CITY HIGHLIGHT, FEBRUARY 2005

RETAIL LEADS RECOVERY IN SUBURBAN CHICAGO
Ed Lowenbaum, Lawrence Morgan, Steve LaKind, Scott Carr

Chicago’s commercial real estate market, which had begun to show signs of improvement in late 2004, continues to look optimistic for all four property types, with retail leading the way. Retail rental rents have climbed 22 percent during the past 2 years, and retail growth is exploding in Oswego and Plainfield. User sales and construction activity are fueling the industrial market. The office market, which is currently battling high vacancies, is expected to see an increase in speculative development during the next 2 years. Suburban Chicago’s multifamily sector continues to benefit from the increased traffic and occupancies from last year.

Multifamily

The suburban Chicago apartment market saw continued recovery in 2004. While rents continued to lag — with concessions still being offered, especially in Class A communities — there was increased traffic and steadily increasing occupancies during the past year. The availability of capital and historically low interest rates continued to convert renters to single-family or condominium owners. In fact, one of the biggest trends in recent years has been the number of condominium conversions of existing apartment communities, especially in the northwest suburbs. New development in the suburbs also has slowed in the past year with only a few projects being completed now and a fairly low supply in the pipeline.

The majority of suburban apartment development since the mid to late 1990s took place in the collar counties of DuPage, Lake, Kane, Will and McHenry. Cook County, which includes the city of Chicago, experienced virtually no development during the last decade. This was due to several factors, including a high level of real estate taxes, the availability of land and the absorption of development in the late 1980s. DuPage County, which is located west of Chicago, saw the greatest amount of new apartment development with more than 5,000 units built between 1996 and 2004, mostly in the Naperville/Aurora submarket. Lake County, to the north, also has seen a fair amount of new development in recent years. While development has slowed in the last 2 years, these counties continue to see the most of the apartment development activity in the Chicago area, with the exception of downtown Chicago, which has seen a resurgence of new projects in the past 5 years, including apartments and condominiums. Rents at these new suburban communities have been in the range of $1.25 to $1.35 per square foot not including concessions, which have between 6 percent and 10 percent of the total annual rent.

These collar counties continue to have more development than Cook County because they have available land and generally lower real estate taxes. The difficulty for most developers has been obtaining the zoning required from the various municipalities, who sometimes see apartment development as a negative to their communities. In most cases, the apartment homes being developed have been luxury units with the amenities and feel of a single-family home. The developers of these projects have gone after the “renter by choice,” someone who can afford to own and wants a nice place to live, but who would rather rent. With the exception of a few tax-credit and senior developments, this continues to be the type of development that is occurring and the type of tenant that these developments are hoping to attract. The newest project being completed is the ultra-luxury Museum Gardens in north suburban Vernon Hills by AMLI Residential. What makes this 294-unit, mid-rise community interesting is that is will be the first new apartment development in central/southern Lake County in the past 10 years.

Apartment development in suburban Chicago will likely remain slow during the next several years as recent developments are absorbed and single-family and condominium markets cool down. The submarkets that will continue to experience growth in the future will likely be the far north, west and northwest suburbs. If Chicago’s third regional airport is developed in far south suburban Peotone, these areas could finally begin to see development of new market-rate communities. However, if this does come to fruition, it will not likely be for another decade.

— Ralph A. DePasquale is a senior investment advisor for the Chicago office of Hendricks & Partners, LLC.

Office

While the suburban office market is showing signs of improvement, a full recovery may be a few years down the road. Until then, tenants will continue to reap lower-than-average rental rates and better-than-average concessions while landlords contend with high vacancies.

Reacting to the still-sluggish economy, companies are adding headcount in a tentative, measured way with job losses and consolidations continuing to dampen space demand. However, with an improving economy and incremental job growth, the demand for office real estate will increase. This, in combination with a lack of suburban speculative office development, should lead to a slow increase in rental rates and a reduction of concessions, particularly for large blocks of space.

Suburban rental rates continue to decline, although the availability rate, which includes sublease space, decreased during the fourth quarter of 2004 by almost a full percentage point to 21.7 percent — the lowest rate since 2001. The total decline since mid-year 2000 has been 13.5 percent, or $3.08 per square foot, to the current average rental rate of $19.60 per square foot.

The lower rental rates and high concessions have kept most developers on the sidelines. The majority of recent development is in the form of build-to-suits commissioned by specific space users, such as the 150,000-square-foot headquarters project for pharmaceuticals company Takeda in Deerfield.

However, speculative development is occurring in one niche market. Older buildings that are either empty or have large blocks of available space are being redeveloped in the East-West Corridor and the northwest suburbs. Buildings, such as 263 Shuman Boulevard in Naperville and 3850 North Wilke Road in Arlington Heights, are vacant and have been recently purchased by owners that predict future demand for large blocks of space. By purchasing these buildings at low prices, the developer can afford to retrofit them to attract tenants, yielding a return on investment not possible in a new development.

Overall building construction scheduled for completion in 2005 totals 604,000 square feet. More than 80 percent of this construction is taking place in the East-West Corridor, one of the healthiest submarkets in Chicagoland. The proximity to employees, available land sites and low DuPage County real estate taxes are all contributing factors to the western expansion.

The next 2 years will most likely see a hefty increase in speculative development as the economy continues to improve. Proposed construction stands at 7.4 million square feet. Developers have secured sites and will break ground as soon as economically practical. The first new developments will likely be projects that are 50 percent to 75 percent pre-leased, giving developers time to seek other tenants to fill remaining space. Similar to what has occurred in downtown Chicago, construction is being catapulted by a shortage of large blocks of space. In certain suburban submarkets – East-West Corridor, northwest and O’Hare – there are plenty of space options in the 25,000- to 50,000-square-foot range, but few larger options. As in downtown, suburban development will be triggered by an anchor lease such as that of Sidley, Austin, Brown & Wood at 1 South Dearborn.

Like downtown, the concern surrounding new development is whether there is any true absorption. Tenants are relocating to new buildings, but are leaving behind substantial vacancies in their prior buildings. Until true absorption is sustained by job growth, the suburban markets will not see a steady rise in rental rates.

A notable proposed development is Catellus Development Corporation’s 400,000-square-foot Class-A building at Patriot Boulevard and Willow Road, a part of the master development of the Glenview Naval Air Station.

One encouraging office market indicator is that overall suburban leasing activity last year was 8.8 million square feet, higher than the previous 3 years. Interestingly, the East-West and Northwest Corridor accounted for two-thirds of all leasing. Notable transactions include Ameriquest Mortgage signing a sublease at Windy Point in Schaumburg for 300,000 square feet and Caremark renewing its lease in Northbrook at 2211 Sanders Road for 195,000 square feet. Adding to the office availability, Esplanade II in Downers Grove now has 500,000 square feet of available direct and sublease space from the departures of Spiegel and CNA Insurance.

Many developers have land sites available for potential development. Hamilton Partners, Duke Realty, Prentiss Properties and Sears-Prairie Stone all have land sites that could accommodate new office projects.

— Laurence Morgan is executive vice president and co-branch manager and Steve LaKind is executive managing director with Studley.

Industrial

Demand for industrial real estate accelerated late last year, ending with higher levels of user sales, leasing and construction activity as compared to the close of the previous year. This improvement closely followed gains in the Midwest manufacturing sector. According to the Institute of Supply Management, industrial output increased sharply in December and has been expanding since May 2003. With real estate transactions generally lagging industrial activity by 9 months, the results were illustrated by a falling suburban vacancy rate that ended the year at 9.1 percent.

With interest rates hovering near their lows, user sales and construction activity have been especially strong. The year began with almost 10 million square feet under construction. Most activity has been occurring in the Joliet area, Interstate 55 Corridor and far south suburbs. Much of the ongoing and proposed building activity reflects the development of large regional distribution centers that enable companies to ship product to customers more efficiently. Among several others, PetsMart and Target announced plans for major new facilities this year.

Previously, higher land costs and rental rates would have relegated many of these developments to rural locations. Now, however, several economic factors are making these projects feasible to build closer to Chicago. In October, Phoenix-based PetsMart Inc. announced plans to build a 1 million-square-foot North Central Distribution Center at Interstate Commerce Center business park in Ottawa. PetsMart previously considered Champagne as a potential site, but continued strong institutional demand for well-leased, state-of-the-art industrial assets has pushed asset prices higher. In turn, the higher asset prices enable developers to underwrite very aggressive lease rates because they can recoup their costs upon sale of the property. This environment creates an interesting juxtaposition of market forces — creating downward pressure on rents while prices and values are on the rise.

In addition to the development of super distribution facilities, infill redevelopment should continue in 2005. Modern industrial product is in high demand near the urban center where companies can draw on skilled labor and remain closer to customers. This has spurred interest in redevelopment projects in communities such as Niles, Skokie and Morton Grove. Missner Group, for example, is redeveloping the Niles Industrial Center on Howard Street, a speculative project that includes two modern facilities with approximately 210,000 square feet each. These facilities, as well as other Duke Realty and Opus North projects in Northlake and Melrose Park, are creating premium space in older, more mature suburban markets.

Even with rising construction prices and higher interest rates, overall activity should remain steady as building values climb higher. Particularly strong demand for first-generation single-user facilities and well-leased multi-tenant buildings should keep cap rates near record lows. And rents look to remain relatively stable, although some rent inflation could be seen later in the year if higher building costs persist.

— Ed Lowenbaum is a senior vice president with the Trammell Crow Company in Chicago.

Retail

During the last 2 years in the Chicago market, rental rates for apartments, offices and warehouses have all declined. But, retail rents have climbed a vertigo-inspiring 22 percent, according to the National Real Estate Index. This dramatic growth reflects the continued health of retail even in a relatively sluggish job market. Year-end figures have failed to brighten the economic picture, yet retail remains hot. Greater Chicago’s vacancy rate dropped to 7.8 percent in the third quarter of 2004, down 1.4 percent from the previous year.

One of the year’s most striking success stories is the southwest suburb of Bolingbrook, which has steadily grown into a regional retail powerhouse. Building on its coup of wresting über-trendy IKEA from its original destination in the city of Chicago, the suburb recently announced that a new Marshall Field’s will be built in town. Bass Pro Shop breaks ground in Bolingbrook in July.

New construction in Chicago’s retail market has turned away from traditional enclosed malls and instead toward grocery, open-air and lifestyle centers. Even existing indoor malls are following this trend — such as Yorktown Mall in Lombard, which is adding lifestyle components — to contend with the new breed of retail. Just a few blocks to the east of Yorktown Mall, NAI Hiffman is proposing a competing lifestyle center on the site of what is now a Waste Management, Inc. office building. The year’s biggest redevelopment was the transformation of the Brickyard Mall on Chicago’s West Side from an indoor mall to an open-air hybrid center, combining a grocery and big box power center. Whitehall Street Real Estate Funds and Mid-America Asset Management oversaw the metamorphosis of the 573,000-square-foot center.

The malls had a stronger Christmas, however, than suburban downtowns, which had previously benefited from the de-malling trend. After receiving millions of dollars in recent years for renovations and redevelopment, downtown merchants were disappointed to see holiday shoppers flocking to larger shopping centers, leaving suburban Main Streets hurting for customers.

The north side of the city is Chicago’s most heavily retailed area, with a mere 3.8 percent vacancy rate. The South Side and West Side remain less densely occupied, but the South Loop and the West Loop, just outside the central business district, have continued a remarkable expansion.

Target has been, perhaps, the most aggressive and successful big box mass merchant retailer within Chicago proper. After benefiting from the development of the South Loop’s Roosevelt corridor, Target is now eyeing a location in the newly gentrifying Uptown neighborhood. The city council will soon vote on the Planning Commission-recommended Wilson Yard project, which was proposed by Holsten Real Estate Development Corporation and Kenard Corporation for Broadway Street and Montrose Avenue. The project, if approved, will provide the long development-deprived far North Side neighborhood with a Target, a 12-screen movie theatre and an Aldi grocery store.

Meanwhile, growth has exploded in far-flung exburbs like Oswego and Plainfield, and Montgomery and Ottawa may be hot markets to watch in the future.

— Scott Carr is the president of Inland Commercial Property Management.



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