If you had hopes that the end of 2002 would mark the end of the nation’s economic woes, by now you’ve received your reality check. A weakened stock market and the threats of war or another terrorist attack all play into creating an uphill economic climb. And, the office sector is certainly feeling the economic crunch. According to Marcus & Millichap’s fourth quarter, 2002 National Office Report, vacancy rates are at their highest levels since 1994, and 2003 will mark the third consecutive year of rent declines.

However, there is a bright side to this gloomy economic picture. The report notes that much of the sublease space permeating the market is likely to be pulled off as a sustainable recovery takes shape. Forecasters also predict a return to equilibrium in most markets by late 2005 or early 2006.

Like the national picture, office markets in the Midwest are experiencing high vacancy rates, few new developments and no speculative building of consequence. Heartland Real Estate Business talked to several office players in the region to evaluate the current state of the market and to paint a picture for 2003.

Chicago

With a combination of some new construction coming on the market, and tenants moving and leaving behind space, vacancy rates are continuing to increase in the West Loop of Chicago. There will also soon be significant vacancy in the East Loop market. For example, Deloitte & Touche has plans to vacate its 340,000-square-foot space and move into the West Loop at 111 South Wacker, an approximately 600,000-square-foot building developed by John Buck Company.

“Prices are going to have to continue to come down for tenants to fill up the vacant space in the East Loop, which has over 18 percent of Class A office space,” notes Andrew Kelly, managing director for Julien J. Studley, Inc.

Another new building is the Hyatt Center at 71 South Wacker, which will open in late 2004 or early 2005. With more than 500,000 square feet of vacant space, the building will be home to the Hyatt Corporation, Goldman Sachs and a law firm, and all are leaving behind leases in other Class A buildings.

“One thing about Chicago is that we don’t hit the highs and lows as hard as the East and West Coasts do,” Kelly notes. “In the down economy, we’ve only seen a 6 percent increase in vacancy rates. In 2002, we hit a peak of about 6.5 million square feet of vacant space, which is triple the historical average for downtown Chicago. We’re down to 5.7 million square feet available today.”

Yet, Kelly does not think Chicago will see significant recovery from a landlord perspective in 2003. “To get back to the historical average of sublease space of 2 million square feet, we’d have to have significant absorption next year, and this year we are really flat for absorption,” Kelly says. “So even if we have a positive absorption year, we’re not going to be improving the landlord situations.”

Cleveland

Like most markets around the country, Cleveland also is not experiencing much development in its office sector. “I couldn’t tell you a building that was opened in 2002,” says Pat Lott, senior vice president for Forest City Enterprises. “There may have been some build-to-suit activity for users, but nothing significant. We didn’t open anything in Cleveland.”

Several factors are responsible for the lack of development, including a lack of demand and an abundance of sublease space. “With the economic slowdown, companies basically aren’t expanding,” Lott explains. “They’re not hiring, and they don’t need more office space, so they have a tendency to stay where they are. Secondly, there’s a great deal of sublease space out there. As companies contract, if the contraction is big enough, they will put excess space back on the market. So if you’ve got sublease inventory being offered at $10 per square foot, and it costs $25 per square foot to build a new building, clearly new buildings aren’t going to get built.”

Unfortunately, Lott predicts more of the same for 2003, which will remain slow with rents flat or further depressed. “Depending on the economy, we may see some improvement by late 2003 or early 2004, with no buildings having been built for two and a half years up to that point,” he speculates. “Inventory should come back online, and you’ll see some possibility of some new office development at that point.”

Detroit

The majority of speculative development that has occurred in Detroit has mainly been on the Interstate 696 corridor between Southfield and Farmington Hills. These are two markets to keep an eye on for the future, according to Tysen McCarthy, senior vice president of business development for Southfield, Michigan-based REDICO Management.

“People are going to want to watch to see how those areas lease up,” McCarthy says. “They’re relatively stable markets, particularly Southfield, which is the largest suburban market. People [also] need to watch the suburban Troy market, which is arguably the worst hit market in metro Detroit right now. Vacancy there is something in the order of 23 percent.”

One of REDICO’s major projects is Oakland Towne Square 2, a 180,000-square-foot, Class A building in the city’s central corridor. Despite this project, McCarthy does not anticipate seeing any major development in the near future.

“What you’re going to see is the trading of buildings,” he notes. “People are going to be looking for opportunities to get ready for the resurgence.”

For 2003, he remains cautiously optimistic and anticipates rates stabilizing to some degree, occupancies going up marginally and positive absorption. “We’ve already started to see precursor signs of hope, things like the absorption of sublease space,” McCarthy says. “There are a number of large tenants that are active in the marketplace, and we’ll anticipate them absorbing some of the larger vacancies, which will help stabilize the market.”

Indianapolis

According to Bill Ehret, principal with Summit Realty Group, the majority of development currently taking place in Indianapolis is in the north suburbs at the intersection of Interstate 465, and north along Meridian Street into the Carmel area. “The majority of that development is some speculative office, with the completion of the Parkwood project by Duke Realty at the corner of 96th and Meridian Streets, and I-465.”

A tremendous amount of medical development occurring north along Meridian Street is fueling some of the absorption activity, Ehret says. “That [absorption] also happened downtown. Clarion Health took a significant amount of sublease space off the market at Bank One Center, and IU Medical Group took a significant amount — one transaction was approximately 90,000 square feet, and the other was close to 55,000 square feet — at the Safeco Building.”

Summit represents Bank One Center, a 1.1 million-square-foot project consisting of two buildings — the 48-story Tower Building and the 12-story Circle Building — located in the heart of downtown on the Circle. Equity Office Properties and Lend Lease own the property, which was built in 1990 and, today, is the largest development in the city.

“There have been no new speculative multi-tenant office buildings built in downtown Indianapolis since [Bank One Center],” Ehret says. “It’s just tough. You see some progress, but then there’s a major merger or an acquisition.”

However, Ehret thinks the north corridor, fueled by future development, will continue to see good activity. “It will run from maybe as far south as 86th Street and Meridian all the way up to 126th Street,” he says. “That’s a fairly long run.”

Kansas City

Corporate downsizing and bankruptcies have taken their toll on the office market in Kansas City. But certain segments, like mortgage companies and law firms, have managed to remain steady and, in some cases, have even grown, says E. Gibson Kerr, vice president of Tower Properties. “So it’s not total doom and gloom, but no developers are talking seriously about spec office space, and they probably won’t consider it for a while.”

Other than the nearly complete Sprint campus, the only significant office development projects in Kansas City are Shook Hardy’s new 600,000-square-foot headquarters in Crown Center and the Plaza Colonnade, a 320,000-square-foot development on the Plaza. The Plaza Colonnade is the future home of Blackwell Sanders law firm, RSM McGladrey and a public library.

Downtown has numerous development projects underway, but they are mostly residential or public projects, such as the Downtown Library, the Performing Arts Center, and the 909 Walnut project, which will deliver more than 200 high-end residential units and 80,000 square feet of office space.
The downtown submarket will be the hottest in the next 5 to 10 years, according to Kerr. Downtown property owners formed a Community Improvement District to keep the central business district (CBD) clean and safe, and the mayor recently formed the Greater Downtown Development Authority, which is targeting specific projects to serve as catalysts for revitalization. The mayor has also formed a commission to finalize a proposal for a new downtown arena.

“All of this work is creating a healthy climate for businesses to relocate to, or expand within, the CBD, which has several great Class A space options available for the first time in several years,” Kerr notes. As for future trends, Kerr says tenants will continue to seek quality — in their buildings and in their landlords — now that Class A office rents are often cheaper than many Class B buildings were a couple of years ago.

“There may be a few cases of building owners giving the keys back to their lenders, but thanks to low interest rates and greater market discipline, there will not be as many foreclosures as we experienced in the last downturn,” he predicts. “Rates will soon bottom out, tenant improvement allowances will be lower, and concessions (mainly free rent) will peak this year.”

St. Louis

The office market in St. Louis is pretty weak, says Burt Follman, CEO of Follman Properties-ONCOR Inter-national. Vacancy is higher than historical standards, and developers are more cautious when starting new projects, if they are starting new projects at all. “Most [developers] are trying to lease up [space] that they have or re-fill vacancies that have occurred. They are not thinking about new speculative projects,” Follman says.

However, O’Fallon, Missouri, in St. Charles County, is one area that has seen substantial growth with what will be the continuation of Interstate 64 over the old Highway 40. “St. Charles County has grown in the last 12 or 13 years from 50,000 to 275,000 people,” Follman notes. “You have retail of all kinds following that, so it’s one of the key areas where most of the development is taking place.”

In addition, three or four major corporations have elected to consolidate and grow in the O’Fallon area. One of those corporations is MasterCard, which moved its global administrative and technology center from one of St. Louis’ nine office submarkets to a 500,000-square-foot building in O’Fallon.

Downtown is another growth area in St. Louis. Warehouses are being converted into lofts, two hotels are being rehabilitated, the Merchandise Mart is being converted to apartments, and a private financing deal by the St. Louis Cardinals is allowing for a new stadium to be built.

“All of those things are going to accelerate development downtown in the next 7 or 8 years,” Follman says. “I would also keep an eye on the municipality and suburb of Clayton, Missouri, which has [several] major corporate headquarters like Brown Shoe and Sara Lee Bakery. There has just been about 800,000 square feet of development in the last 24 months with three new high-rise office buildings, and they’ve done fairly well.”

Though Follman says it’s hard to predict what will happen in 2003, he says that at least the first 6 months are not going to be decidedly different from current conditions. “It’s going to be slow and bumpy on the bottom, deals are going to be hard to conclude, and there are going to be some concessions for landlords to get their space re-occupied,” he says.


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