We’ll start with a short quiz to ask whether you’re seeing some correlation here:
Two years ago, the Tucson Office Market was experiencing a 12.5% vacancy rate (CoStar). Last year, when this same article was prepared, the vacancy rate was 12.9%. Today, it’s 13.1%.
Two years ago, the average quoted full service rental rate was $18.52. Last year, the average rental rate was $18.50. Today, it’s $18.41.
Two years ago, according to the U.S. Department of Labor - Bureau of Labor Statistics, the Tucson Metropolitan Area unemployment rate was 6.7%. A year prior to that, the unemployment rate was 6.4%. Today, it’s 6.6%.
Yes, the answer it that the numbers aren’t changing very much. They’re actually moving a bit in the wrong direction for that of an improving market. The bottom line… Tucson is not creating jobs. It’s really pretty simple. Without new jobs, there’s no reason for an increase in demand for office space. Fortunately, this is “Tucson,” a market that WILL see good times again, but it’s going to be a slow road, something we’re just not used to.
In spite of the overall lack of new jobs, we are seeing some positive activity and expansion. Genesis OB/GYN, Grand Canyon University, Saguaro Physicians and HDR Engineering, all experiencing some growth, moved into larger spaces. Regus, a provider of furnished office space for start-ups to Fortune 500 companies, entered the market, taking an entire floor at 1 S. Church. And, there are others. Better properties continue to attract and retain the majority of tenants looking to move or renew. Given that tenants today can move into better space for the same, and sometimes less, rent than they were paying, it’s no surprise. Tenants looking to renew their leases typically find that they can significantly reduce their rate and/or negotiate some excellent lease concessions in the process. Again, as stated above, in time the tides will change… be ready!
There was limited activity in office investment sales due in large measure to lack of quality product. Larsen-Baker’s purchase for $9.1 million of MDA’s 82,942 square foot former national headquarters at 3300 E. Sunrise Drive was perhaps the most noteworthy transaction. Brokered by PICOR, this $110 per square foot sale helped to define overall market valuation. The vacant Class A+ building is being repositioned by the buyer for lease to high-end tenants. On the other hand, the on-line auction.com offering of the 152,314 square foot Tri Pointe Plaza did not transact because bidders failed to meet the seller’s reserve, which was likely in the $9 million range ($60 per sq ft). When that outcome is contrasted with Tri Pointe’s 2005 sale for $20.9 million ($137 per sq ft), we see dramatic illustration of the marked devaluation that has occurred in investment office property as a consequence of the Great Recession. As go rents -- down-- so goes value. While it appears that rents are now stabilized, the conditions of the continuing ‘tenant’s market’ pressure Landlord s to accept reduced rent income, as well as funding rent abatement and tenant improvements.
Amidst this value-oriented environment, several owner-users have decided that this is the right time to buy. Occupying about one-half of the 44,734 sq ft Casas Adobes offices at 6840 – 6860 North Oracle, Pima Federal Credit Union elected to purchase the entire property for $7.8 million ($174 sq ft), Other notable owner-user transactions were Rick Engineering’s purchase of their 16,900 sq ft office at 3945 E. Fort Lowell for $3.5 million ($207 sq ft), of which 7,800 sq ft is leased to 3rd party tenants, and Truly Nolen’s acquisition of the 27,240 sq ft office property at 432 S. Williams Boulevard for $2.55 million ($93 sq ft).Truly Nolen reportedly will occupy the entire campus as tenant’s leases lapse, and construct an additional 25,000 sq ft building on the 6.75 acre site. During the next year, we anticipate that we’ll see additional owner-user acquisitions due to the unique opportunity to buy well below replacement value, secure extremely favorable financing, and strike agreements with current owners who prefer to sell in the face of their property’s distressed valuations (often in the face of lender pressures).
Looking back at our Trend report of last October, while we see many of the conditions we cited then as influencing the medical office market remain relevant to the 3rd quarter of 2014 and for the foreseeable future, there are new forces on the horizon that may bring dramatic changes to the profile of healthcare in Pima County. There have been no final announcements to date, but discussions with new partners by two of Tucson’s healthcare groups; Carondelet with Tenet and Dignity Healthcare and University of Arizona Health Network with Banner Health, would introduce a new era of investment, expansion and competition in the healthcare marketplace. The U of A Board of Regents has announced more details on the Banner Health merger which suggest an unprecedented level of investment in programs, physical plant and endowments. It will be extremely interesting and exciting for Tucson and Southern Arizona if these plans come to fruition.
Demand for medical office space continues to outperform the general office market. Federal health care policy has produced an increasing population of citizens who can access healthcare services. Those individuals need healthcare professionals in medical office settings to serve them. Acute care hospitals throughout Tucson are at the center of demand for medical office and clinical space. Specialties in orthopaedics, ob/gyn, cardiology, oncology and neurology choose to cluster on or near hospital campuses for access to their hospitalized patients and for special services hospitals can provide.
The behavioral health services sector continues its rapid expansion. Several local organizations are experiencing significant growth and planning for new facilities. Universal Health Services acquired Tucson Medical Center’s Palo Verde Behavioral Health hospital and is commencing construction of a new 15,000 square foot facility to expand capacity from 48 to 84 beds.
On the financial front, conditions have yet to improve significantly. While rents achieved in medical space are generally 15% higher than those for general office space, landlords still wrestle with high improvement costs against rents that continue to be flat. Looking at the glass as half full we are optimistic about prospects for the last quarter and for 2015.