COVER STORY, DECEMBER 2011
While the real estate recovery faces headwinds, savvy investors refuse to write off the Midwest.
Matt Valley and Liz Burlingame
From the financial crisis in the euro zone to Standard & Poor’s downgrade of the U.S. credit rating to the Occupy Wall Street protests, it has been a noisy and contentious 2011. But amid the tumultuousness, the commercial real estate industry has quietly marched toward stabilization. The combination of rising demand for space and little or no new supply is driving the recovery.
While loan workout specialists and court-appointed receivers will remain busy in 2012 as many property owners undergo a painful deleveraging process, the recovery is methodically gaining momentum. Rather than shy away from the Midwest, as many pundits advise, savvy investors are mining opportunities across the region. What follows is a forecast for each of the five main property sectors.
As employment goes, so goes the office sector. With job growth occurring at a tepid pace, the office recovery has been slow to materialize following the Great Recession. The U.S. economy created an estimated 80,000 jobs in October, a relatively low figure more than two years into a recovery.
Against that backdrop, the national office vacancy stood at an unhealthy 17.4 percent in the third quarter, reports New York-based Reis. Many Midwest markets posted vacancy rates well above the average, including Detroit (26.7 percent), Cincinnati (20.6 percent), Minneapolis (18.9 percent) and Chicago (18.8 percent).
Of 12 major metros tracked by Reis across 10 states, only Omaha (15.3 percent) and Kansas City (17.2 percent) outperformed the national average.
The Midwest office market is likely to experience marginal improvement in 2012, forecasts Ryan Severino, chief economist for Reis. He expects the vacancy rate in the region to decline by about 30 basis points over the next 12 months and rents to slightly improve. “The Midwest is in a bit of an unfavorable position relative to the country because it is still contending with the erosion in the manufacturing sector that has been occurring for decades,” he says.
The suburban office sector has been particularly hard hit. Troy, Mich., for example, was once a stellar submarket in metro Detroit that enjoyed less than 5 percent vacancy in the 1990s. That was before the U.S. auto industry and related companies fell on extremely hard times over the past decade, and before many financial firms contracted amid the global credit crunch. In the third quarter of this year, the office vacancy rate in Troy stood at 30.2 percent, according to Grubb & Ellis.
“[Troy] has the best office product, it has the most affluent demographics surrounding it, and it has suffered the most,” says Andy Farbman, president and CEO of Southfield, Michigan-based Farbman Group. The company owns 6 million square feet of office space in Southeast Michigan, including 1 million square feet in Troy.
“The reason Troy has suffered the most is that it has had the biggest corporations. And when the biggest corporations shed space, they shed considerable space,” explains Farbman. EDS, General Motors and Chrysler are a few of the companies that vacated space in Troy.
In 2005, Kmart Holding Corp. bought Sears, Roebuck & Co. for $12.3 billion. As a result of the merger, Hoffman Estates in suburban Chicago became the headquarters for the newly combined companies. Kmart vacated nearly 1 million square feet of office space in Troy.
The Farbman Group has successfully capitalized on metro Detroit’s office market woes. The company typically buys buildings that are 35 percent to 70 percent occupied and then aggressively leases up the vacant space. In 2009, the company acquired Riverside Center, a 183,000-square-foot building in Southfield for $5 million, or 15 percent of the cost to build it new, according to Crain’s Detroit Business. Like Troy, Southfield’s office vacancy rate is approximately 30 percent.
At the time of the sale, Riverside Center was 40 percent occupied. Farbman Group was able to attract a mix of tenants, including a health care company, an information technology firm, and a furniture-related business. Today the occupancy of Riverside Center stands at about 87 percent.
“It’s been a phenomenal investment,” says Farbman. “We bought a great product that had been institutionally owned. We marked the rents to the appropriate marketplace, and there was a ton of demand.”
Since buying the former Bell Federal Savings & Loan building in Chicago, the Farbman Group has boosted occupancy from 40 percent to more than 80 percent.
Farbman emphasizes that his firm will not purchase an office building in Southeast Michigan if the deal doesn’t make economic sense from day one. He does not subscribe to the theory that an improving market will lift all boats. “But if you buy the right product, there is real upside to it.”
The company is using the same playbook in Chicago by focusing on distressed properties in the Loop. In December 2010, Farbman Group purchased the former Bell Federal Savings & Loan headquarters at 79 W. Monroe St. from Bank of America Corp. for under $10 million.
Built in 1903, the 15-story, nearly 200,000-square-foot-building was 40 percent occupied when Farbman Group acquired the building a year ago. The Farbman Group has signed new tenants, including a law firm, a psychologist and a non-profit company, helping to boost the occupancy to more than 80 percent.
When conducting due diligence on an office building, Farbman asks himself a critical question: “Will the building adapt to the modern world?” Corporate America is moving toward a more open-air office environment, points out Farbman, and in some cases office buildings constructed in the 1920s and 1930s were designed to meet the needs of today’s tenants.
Farbman is aware that his investment strategy is not for everyone. “Most national investors don’t want to spend time focused on unique opportunities. They would rather make global bets that if they buy a building in a specific submarket, they’re going to make money because the rents are going to do well,” he says. “It’s easier to do that than to come into a Midwest city and try to figure out what’s a good corner, and what’s going to have long-term value.”
The U.S. hotel industry is exhibiting three compelling trends nationwide: limited new supply, continued growth in room demand, and a modest rise in room rates.
“The change in supply is a historic low,” says Jan Freitag, senior vice president with Smith Travel Research (STR) based in Hendersonville,
Tennessee. Indeed, there were 55,000 hotel rooms under construction nationally in October 2011 compared with about five times that amount at the peak of the market in 2007.
STR forecasts a 0.9 percent change in supply in 2012 over 2011 levels. “That is noteworthy because the 20-year average is 2.2 percent, so it’s quite a bit lower than the long-term average,” says Freitag.
The researcher forecasts that demand, or room nights sold, will increase 1.1 percent in 2012. In addition, STR forecasts occupancy to rise 0.2 percent, average daily rate to increase 3.7 percent, and revenue per available room to tick up 3.9 percent.
One concern is that while occupancy is growing at a healthy clip, the rise in room rates has fallen short of expectations. “Some blame the OTAs (online travel agencies),” says Freitag. “Discounting is now so ingrained in the consumers’ minds that you can’t raise rates.” Another explanation for the lag in room rate growth could be that hoteliers were hesitant to push rates when conducting advance bookings in 2009 and 2010.
“There still is a lot of concern that what is happening in the macro economy is going to creep into our sector,” says Robert Habeeb, president of Rosemont, Illinois-based First Hospitality Group, referring to the $15 trillion U.S. budget deficit.
Still, First Hospitality Group expects to post an 8 percent increase in revenues on a year-over-year basis in November at the 50 hotels and two freestanding restaurants it either owns or manages in the Midwest.
The company’s portfolio ranges from the Hyatt Place in downtown Des Moines to a Homewood Suites by Hilton on Grand Avenue in the heart of Chicago to the Residence Inn by Marriott on Arrowhead Drive in Maumee, Ohio.
First Hospitality Group is converting the 125-year-old Loyalty Building in downtown Milwaukee into a 128-room Hilton Garden Inn.
In March, First Hospitality Group purchased two office buildings in downtown Milwaukee, one of which it is converting into a hotel and restaurant. The 125-year-old Loyalty Building, the former headquarters for Northwestern Mutual Life Insurance Co., will become a 128-room Hilton Garden Inn in June 2012. The remodeling of the six-story, 92,000-square-foot building will begin late this year.
“The office buildings of yesterday line up really well with the hotel buildings of today,” says Habeeb. “They generally have nice atriums, and they are very well-appointed [properties]. They are very ornate. You wouldn’t rebuild those buildings today. You probably couldn’t afford to.”
Habeeb says that when trying to forecast the performance of the economy and the hotel industry, the 800-pound gorilla in the room is the impact of government at every level. In January 2011, the Illinois Legislature voted to raise the corporate tax rate to 7 percent from 4.8 percent to help resolve a $13 billion state budget deficit at the time.
Habeeb says that such a move has a “negative effect on people’s willingness to invest in speculative ventures like hotels and certainly has been chasing employers out of the state.”
In November, the Chicago City Council agreed to raise the city’s total hotel tax from 3.5 percent to 4.5 percent, which will result in an average tax increase of $1.78 per room night and raise $14 million annually. “Most people believe that has some kind of negative effect on travel,” says Habeeb. The city’s tax hike on hotel guests was part of Mayor Rahm Emanuel’s 2012 budget, which sought to close a $636 million budget deficit.
Much like the office market, the retail sector will only see modest improvement in occupancy and rents until the labor market is on more solid footing, according to Severino of Reis.
Discretionary spending has taken a hit due to tepid job creation and income growth, Severino explains. “This is especially true in the Midwest where the economic and employment base has been eroding for decades.”
“Retail is the one property type where the opportunities are very local,” continues Severino. “Good opportunities can be found, but the focus needs to be on the asset and the deal because overall the sector will continue to struggle.”
Though construction of retail centers was minimal during the recession, Severino says construction activity is likely to increase next year as the economy slowly recovers.
Retail vacancies in the third quarter across the Midwest were primarily flat or down slightly from the same period a year ago, while effective rents reflected a similar trend, reports Reis.
In Chicago, the vacancy was unchanged in the third quarter on a year-over-year basis, while effective rents fell 0.9 percent. Peter Borzak, managing principal at Pine Tree Commercial Realty in Northbrook, Illinois, says the drop in rents is a sign of a flight to quality as retailers move to stronger locations. In order to keep retail tenants from fleeing, landlords of Class B assets are lowering rents.
Mariano’s Fresh Market recently opened at Village Market, a 105,000-square-foot shopping center located at 333 Benton Place in downtown Chicago.
In Chicago, a growing desire among consumers for fresher or organic foods has helped upscale grocers remain in demand, says Borzak. At the same time, wholesale clubs and lower-priced grocery stores are appealing to shoppers seeking to save money. One rapidly expanding brand in Chicago is Mariano’s Fresh Market, says Borzak, which offers discounted products as well as specialty areas, such as a gelato cafe and sushi bar.
“If you have a site that would work for food, you’re no longer limited to the top one or two traditional grocery stores in the market,” says Borzak. “There are a lot of niche players in that base right now.”
Scott Wiles, senior associate of Marcus & Millichap’s Cleveland office, says auto parts retailers, dollar stores and tenants that appeal to deal-driven consumers are seeking new space.
In the last year, the appetites of buyers on the investment front have also shifted toward more stable and easily identifiable returns.
“Investors and buyers are more prone to accept a lower yield in favor of something that is a guaranteed return, rather than something that is more speculative or based on a presumption that market conditions are going to improve,” says Wiles.
In Cleveland, the retail vacancy rate climbed 120 basis points in the third quarter on a year-over-year basis, while effective rents dipped 0.9 percent. Wiles says that recent development downtown should be a significant traffic generator in the future.
Both the $465 million Medical Mart and Convention Center and Horseshoe Casino in Cleveland will be complete by 2013. Construction will also begin early next year on a 700,000-square-foot corporate headquarters for American Greetings, which committed to relocate 1,750 employees from Brooklyn to Westlake by 2014.
The big question for the Midwest industrial market in the wake of investors flocking to coastal markets to acquire Class A warehouse and distribution space at cap rates as low as 5 percent is what’s next? Consider that same Class A product trades at approximately a 6 percent cap rate in Chicago, 12 percent in Detroit and somewhere in between for many industrial markets in the heartland.
“The spread between cap rates here and the coasts has increased. At what point does it make sense to invest in the Midwest?” asks Rene Circ, national director of industrial research based in the Chicago office of Grubb & Ellis.
“If the economic recovery continues to be sustained or accelerates, there should be some greater allocation toward these markets because not everyone has a low enough cost of capital to pay a 5 percent cap rate for a building,” says Circ. The true cost of capital for many institutions is approximately 8 percent, he adds.
The national industrial market absorbed 23.7 million square feet in the third quarter of this year, the sixth consecutive quarter of positive absorption, according to Grubb & Ellis. That means the industrial sector is just one quarter away from reabsorbing all of the 153 million square feet vacated during the Great Recession.
The storyline in the Midwest is that while absorption is on the rise and concessions are slowly burning off, face rents remain flat in many markets. “Given the severity of the decline, the current recovery is progressing ahead of the one that followed the 2001 recession,” concludes Grubb & Ellis in its third-quarter industrial report.
Industrial vacancy rates in most markets remain in double digits, but conditions are improving. Chicago’s vacancy rate stood at 11 percent in the third quarter of 2011, reports Grubb & Ellis. The market absorbed 2.5 million square feet during the third quarter and nearly 6.6 million square feet through the first three quarters.
Columbus, which had become overheated as a warehouse and distribution market, is rebounding. The overall vacancy rate in Columbus stands at 11 percent, down from 12.2 percent at the end of 2011, reports research firm Xceligent. The Columbus industrial market absorbed 2.2 million square feet in the third quarter.
“We are seeing companies with a local presence expand into larger blocks of space, including Honeywell, Union Tools and Thirty-One Gifts,” says John Huguenard, head of industrial capital markets for Jones Lang LaSalle based in Chicago. “In addition, there are a number of users circling the market looking for spaces in excess of 500,000 square feet.”
Expect to see rising apartment occupancies and rents in 2012 as demand remains strong. “The market is already tight,” says Severino of Reis. “With strong demand and relatively little new supply coming on line, 2012 should be another good year for the apartment market.”
Approximately 10,400 new units will be completed next year across the region, according to Severino, which is about double the amount forecast to come on line in 2011. “But we expect demand to surpass construction next year,” emphasizes the economist.
(For a more comprehensive look at the state of the Midwest multifamily market, see “Apartment Sales Heat Up” in the November issue at
Emerging Trends in Real Estate 2012, a forecast published by the Urban Land Institute and Pricewaterhouse Coopers, concludes that investing in the multifamily sector is a smart play in uncertain times. “Apartments are the safest real estate investment bet, promising to sustain decent returns even if the economy fails to reignite.”
Total returns for apartment real estate investment trusts year-to-date through Nov. 23 rose nearly 2.6 percent, according to the FTSE NAREIT U.S. Real Estate Index. That compares favorably with the hotel and office sectors, which saw total returns decrease 27 percent and 10.7 percent, respectively, during the same period.
©2011 France Publications, Inc. Duplication
or reproduction of this article not permitted without authorization
from France Publications, Inc. For information on reprints
of this article contact Barbara
Sherer at (630) 554-6054.