COVER STORY, APRIL 2008

CHICAGO CBD FINDS BALANCE
The various forces at play in Chicago’s thriving CBD office market have found an equilibrium.
Kevin McLennan

If the Chicago central business district (CBD) office market had a horoscope, it would read something like this: The forces are in balance.

The ever-shifting fulcrum point between landlords and tenants has found its way to the middle, thanks to a combination of market fundamentals, economic factors and an increasingly powerful player on the scene.

Market Fundamentals

By the close of 2007, overall vacancy in the CBD had dropped to 11.5 percent, down from 13.8 percent at the end of the year’s first quarter. Net absorption for the year totaled 3.2 million square feet, with Class A space dominating. Among the major leases of 2007, William Blair & Company signed for 334,500 square feet at Hines’ River Point, and law firm Skadden, Arps, Slate, Meagher & From leased 192,143 square feet at The John Buck Company’s 155 Wacker Drive.

As space availability tightened, rental rates rose, most significantly in Class A properties, where they now reach the high $20s or low $30s net per square foot. The top tier of new construction is soaring even higher, with Buck asking $33 net per square foot for its vacant high-rise space at 155 Wacker Drive. Class B properties are feeling the upswing as well, rising to $18 or $19 net per square foot, up from $14 to $16 per square foot a year ago.

The balance will shift, however, as 4.5 million square feet of new office construction is scheduled to come online between mid-2009 and 2012. New construction includes Mesirow Stein’s 353 North Clark, the expansion of Blue Cross Blue Shield’s headquarters at 300 E. Randolph St. and Prime Group Inc.’s proposed tower at 400 W. Randolph St. The looming influx of development has triggered a parallel response from landlords and major space users: longer leases, negotiated earlier.

Economic Factors

Both tenants and property owners are seeking to hedge their long-term risk against economic uncertainty. While unemployment remains relatively low, the weak dollar, credit crunch and rising cost of goods have set the stage for a recession. Owners accustomed to buying properties and selling at a profit now fear they will be left holding assets with declining value. Seeking stability, owners want to lock in large-scale, credit-worthy tenants for the long term.

For their part, major space users, now faced with escalating rents, want to lock in their occupancy costs. Tenants in the best position to take advantage of the situation are well-established companies with significant space requirements. In first-quarter 2008, tenants looking for 80,000 square feet or more in the CBD could find 18 blocks of Class A space available, 3 million square feet in all, not including new construction. Space consolidation by Bank of America and Northern Trust may create additional openings at 135 South LaSalle and 540 West Madison.

The competition for large tenants is keeping deal terms rational. Rents are rising enough to generate positive returns to the landlord, but not beyond what the market will bear. Tenants are satisfied they’re getting what they pay for — great space in a premier building in a prime location, all critical to an emerging force in their decision-making process.

The Third Party

Traditionally, tenants and landlords have driven the real estate market. Now a third party is making its presence felt: the talent.

More and more, the desire to recruit and retain top talent motivates tenants’ real estate decisions. The drive to hire and keep the best has helped reverse the flow from the suburbs back to the CBD. Focusing on convenient commutes, employers are gravitating toward the West Loop, especially along Wacker Drive. The East Loop, once struggling, is again holding its own as companies such as Microsoft put down stakes near Millennium Park and the new downtown residential towers, with easy commutes to popular North Side and South Loop neighborhoods.

The quest for talent also is accelerating the trend toward green design. Tenants are coming to realize that “green” means more than energy and cost savings. By opting for space with sustainable design features, companies communicate a corporate culture attractive to a forward-looking professional team. They also reap the tangible benefits of green building technologies, including more natural light, better air quality and, as studies increasingly suggest, enhanced staff performance and productivity.

Not surprisingly, green building systems are more common in newer properties, and sustainable design features add to build-out costs, already up to around $50 per square foot, a 20 percent increase compared to last year. The added costs might once have dampened interest in green space, but, despite the economic tremors, today’s tenants are standing firm. They want what they want, and they’re ready to pay a fair price to get it. Taking advantage of longer lease terms helps make the increased build-out and occupancy costs more manageable.

Watch and Wait

With the economy teetering, and tenants and landlords in equilibrium, expect real estate activity to stagnate during 2008 and 2009. Landlords are ready to make deals but not bad ones; tenants are exploring their options earlier but weighing them carefully. For most, this is a good time to track the market, evaluate long-term needs and hold for the right opportunity. To borrow another page from the real estate horoscope, watch and wait.

Kevin McLennan is senior vice president of Chicago-based Steinco Corporate Real Estate Advisors, a national corporate real estate firm.

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