OfceResearch

M A R K E T
Philadelphia Metro Area

O V E R V I E W
Third Quarter 2012

Vacancy Tightens Near Core, Suburbs Slower to Improve

As the metro posts firm white-collar job growth, favorable tax credits will drive demand for quality office space near the core. Venture capitalists have poured nearly $500 million into Philadelphia in the last year to support the growth of the life sciences and technology industries. Many of the cost-conscious startups were able to lease prime office space at a discount in tax-free zones located in pockets of North and West Philadelphia, Delaware County and Center City. Known as the Keystone Opportunity Investment Zones, these areas offer growing businesses an exemption from paying state and local taxes for a specified period. Additionally, owners of buildings in the tax-free zones will be exempt from paying real estate taxes, which will allow the operator to allocate additional funds to tenant improvements to attract office users. As this trend persists, Philadelphia and Delaware counties should record positive absorption in 2012. Outside the core, especially in Bucks County, Blue Bell and Horsham, operations will improve at a slower pace as businesses relocate near the CBD to capitalize on the larger pool of talent. Although job growth is picking up, multiple quarters of solid gains in the office-using sectors will need to prevail before demand spills over to tertiary markets. Soft demand may hinder operations in the suburbs, creating a favorable environment for value-add buyers. Owners who purchased during the last boom cycle may experience declining revenues in the coming months as leases expire. Cash-strapped operators, in particular, have been unable to compete with the lucrative incentives being offered by well-capitalized landlords. As cash flow diminishes, these overleveraged owners will struggle to cover the monthly debt service, and some will face foreclosure. Troubled Class B/C buildings in receivership may trade below $40 per square foot, while assets with at least 50 percent occupancy should command up to $80 per square foot. Opportunistic investors will target these properties and make major upgrades to boost rent rolls. After stabilization, the property can sell as high as a 9 percent cap rate. Conversely, investors seeking long-term stability will purchase Class A assets net leased to a corporate tenant. First-year returns for this property type hovers around 7 percent.

2012 Annual Ofce Forecast

1.0% increase in total employment

Employment: By year end, the metros labor market will gain 27,000 workers, marking an increase of 1 percent. The office-using sectors will gain 12,000 positions this year as payrolls expand by 1.8 percent. In 2011, 2,500 overall jobs were eliminated.

700,000 square feet will be completed

Construction: In 2012, construction output will reach a four-year high as developers bring 700,000 square feet to the market, increasing supply levels by 0.6 percent. However, most of the new supply is already preleased.

60 basis point decrease in vacancy

Vacancy: By the close of this year, the metro will absorb nearly 1.3 million square feet, which will compress vacancy 60 basis points to 14.5 percent. Last year, vacancy held firm at 15.1 percent.

2.0% increase in asking rents

Rents: Lower vacancy will support a 2.0 percent increase of asking rents in 2012 to $24.90 per square foot, while effective rents finish the year up 2.4 percent at $20.39 per square foot. In 2011, asking rents rose 1.1 percent and effective rents jumped 1.3 percent.

Economy

Employment Trends
6%
Year-over-Year Change Nonfarm Ofce-Using

Spurred by growth in most employment sectors, payrolls expanded by 0.5 percent in the last six months as 13,400 positions were created. The gains represent a significant improvement from the prior two quarters, when 5,200 positions were cut. The office-using sectors added just over 12,600 jobs year to date, showing growth of 1.8 percent. The professional and business services sector was a major catalyst for the improvements during that time as those industries posted 11,200 new jobs. Additionally, the financial services segment added 1,700 positions. Dow Chemical will relocate 800 employees from its Spring House campus in Montgomery County to a Pfizer facility in Collegeville. The move will take place in January and provide the company with an additional 200,000 square feet of research space. Although no new jobs have been announced, the strategy leaves room for expansion and boosts Dows long-standing commitment to Philadelphia. Outlook: By year end, companies will generate 27,000 workers, which marks an increase of 1 percent. In addition, 12,000 office-using positions will be created.

3% 0% -3%

-6%

08

09

10

11

12*

Construction

Ofce Construction Trends

2
Millions of Square Feet Completions Absorption

In the last year, a total of 250,000 square feet of office space hit the market, expanding inventory by 0.1 percent. The 114,000-square foot Hillcrest I came online in Blue Bell late last year, bolstering stock in the area by 2 percent. The construction pipeline is relatively full with 1.1 million square feet under way in Philadelphia. Most of the projects will be completed by early 2014, while 450,000 square feet will come online fully preleased in the Exton/Malvern/North Chester by year end. Over 16 million square feet is planned for the metro, which represents 15 percent of the total inventory. Approximately, 5 million square feet is slated for the Exton/ Malvern/North Chester submarket, while 2 million square feet is proposed for the Camden/Gloucester submarket. Outlook: In 2012, construction output will reach a four-year high as developers bring 700,000 square feet to the market, increasing supply levels by 0.6 percent.

1 0 -1 -2

08

09

10

11

12*

Vacancy

Vacancy Rate Trends

19% 17%
Vacancy Rate Metro Area United States

Spurred by firm gains in the office-using sectors, vacancy fell 20 basis points in the first half of 2012 to 14.9 percent as tenants occupied 275,000 square feet. However, 5.2 million square feet of underutilized space still remains on the market. Vacancy in the Class A sector finished the second quarter at 13.9 percent, which is down 20 basis points from a year earlier as tenants with expiring leases upgraded to higher-quality space. In the Class B/C arena, vacancy also fell 20 basis points year over year to 16.3 percent. Leasing activity was strong in the Center City submarket during the past 12 months, with Class A vacancy tightening 70 basis points to 11.6 percent. At the same time, robust demand for Class B/C space reduced vacancy 150 basis points in the area to 10 percent. Outlook: In 2012, the metro will absorb nearly 1.3 million square feet, which will compress vacancy 60 basis points to 14.5 percent.
Marcus & Millichap

15% 13% 11%

08

09

10

11

12*

* Forecast page 2 Office Research Report

Rents

Year-over-Year Change

The uptick in leasing activity and lack of new competition allowed owners to raise asking rents 1.3 percent from the prior year to $24.59 per square foot. Effective rents grew at a faster clip in that time, increasing 1.6 percent to $20.08 per square foot. In the previous 12 months, asking and effective rents rose 0.9 percent and 0.8 percent, respectively. Stoked by gains in most submarkets, Class A asking rents climbed 1.4 percent in the last year to $27.67 per square foot, marking the largest annual percent change since early 2009. In the same period last year, asking rents rose 0.9 percent. Although demand was soft for Class B/C space in the last year, landlords had enough leverage to boost lower-tier rents 1.1 percent to $20.18 per square foot. In the preceding four quarters, rental rates ticked up 0.2 percent. Outlook: Asking rents will rise 2.1 percent in 2012 to $24.90 per square foot, while effective rents climb 2.6 percent to $20.39 per square foot.

Rent Trends
6% 3% 0% -3% -6%
Asking Rent Effective Rent

08

09

10

11

12*

Sales Trends**

As investors gained greater access to capital, investment activity increased by 8 percent over the last year. A few REO sales took place in that time, while institutions targeted stabilized portfolios in sought-after areas. Although investor demand was intense during the past 12 months, the median price held constant at $101 per square foot due to the distressed assets that traded. Highly vacant Class B/C buildings in the suburbs sold below $40 per square foot, while trophy assets fetched above $300 per square foot. Attractive debt and low price points helped spur demand for office properties in the last year, which applied downward pressure to cap rates. In fact, initial yields tightened 70 basis points to average in the low-7 percent range. Class A properties net leased to an investment-grade tenant traded near 7 percent. Outlook: Investors willing to take on more risk will target note sales, which can trade at a 15 to 30 percent discount to face value. If the borrower is current on the loan, the note holder will act as a lender and continue to collect the monthly debt service. Owners facing capital constraints, however, will be forced to relinquish the property immediately.
Median Price per Square Foot

Sales Trends
$140 $125 $110 $95 $80

08

09

10

11

12**

Medical Ofce

Medical Ofce Vacancy

13% 12%
Vacancy Rate Metro Area United States

Medical office building activity picked up in the last year as over 460,000 square feet came online, enhancing stock by 3.1 percent. In Voorhees, a 300,000-square foot building came online 95 percent pre-leased in the first quarter. Vacancy in the medical office sector recorded a 10-basis points improvement year over year to 16.1 percent as solid growth in the health sector supported positive absorption of 400,000 square feet. Asking rents for medical office space finished the second quarter at $24.59 per square foot, representing an increase of 5 percent from a year earlier, which is a significant improvement from the prior 12 months, when rates rose 0.6 percent. Sales velocity slightly rose in the last 12 months as buyers targeted properties between the $1 million to $10 million range. At the same time, the median price spiked 37 percent to $130 per square foot as cap rates tightened below 8 percent.

11% 10% 9%

08

09

10

11

12***

* Forecast ** Trailing 12-Month Period ***As of 2Q 2012 Sources: Marcus & Millichap Research Services, CoStar Group, Inc., Real Capital Analytics page 3

Marcus & Millichap

Office Research Report

Capital Markets
By WILLIAM E. HUGHES, Senior Vice President, Marcus & Millichap Capital Corporation

Alan L. Pontius Senior Vice President, Managing Director National Office and Industrial Properties Group Tel: (415) 963-3000 apontius@marcusmillichap.com

The FOMC announced after its August meeting that it would take no new steps to improve the economy before September. The Fed has pledged to maintain its lending rate near zero through at least late 2014 and has also amassed a portfolio of long-term U.S. Treasurys in an attempt to hold down long-term rates. In fact, the Fed expanded Operation Twist by $267 million during June of this year. In general, lenders continue to be discriminating. Banks remain a source of relatively low-leverage financing for acquisitions of multi-tenant properties, and will also underwrite deals for three- and five-year terms. Life companies are focused on quality assets in primary markets, while conduit lenders are more apt to loan on lesser-quality properties in primary, secondary and, in some instances, tertiary markets. Additionally, smaller, owner-user purchases are often funded using SBA 7A and 504 loans. Ten-year loans are available at rates in the mid-4 percent range, or roughly 250 basis points to 300 basis points above the U.S. Treasury. The rate on the benchmark 10-year U.S. Treasury hovered in the mid- to high-1 percent range throughout the second quarter and into the summer. DSCs start at 1.25x, with repayment schedules of 25 years and LTVs of up to 70 percent available.

Submarket Overview

Endo Pharmaceuticals is in the process of constructing a 320,000-square foot corporate headquarters in the Exton/Malvern/North Chester submarket. The company will vacate its current home in Chadds Ford and relocate to the new site by year end. In addition, Endo will create 135 jobs over the next three years. Muted construction activity since 2003 and firm demand for Class B/C space in the North Philadelphia submarket supported positive net absorption of 40,000 square feet of lower-tier space in the last year. As a result, Class B/C vacancy plunged 140 basis points during that time to 10.9 percent.

Prepared and edited by

Justin Britto
Research Associate Research Services For information on national office trends, contact

Submarket Vacancy Ranking

Rank
1 2 3 4 5 6 7 9 10 11 12 13 14 15

John Chang
Vice President, Research Services Tel: (602) 687-6700 john.chang@marcusmillichap.com Philadelphia Office: Spencer Yablon Vice President, Regional Manager syablon@marcusmillichap.com 101 West Elm Street Suite 600 Conshohocken, Pennsylvania 19428 Tel: (215) 531-7000 Fax: (215) 531-7010 Price: $150

Submarket
West Philadelphia Delaware County Center City North Philadelphia South Chester Lower Merion King of Prussia Burlington Exton/Malvern/North Chester Camden/Gloucester North Montgomery County Blue Bell/Plymouth Meeting Bucks County Horsham

Vacancy Rate
7.9% 9.6% 11.1% 11.6% 14.1% 15.5% 15.9% 18.4% 19.0% 19.2% 19.4% 20.0% 23.1% 24.0%

Y-O-Y Basis Point Change

-20 -140 -100 -100 -110 20 20 110 240 120 -290 30 180 70

Effective Rents
$26.38 $22.08 $21.32 $18.21 $20.43 $24.94 $19.58 $16.60 $18.57 $17.31 $16.87 $19.38 $18.56 $15.70

Y-O-Y % Change
1.9% 1.4% 2.9% -0.5% 0.1% 0.6% 2.2% 0.5% 0.0% 1.1% 1.9% 0.9% 0.5% 1.0%

Marcus & Millichap 2012 www.MarcusMillichap.com

Notes: Employment growth is calculated using seasonally adjusted quarterly averages. Construction, rent and vacancy figures exclude build-to-suit, flex space and medical office properties unless otherwise noted. The information contained in this report was obtained from sources deemed to be reliable. Every effort was made to obtain accurate and complete information; however, no representation, warranty or guarantee, express or implied, may be made as to the accuracy or reliability of the information contained herein. Sources: Marcus & Millichap Research Services, Bureau of Labor Statistics, CoStar Group, Inc., Economy.com, Real Capital Analytics, Reis, Torto Wheaton Research Services.