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With Diminishing Office Inventory, Region Will Soon Struggle to Meet Tech’s Protracted Growth

San Francisco Bay Area, Seattle, CBRE, Orlando, San Diego, Bay Area, Washington D.C., Tucson, Waterloo, Las Vegas, Hamilton

By Jack Stubbs

As growth and densification continues to occur throughout the Puget Sound region in Seattle and on the Eastside, employer and tenant demands are changing as companies continue to pursue commercial space in a burgeoning market. As commercial inventory in the region continues to dwindle, the market could start to feel the effects over the next few years: landlords and tenants are beginning to put more stock into their decisions about where to locate due to the limited available inventory.

“Major tenants will continue to look on both sides [of the lake], but you also have to take transportation and access to schools into account. So, it’s not unusual to have a flag planted on both sides,” said Steve Schwartz, senior vice president at CBRE at a NAIOP-sponsored annual event held on Wednesday, April 18th.

At the event, “2018 Broker Forecast: Is the Air Getting Thin?,” which was held at the Hyatt Olive 8 in downtown Seattle, three brokers—Schwartz was joined on the panel by JJ Shephard, managing director in JLL’s Seattle office, and Paul Sweeney, principal/co-founder of the Broderick Group on the Eastside—discussed what the year ahead holds in terms of changing tenant and employee needs, where current demand for office space is coming from and how landlords’ strategies are accounting for anticipated market changes in 2018 on both sides of Lake Washington.

Beginning the panel, which was moderated by Wende Miller, senior leasing director with Talon Private Capital, the speakers characterized the current state of the commercial markets in Seattle and the Eastside. According to Shephard, activity in the broader Puget Sound region is as robust as ever and continues to outpace other markets along the West Coast. “There was 4.1 million square feet of net absorption in the Puget Sound region in 2017, which is staggering if you think about that figure in relation to the other markets…Seattle had more net absorption than all the other markets (Los Angeles, Sacramento and San Francisco) combined.

And as has been the case over the last several years, the commercial market is still driven by technology companies, according to Shephard, a fact that continues to put pressure on the market. “The story is tech, and we are dominated in the region by tech absorption. Seattle was #1 in all other cities with the net amount of tech companies moving [here]….but we are running out of space, and over the next couple of years in Seattle we see that demand is outweighing supply in the pipeline.” The vacancy rate for the entire Seattle market sits at 5.9 percent, according to a first quarter 2018 Seattle Office Market Overview report by Broderick Group, down from the figure of 6.3 posted in first quarter 2017.

The situation on the Eastside—a commercial market characterized by decreasing vacancy rates and not enough inventory—is similar to that in Seattle, according to Sweeney. “It’s much the same story…this is the tightest office market we’ve [seen] in 18 years,” he said. “The vacancy rate for Class A buildings in the Bellevue CBD, where the tenants want to be, is 7.5 percent.” According to Broderick Group’s first quarter 2018 Eastside Office Market Overview report, the vacancy rate for the entire Eastside market sits at 8.7 percent, a figure that is down from the 11.5 percent vacancy figure posted in first quarter 2017. Additionally, the vacancy rate for Class A buildings on the Eastside currently sits an 8.2 percent, according to the first quarter 2018 report, which is down from the 14.8 percent figure posted in early 2017.

Broderick Group’s first quarter 2018 report products that the Bellevue CBD vacancy rate—currently 7.5 percent—will continue to drop steadily into the 4 percent range by year-end 2018 due to signed and pending leases. And according to Sweeney, the presence of larger companies signing bigger leases—with little available inventory left—means that pressure in the Eastside market will continue to mount. “If you were a 100,000 square foot tenant looking for space on the Eastside, you would have no options…the tenants on the Eastside who want the big quality spaces in the urban core are really in trouble…the question for tenants is where the relief is coming from,” he said.

On the Eastside, there are only four new under-construction and planned new developments, only one of which is in the Bellevue CBD. These include Talon’s Kirkland Urban North project, a 190,000 square foot Class A development scheduled for completion in 2018; Wright Runstad’s planned Spring District: Block 16 project, a 325,000 square foot undertaking in the Bellevue suburban submarket scheduled for completion in 2020; and Summit III, a 370,000 square foot project in Bellevue’s CBD also slated for completion in 2020.

Due to the relative lack of construction, and subsequent dearth of inventory in Seattle and the Eastside, landlords are beginning to be more competitive in order to attract larger tenants—especially on the Eastside and in the further-out suburban markets, according to Sweeney. “The big competition is occurring between Bellevue CBD—where there are the amenities, access to transit and higher density—and the suburban markets,” he said. “Those tenants don’t really want to be out there, they want to be in the core where they can compete for jobs…but [they] will pay incredible amounts to get the best real estate, because they need the employees.”

And across the lake in Seattle, also, landlords are beginning to adopt new strategies when it comes to assessing whether or not to take on potential tenants, with landlord concessions continuing to play a role. According to Shephard, the Seattle market is one currently dominated by landlords rather than tenants. “It’s a landlord’s market right now; we’re seeing the smaller tenants getting the bad end of the stick and getting shoved out of the market, because landlords are looking at the bigger blocks of space,” he said. “Landlords are also forcing tenants into longer-term commitments. It’s a mismatch in the market, where companies are coming up from the Bay Area not so sure how big they’re going to become…the tenants want a 3-year commitment, and the landlords are asking for a 10-year commitment,” he said.

Another factor that continues to impact landlords’ decisions about the available inventory is the continually-growing presence of WeWork. And the dynamics behind co-working have evolved as a result of the tech-based co-working and office space provider, according to Schwartz. “Old view of co-working was that it was one- and two-person offices where you’d go to get services and amenities. In today’s world, co-working is part of today’s corporate real estate strategy,” he said. “[Co-working] not just taking an office and putting seven people into it; WeWork is leasing buildings and putting Amazon or IBM in there, which allows corporate users to maintain their flexibility. Landlords are willing to do short-term leases.”

And WeWork’s presence in and around Seattle shows little signs of slowing. Based on a Seattle Office Market Overview from third quarter 2017, WeWork leased 73,000 square feet at the Hines-owned Fourth & Madison building in Seattle and also took 54,336 square feet at Hudson Pacific’s Hill7 in the active Denny Triangle area. Most recently, in mid-April 2018, the company leased the entire 61,000 square foot Watershed building in Seattle’s Fremont neighborhood, according to a report by the Puget Sound Business Journal.

While in some respects the current market is overwhelmingly driven by the landlords rather than their tenants, proactive discussions between both parties is a factor that might begin to level the playing field looking forward, according to Schwartz of CBRE. “We’re trying to understand the ownership parameters to advise our clients in terms of what the motivations of the building owners are and starting this long-term discussion about whether they have a long-term strategy in place about how they want to reconfigure their workplace environment. A big piece of it is setting the stage and managing expectations right out of the gate,” he said.

Workplace design and configuration is a factor that across the board is influencing tenants’ decisions, an especially ever-present consideration in the tech sector, which continues to drive demand in the broader market. “What’s critical is what’s going on in the workplace and how tenants are utilizing the workplace. Tech tenants are leading the trend in reinventing the workplace, and are bringing along the more traditional office users, like law firms, to adopt these open floor plans and leverage amenities,” he said. “Supply is constrained, which requires that tenants get ahead on their planning. Under these market conditions, tenants really need to be looking 2 to 4 years in advance.”

According to CBRE’s 2018 “Americas Occupier Survey Report,” which included 138 responding companies (26 percent in banking and finance, 21 percent in tech, 11 percent in professional services and 9 recent in healthcare and life sciences), standards and expectations around workplace configuration continue to evolve. 45 percent of respondents anticipated migrating to an activity-based workplace curated for employee effectiveness; 52 percent of respondents anticipated implementing some level of unassigned seating in their workplace to promote greater space efficiency; and 81 percent of respondents perceived amenities as integral to the employee experience and encouraged landlords to enhance these offerings to their employees.

With the technology sector leading the way when it comes to pioneering workplace design, a wide array of technology companies—not just the big hitters like Amazon, Facebook, Google and Microsoft—are moving to the Puget Sound region. This means that geographical shifts are occurring and more pressure is putting more pressure on markets to northern and southern markets outside of Seattle and Bellevue. In the longer-term, the further-out submarkets might appeal to tech companies moving to the region due to the dearth of available inventory in the downtown core, according to Sweeney. “Bothell has a vacancy rate of 18 percent, and the Eastside vacancy rate is 8.7 percent. If there’s a 50,000 square foot case study in Bothell, not every company is a Facebook or a Google; there are [also] insurance companies and airplane manufacturers,” Sweeney said.

In spite of of the greater variety of tech companies locating in the Puget Sound region—in both Seattle and the Eastside—Facebook nonetheless remains a significant presence. “They are gobbling up everything they can to satisfy their requirements,” Sweeney said. On March 13th, 2018, Facebook expanded its footprint in Seattle by announcing the opening of its new 6-story 150,000 square foot Westlake office in South Lake Union, which is right across from the company’s office at Dexter Station, a roughly 346,000 square-foot, 10-story Class A office building that the company has occupied since early 2016, and which is now home to approximately 2,000 employees. And in December 2016, the company signed a lease with Vulcan Real Estate for the 384,000 square foot Arbor Blocks campus in the heart of South Lake Union. In January 2018, the company acquired two high tech/flex buildings totaling just over 72,000 square feet for $20 million from Redmond-based Crane Aerospace Inc. Facebook has amassed nearly 700,000 square feet of office space across a number of properties around Redmond’s Willows Road, according to sources with direct knowledge of the company’s activities in the region.

While much of the coverage concerns tech companies taking up space in the Seattle and Bellevue central business districts, markets to the north and south will be seen as more viable alternatives moving forward as space continues to be constrained in the downtown cores. The panelists highlighted three cities in particular—Everett to the north of Seattle and Tacoma and Renton to the south—which might experience more activity as employment hubs in the coming months. But as is often the case with technology companies’ strategies, there will have to be a first to precipitate a trend further afield from Seattle’s downtown core, according to Schwartz. “I expect that Everett and Tacoma will become urban centers, but some company is going to pioneer this. You need critical mass to make it work,” he said. “It’s a gamble, and each of these users will study the labor force and make an informed decision about where they can be located based on where they will be able to attract the talent.”

In terms of attracting and retaining companies, prospective employers in both the Seattle and Eastside markets will have a number of factors to consider moving forward. One of the significant trends dictating the employee base on both sides of the lake are differing employee demographics, according to Sweeney. “We’re seeing a difference along demographic lines. If millennials are your target employee, [companies] will go to Seattle, while the Eastside is known more for the schools (seven of the ten top high schools in the state are on the Eastside) and longer-term family-oriented employees,” he said.

In either case, Sweeney thinks that the fact that Seattle is by most account maxed out means that a greater consideration will need to be given to large-scale companies like Amazon moving forward. “There’s no clear pattern, but Seattle is pushing out businesses, and the city has to consider how it treats big businesses.” The tech giant’s impact in Seattle, in particular, has come under the spotlight in recent months, especially given the company’s announcement about its search for a second world headquarters in fall 2017. According to JJ, Amazon’s footprint in the Puget Sound region currently totals around 12 million square feet, and the company has plans to increase its footprint to 15 million, roughly the same size of Microsoft’s presence on the Eastside.

As Amazon continues to take up more space in the region, greater consideration is also given to the wider implications of the extensive growth occurring throughout the region. The panelists’ discussion ultimately shifted to how tenants will accommodate for growth in Seattle and on the Eastside: in terms of development capacity, expansion to the north or south is the only logical choice remaining. SODO—just south of Pioneer Square—and the University District represent two areas where future development is a possibility, according to Shephard. “We have some constraints, and growth will either go north or south since I-5 divides [Seattle]. SODO seems the next logical step for the city to allow development, but he challenge is that the area is not zoned for commercial.”

Shephard also sees potential for the evolving U-District to the north. “The next big stop on the light rail is the U-District, which is an untapped area,” he said. And the neighborhood continues to evolve: on Monday, April 9th, an 8-parcel property totaling 41,200 square feet and located at 4202-4238 12th Ave NE was brought to the market as a redevelopment opportunity. According to Colliers Seattle’s Multifamily Property Advisors team who marketed the property, “Campus Station”—which can accommodate either 549 market-rate units or 372 units of student housing—is the largest single-fee assemblage brought to the market since the U-District was up-zoned in early 2017.

In the longer term, there is a sense that in the case of a downturn in the commercial real estate market landlords looking to establish their presence in the Puget Sound region will take a more protective approach. According to Sweeney, “The end of a market is categorized by defensive leasing, even though [landlords] don’t need [the space]; there’s a feeding frenzy, and there will be some shadow space. Landlords have to remain humble and do the right thing to lock in long-term rates,” he said. “The only difference that I’ve seen in this cycle that I haven’t seen before is that we’ve absorbed all our supply.”

As has been the case over the last several years in particular, the strategies and characteristics of tech companies will continue to play a significant role in shaping the commercial real estate market. Taking a longer view of the market, Sweeney predicts that the biggest risk—and potential bubble to pop—is posed to smaller tenants rather than the more established ones. “A lot of the companies that aren’t profitable or have been funded by venture capitals have had a fair run. I think that if there’s a bubble, it’s a smaller one bubble [involving] some companies who aren’t making it,” he said.

And even though the more established companies like Amazon might themselves be insulated from a potential downtown in Seattle, there is a fear that the city itself might not be so lucky, having depended on the tech sector—Amazon in particular—for so long, according to Shephard. “Amazon is our dominant tenant, and if the company decided to put one or two buildings on the market for sublease, it would change the market overnight,” he said. “Our Achilles heel in Seattle is that we’re so tech-centric. If we have a downtown in tech, we’ll definitely feel it more-so [here] than other national markets will.”