High-priced real estate

With area office building space availability tight, will the next wave of Class A structures lure tenants prepared to pay top dollar?

In the first quarter of this year, the vacancy rate for Class A space in Nashville hit an all-time low.

With vacancy at 5.2 percent — it rose ever so slightly to 5.4 percent in the second quarter — rental rates for the top-end office space spiked as well. Rents for existing space in the always-desirable Green Hills, for example, passed $30 per square foot, while the average across the market was about $24.

Nashville's emergence as a hot city has been well documented during the last 18 months or so. Indeed, Music City has rebounded mightily from a recession that affected its Sun Belt cohorts far more negatively.

But being hot comes with its own set of problems.

New arrivals to the office market want the best space. Similarly, companies riding the wave back to the top want to upgrade.

For much of the last decade, Class A space was built-to-suit. The first wave of corporate relocators demanded, and landed, top-flight buildings and they occupied them to the hilt.

New buildings were being built for new arrivals — a zero-sum game. What speculative office product was built was gobbled up quickly, as well.

But now the market is trying to absorb more Class A tenants with minimal Class A space to spare.

The Cool Springs and Brentwood markets have a combined vacancy of less than 5 percent. That's driving lessees into the central business district where, even still, Class A vacancy is in the double digits. But if the reverse exodus continues, it won't be for long and with little expected in the way of delivery, it won't be north of 10 percent indefinitely.

Just before this issue of Nashville Post magazine went to press, North Carolina's Highwoods made news twice in the span of a few days.

First, it announced Ovation, a massive $700 million mixed-use project in Cool Springs. Days later, the company emerged as the likely purchaser of The Pinnacle at Symphony Place, with a price expected to be approximately $290 per square foot, a boffo record price for downtown office space. And this for a building with 16 percent vacancy.

But with a tight market in Williamson County — some of which will be alleviated down the road by Ovation and other huge new projects along Interstate 65 — and with tenants looking to downtown, Pinnacle (the central business district’s most recently completed Class A space) will be an attractive target. Highwoods can use the skyscraper as a cash cow to cover operating expenses while building its replacement.

Highwoods represents for Nashville the new kind of investor in Class A space: an out-of-town entity with money. According to tracking from Cushman & Wakefield, the past five years have seen $1 billion in investment sales in the Nashville market, with about $400 million of that recorded during the record year of 2012. Now 2013 likely will break that record.

Interest rates are still low and banks are becoming more eager to lend. Meanwhile, long-time owners are becoming less risk averse at a time when Nashville is emerging nationally as a hot market.

While tenants are moving in a bit of a circle — notice Tractor Supply and LifePoint moving from older Class A space to new $50 million built-to-suit space — the money is flowing in from the outside.

Couple that with the broader building market — back on the uptick, especially in Nashville where the supply of homes is low and homebuilders are trying to catch-up — and build-out prices for Class A space is on the rise.

Even in existing space, a new tenant means different demands: interior walls created to slice a floor plate into offices.

An office is an end product. And before that chain reaches its end — whether with sparkling new space downtown or in Cool Springs — lumber has to be purchased, gypsum has to be fashioned into dry wall and steel has to forged into beams.

Nashville-based Louisiana-Pacific totaled  first-quarter sales of $538 million — a 49 percent increase over the same quarter in 2012 — but noted an 82 percent increase in prices for particleboard on the futures market.

At the same time, the price of gypsum — a key component in drywall and concrete — went up 30 to 35 percent at the beginning of this year.

And steel — a bigger concern for commercial builders than for residential ones — is facing tougher problems.

Increased demand, plus furnace outages in Ohio and Brazil and a labor dispute in Ontario, drove prices to $630 per ton in early July, a 10 percent increase from its low point this year. Prices dove in the spring as China came to the end of its growth cycle and Europe's economy continued to struggle.

As an example in the increase for build-out, look to One Nashville Place. In December 2012, Tenant Building Group refurbished 14,000 square feet for Walker Tipps & Malone for roughly $21 per square foot. Just eight months later, Solomon Builders charged Transcore about $25 per square foot for a rehab in the same building.

Not only are rents rising, but up-front costs just to secure Class A space are as well.

All of this should stabilize during the next 24 months. The Pinnacle sale should be the last of the Class A buildings in downtown to sell for some time, setting the market for investment through the next cycle. Delivery of the LifePoint and Tractor Supply headquarters will open space at their existing buildings — older Class A space that will attract expanding Class A users and upgrading Class B tenants. Building suppliers will amp up work to deliver necessary material for this round of construction, and externalities in those industries will either disappear or become the new reality, both outcomes having the same result: a more predictable market.

Eventually, cranes will be visible at the Midtown site of West End Summit and the Gulch site of Gulch Crossing, buildings that will wrest from Pinnacle the title of "newest Class A space."

And the question then will be not, "How much is Class A costing today?" but instead, "Who is the newest Class A user?"