Power play for trophy space

Five years ago, Thomas Properties Group was in need of a $50 million cash infusion for its Center City trophy office complex Commerce Square.

It had several tenants with leases that were maturing and those firms had occupied their offices for two decades. The landlord needed the money not only to try to retain the companies and spend millions updating their spaces but to make other routine maintenance on the two-building property.

Money wasn’t so easy to come by at what was then the height of the recession and credit crunch but Thomas Properties found an eager company to lend it a financial hand: Brandywine Realty Trust.

After several months of negotiating, Brandywine struck a deal in 2010 to give Thomas Properties $25 million for a 25 percent equity stake in Commerce Square. The arrangement also gave Brandywine the right of first refusal to buy the 1.9 million-square-foot complex if Thomas ever wanted to sell.

It was that deal that secured Brandywine’s ability to quickly become the dominant landlord of trophy and Class A office space in Philadelphia and has caused brokers representing firms looking for space to worry there’s not enough competition in the market.

A shifting strategy

Thomas did decide to sell Commerce Square and Brandywine closed on the $331.8 million acquisition of the property last December and, overnight, Brandywine monopolized the Center City trophy market with 6.7 million square feet, or 51 percent of that category of space.

“Our platform downtown is to control as much of the good quality inventory as possible,” said Gerard H. Sweeney, president and CEO of Brandywine.

That strategy is in stark contrast to where the company was a decade ago.

Brandywine’s brand was synonymous with your run-of-the-mill Class A and Class B suburban office buildings in areas surrounding Philadlphia such as Exton, Plymouth Meeting or Mount Laurel, N.J.

That platform wasn’t good enough for Wall Street, which wanted the real estate investment trust to expand out of the mid-Atlantic region. To that end, Brandywine bought Prentiss Properties Trust in 2006 for $3.3 billion. That transaction gave it a stake in the Southwest and West Coast.

It seemed Wall Street grew tired of that arrangement. Brandywine began shedding some its Dallas and Northern California holdings as well as nearly 2 million square feet of its suburban Philadelphia properties. By 2010 the company decided to shift focus. It would concentrate on urban, transit-oriented development and acquisitions. It adopted the strategy after demographic trends showed people of all ages – and particularly millennials – wanted to live in walkable cities with access to mass transit. Now Brandywine is rolling out its business plan in three core markets — Philadelphia, Washington, D.C., and Austin, Texas.

“We try to make the right real estate decision and articulate the reasons for that,” Sweeney said. “We’ve been fortunate that shifting strategies has been fairly well received.”

At no other time in Philadelphia’s history has one landlord owned so much of the city’s high-end office space. Brandywine isn’t settling on what it already owns. It wants more. Its goal here and its other key markets is to control as much of the “good” inventory as possible, Sweeney said.

“We believe in Philadelphia and we believe in its future,” he said. “We look at everything that comes on the market and determine if we can add value, how it fits into our portfolio and does the price point that it is trading at make sense for us.”

‘Control and influence’

The situation has put office brokers who represent tenants on heightened alert. It has meant their negotiating power isn’t as strong with less competition in the trophy and Class A office market.

“Brandywine has a lot of control and influence on the pricing in the market at this point,” said Timothy Monahan, a tenant broker at Savills Studley who co-authored a white paper with colleague Paul Garberson on Brandywine’s ascent as top landlord of Class A space and its implications on the Philadelphia office market. “If a client is seeing space in a trophy asset and all of the proposals come from Brandywine and there’s only one competitor, it has taken a lot of leverage out of the market and pricing.”

Monahan and Garberson say rents have already started to creep up and attribute that to Brandywine’s aggressiveness. Rates in the trophy market would typically increase about .5 percent a quarter and now it’s 1.2 percent per quarter.

“The market is tight but there has been no increase that correlates with the market tightening,” Garberson said.

Monahan believes the turning point with rents ratcheting up came with a lease Brandywine struck with Reed Smith at Three Logan Square. Rather than 50-cent annual bump-ups, the law firm is swallowing 75-cent rental increases.

“That dramatically affects the rent over the term of a lease,” he said.

In general, it’s difficult for a single landlord to control most of the trophy inventory in a major city. It can be done in one of two ways, said Jack Corgel, a professor of real estate at Cornell University. One approach is to buy sequentially over a long period of time as properties become available or through the acquisition of other real estate companies or portfolios where two or three of these assets are being held, he said.

“They don’t come up very often and it takes some work to get a position like this,” Corgel said.

Whether it’s a good thing or a bad thing depends on where one stands. Wall Street prefers that real estate investment trusts concentrate on a property type.

“Investors want companies who are focused and a company like Brandywine is always interested in making shareholders happy,” Corgel said.

There are benefits to having a deep pocketed real estate company own so many buildings since it can finance improvements for building maintenance or for fitting out tenant space. It also gives a company leasing space in one of Brandywine’s buildings the ability to stay within Brandywine’s portfolio.

The concentration of space in a single market does expose Brandywine to some risk, Corgel said. If something catastrophic happens in Philadelphia or a major tenant moves out of a building, it could cause vacancy issues for the company. It also means Brandywine has some degree of control over rents.

‘A brilliant strategy’

“It’s a brilliant strategy that can’t be executed in any other top 10 city in the country,” said Glenn Blumenfeld with Tactix Real Estate Advisors, which represents tenants in lease negotiations. “As far as options go, who the owner is doesn’t change the analysis. What it does change is the pricing. If one landlord controls a material portion of a submarket there’s less competition in that market.”

Similar dynamics are at work in Radnor, where Brandywine owns a majority of the office space.

Sweeney isn’t convinced Brandywine has enough power to influence rents since there is competition in the Philadelphia office market.

“I wish we were in the position to control rents,” he said. “The myth of control is it brings more positive pricing for a landlord. The free market system allows pricing to find its common denominator.”

Even Brandywine’s buildings compete among each other since the company has a tiered pricing system for the portfolio, Sweeney said. One, Two and Three Logan are the price leaders in the mid-$30s a square foot, Commerce Square follows and 1900 Market St., once it is redeveloped, below that. FMC Tower is at the very top since it’s new construction.

Investors and analysts seem pleased over all with the way things are going. Brandywine’s stock price has steadily risen over the last five years and its 52-week high was $15.42 compared with a low of $12.33 a share.

With this dynamic at play in Center City or even Radnor for that matter, what’s a tenant to do? Start looking for options way in advance of a lease expiring.

“The more time you have in front of a deal the more leverage you have,” Monahan said.

GLOSSARY

Trophy Building: A landmark property that’s highly sought by investors and tenants.

Class A: An office building with asking gross rents based on a specified range between the top 30 percent to 40 percent of the office rents in the market.

Source: NAIOP

Source: Philadelphia Business Journal