Flex space back in the race

Slowdown since '03 ending; vacancy rate at 5-year low

Surging office rents are causing more investors and developers to return to a somewhat forgotten frontier: the flex market.

Just ask Adam M. Lutz. His Farmington Hills, Mich., firm is the latest to bet that flex space -- property that can be used for offices, warehouses or light manufacturing -- is ready for a rebound in the Triangle.

Lutz Real Estate Investments partnered with Capri Capital Partners to pay $56.3 million for 11 flex buildings in Morrisville and North Raleigh.

The 631,582-square-foot portfolio is just 79 percent leased.

"There's going to be a little sticker shock in offices," Adam Lutz said.

"You'll see tenants who don't want to pay big rents but are used to nice space," he said. "We think the time is right for these business parks to be a great alternative after rates in the office market are pushed."

A few years ago, it was the other way around. The tech bust turned parts of the Triangle into a ghost town of empty offices. Landlords slashed rents and offered incentives such as months of free rent and interior construction. That enabled many flex tenants -- particularly cost-conscious startups-- to migrate to fancier offices for a fraction more.

That was one reason the Triangle flex vacancy rate surged from 7.9 percent in 2000 to 20.1 percent three years later, according to Karnes Research data.

But the office market has turned in the landlords' favor. Surging demand, rising construction costs and a string of high-dollar office sales have forced office rents skyward -- a recipe that many brokers and investors think will drive tenants back to flex.

The Triangle office vacancy rate sank to 11.6 percent in 2006 -- the lowest in five years. Meanwhile, average rents rose 4 percent to a record $19.13 per square foot. Rents in new buildings are climbing north of $25 per square foot.

The migration to flex appears to have begun. The Triangle's flex vacancy rate dropped to a five-year-low of 14.4 percent. Rental rates have climbed to a five-year high: $9.79 per square foot.

"More tenants are going to start looking at flex," said Brian Reece, a partner at Karnes.

He thinks more developers will throw money at flex, too.

During the four years ending in 2003, Triangle developers built 2.2 million square feet of flex space. Since then, developers have built one-tenth as much.

The 61,768 square feet built in 2006 were the most in any year since 2003.

"We've seen development drastically slow down," Reece said. "Now that's back. And we're going to see more and more flex as long as office [rent] goes up."

That's where investors such as Lutz might have an advantage.

High construction costs are expected to create a wide gap between rental rates in new space and rents in existing space.

Lutz, which plans to upgrade the Morrisville buildings and rebrand them as EastRidge at Perimeter Park, can raise rents while remaining below the price of new flex space.

"We like the flexibility," Lutz said.

The deal, which includes eight buildings on Perimeter Park Drive in Morrisville and three buildings on Spring Forest Road in Raleigh, is the latest to signal renewed faith in the Triangle's once beleaguered industrial property market.

Investors spent about $270 million on warehouses and flex space in 2006 -- almost three times the annual average in the past 10 years, according to CB Richard Ellis data.

More deals like it could follow. And Lutz might be in the bidding. The company started chasing flex deals two years ago, seeking better returns than it found in the overheated office-investment market.

"Some people who rode it through the tough times see it as time to get out and catch a price where they're happy to exit," Lutz said. "We see it as a time to get in."