham and Willow Grove — which are lumped together — and Plymouth Meeting and Blue Bell have total vacancies of well over 20%.

The Lehigh Valley and Wilmington, Del., are facing vacancy rates just as bad.

But all those submarkets combined don’t come close to the same square footage of office space as the west Market Street area in Center City.

On paper, the heart of downtown Philadelphia’s office district doesn’t have a lot to brag about either with a 17.6% vacancy. But Weitzel said much of the pain is concentrated in a handful of buildings, such as Centre Square. Then there’s the old Morgan Lewis headquarters at 1701 Market St., which will be entirely vacant when the law firm moves down the block. That building, however, is one of the few likely to be converted to residential in the medium term and taken out of the office market entirely.

“If you take out some of the big buildings that are going to be depressed for a long time, it would look a lot better,” said Weitzel. “It’s better than a lot of other markets. It’s still by far and away the most attractive market for your business to be in the city.”

There is an large amount of sublease space right now too, where tenants try to rent out some of the space they still have under contract. CBRE found at the end of the second quarter “21% of the nearly 25 million sq. ft. of vacant office space in the region was sublease space, a significant increase from 7% in 2020.”

The superabundance of subleasing is historically unusual and is a sign of this moment of uncertainty as office users try to figure out how much space they actually need.

“A lot of companies are still kind of figuring out their strategy, but the reality today is that their space is being underutilized,” said Haggett of CBRE. “Marketing your space for sublease is a relatively low risk decision by a company; it doesn’t really cost you anything. So let’s see what happens and test the market, as we figure out our strategy.”

Across the United States the square footage of sublease space available has doubled since the pandemic, according to CBRE, and Philadelphia is no exception. In submarkets like the Navy Yard, almost all of the vacancy is sublease space that’s up for grabs, as opposed to a totally empty, non-income generating void.

Historically, such offerings have drawn little interest. Large-to-medium size office tenants like to have control of their surroundings and don’t want to deal with a previous occupant playing landlord.

Pre-pandemic sublease space also tended to be the least appealing offerings on the market: older buildings, with few amenities, and ugly furnishings.

But today, as companies shrink their office footprints, they are trying to rent out some premiere spaces. Comcast has already successfully rented a couple floors in Three Logan Square, for example, where it subleased 160,000 square feet on seven floors at the beginning of this year.

Weitzel said this is another measure of the strange state of the contemporary office market.

“Historically, corporates didn’t want to go into sublease space, but I think that’s going to change,” said Weitzel. “Usually it’s old, and not very attractive. But we’ve never had this much good sublease space in the city.”