FEATURE ARTICLE, DECEMBER 2007

STORMY WEATHER AHEAD FOR WINDY CITY?
The Chicago office market could experience some growing pains in 2008 as it weathers rent and absorption issues.
Kevin J. McLennan

As the U.S. economy continues to extricate itself from the current credit mess, real estate executives are left to make sense of chaotic fundamentals and what they mean on a microeconomic scale. With 2007 creeping to its end, many are scrambling to answer: What will the year ahead bring for the Chicago office real estate market?

The answer is not simple. The upcoming year will bring much of the same as 2007 — slow change and cautiousness. The office market in Chicago is going through a maturation process as it begins to grow into its frame. As the third-largest real estate market in the country, the Windy City is driving towards its potential with opportunities that, if capitalized on correctly, can propel the city’s real estate market into a powerhouse for real estate investors and tenants alike. 

Still, several fundamentals are staggering when looking at the Chicago office market. With a vacancy rate hovering above 12.5 percent and tenant activity slowing down, construction has increased. Because there is nearly 4 million square feet of Class A product set to come to market beginning in 2010, new owners are attempting to shift net rental rates upward. With tightening lending standards and higher debt costs, new owners of assets are walking a thin line. Deals are getting done, albeit with negative net effective returns.

This trend will have an impact on the market in 2008. Artificial increases in net rents and a decrease in concessions have left an otherwise weak market confused. This year, Chicago experienced the largest real estate transaction of its kind — the sale of Equity Office Properties. The residual effect of that and other transactions will be felt much like a rate change by the Federal Reserve, over a 12- to 18-month period.

Net absorption is modest and new construction is outpacing the strongest of markets. Most astonishing is that, over the last 18 months, office buildings have traded at record prices yet net rental rates have not followed. Market research team shows that between 2009 and 2012, more than 16 percent of all tenants in Chicago will have leases expiring. Based on the prices at which buildings have recently traded, this is a staggering figure that may pose problems for new owners.

A hypothetical example outlines why these sale prices are staggering, and a cause for concern. If an investor secured a $314 million mortgage at 6.40 percent (150 basis points over the November 2007 LIBOR) using a 25-year amortization schedule, assuming creative financing techniques are not a factor, the investor would owe the bank $25 million each year to cover the debt. This equates to approximately $16.05 net per square foot. After factoring in tenant improvements, commissions, free rent and vacancy, the owner would need in excess of $20.00 net per square foot in rent to cover all expenses.

Furthermore, in looking at averages using data from the top 5 building sales since 2006 (see chart below), the figures show an investor appreciation for the Chicago market. Investors are scooping up properties that have strong fundamentals. This is a result of the deals struck over the last 24 months, including early lease renewal and long-term extensions with rate reductions. The pro formas of buildings in metro Chicago have never been stronger.

The key to getting a finger on the pulse for the Chicago office market is not to get too caught up in the general data that’s published, but to dissect on a microeconomic level the velocity of each submarket. The reported numbers (vacancy, rental rates, absorption) can be misleading and often times lead to improper conclusions. Figure A, from CB Richard Ellis, could lead one to draw a conclusion that each downtown Chicago submarket is strengthening — rental rates are going up and concessions are down because of declining vacancy rates. I don’t dispute that — fully. Do the numbers apply to all office tenants? Are tenants in 12,000 square feet of space in the same boat as 80,000-square-foot tenants? I would point out that the market is quite different for a 12,000-square-foot tenant that is looking for standard office space in the West Loop. Figure B illustrates how the space opportunities in downtown Chicago are dispersed.

In 2008, look for the Chicago real estate market to adjust to changes in the economy at little slower than the rest of the nation. As economic indicators improve, Chicago will be positioned to proceed with a positive outlook. New real estate developments will be closer to completion and tenant rent expectations will move more in line with reality. The rhetorical questions that will be asked at the end of next year will deal with all of the Class A space left behind by tenants moving to the new office buildings (see Figure C). While it would be wonderful to have the ability to predict the future and answer that question, in Chicago, the real estate market changes with the wind.

Kevin J. McLennan is a senior vice president of finance for Chicago-based Steinco Inc.

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