COVER STORY, FEBRUARY 2006

OFFICE SUPPLIES
Class A office space is the focus in the Midwest, with tenants in the driver's seat and investors actively seeking opportunities.
Nina Glickman

In the Midwest, the office market has performed well for the most part, with high-quality properties attracting the most attention. Despite a lack of new construction, the tenant-driven Midwest markets are remaining stable and maintaining a constant flow of activity. Heartland Real Estate Business recently spoke with brokers working in various Midwest markets to get their input on the current state of the office leasing market and what to expect for 2006.

Detroit

Fifth Third Bank has secured signage at the top of Southfield Town Center in Southfield, Mich.

“The higher quality properties are receiving the most attention,” Collins says. “Most [of the buyers] that are coming in are looking for above-national-average returns and good value.”

There have been a few notable trends in the office leasing market. Landlords are approaching tenants for lease renewals much earlier than they previously did. Conversely, tenants have been trying to “blend and extend” by giving landlords some additional lease terms in the hopes the landlords will lower the rental rates. Banks in metropolitan Detroit, such as Fifth Third Bank, have been consolidating into office towers and securing signage rights on top of the towers. “All of [the other banks] in the marketplace are looking to do the same thing,” Collins says. Asking face rates have been down 5 to 10 percent in the last 18 months. Tenants are more actively scrutinizing the operating expenses of buildings. This new trend is happening because tenants are becoming more cost-conscious. “Anything to help the bottom line,” Collins says.  

“Landlords are engaging in ‘on-demand suites.' Rather than waiting for the tenant to come and share their tenant improvement requirements, landlords are going ahead and building out spaces, putting in new carpet, painting. Then, when the tenant comes in, a good portion of the work is done. Therefore, they're able to move in quickly,” Collins explains. “It's still a tenant's market.”

This past year has seen steady vacancy and flat new construction. Asking and achieved rental rates are down, and absorption activity has been steady. “[Flat absorption] in itself isn't bad news because we've had a lot of negative absorption in the last several years, so it's balanced out,” Collins says. Positive absorption in the marketplace comes mainly from financial services such as banks and financial advisors. Healthcare and medical office users have continued to grow.

While new construction has been flat, some new buildings have come online. Columbia Corporate Office Center, a 130,000-square-foot, three-story office tower developed by Farmington Hills, Michigan-based Northern Equities Group, is currently being built in Novi, Michigan. In downtown Detroit, Southfield-based Etkin Equities has developed the 115,000-square-foot, five-story 1900 Saint Antoine Street office building. PricewaterhouseCoopers has leased and recently moved into 81.3 percent of the building.

While the suburban office market has been garnering the most attention, downtown Detroit has seen positive net absorption, a good sign for the area. “The city of Detroit has been very aggressive in trying to put together tax incentive packages to draw tenants in,” Collins says.

However, most of the financial, healthcare and insurance companies are looking at suburban properties. Banks are looking for office towers, healthcare is seeking out both multi-tenant mid-rise and single-story locations, and financial advisors tend to want higher end suburban space. Insurance companies typically like suburban mid-rise locations.

The tightest submarkets are Ann Arbor and Birmingham/Bloomington Hills. Both submarkets saw positive absorption in 2005 and have low vacancy rates. The Interstate 94/275 area, which is close to the Metropolitan Detroit Airport in Romulus, has also been doing well. Wayne County is master-planning for the development of approximately 25,000 acres that encompass Metropolitan Detroit Airport and Willow Run Airport in Ypsilanti. “It's a tough market for landlords, but I think the market's flattened out,” Collins says. “One great thing about Detroit is that historically, it's been very conservative in building its stock, so typically, we have a tendency to recover fairly quickly. We never get too far down nor do we get too far up. If we see a hot market turnaround, we could see this market be very elevated in a short period of time.”

Indianapolis

Roughly one-third of the entire Class A base of the Indianapolis suburban office product was sold in 2005, making the investment market very active for the year. Projects with credit term and rental rate bumps listed at or above market rates have received the most attention. Class A and medical product have garnered premium pricing and been favored by institutional investors.

According to Michael Firsich, office sales and leasing associate and Drew Augustin, president and principal with Indianapolis-based NAI Olympia Partners, the current trend in the office leasing market has been a flight to quality. “A lot of the absorption that happened in Indianapolis originated from Class B and C tenants moving to Class A space,” Firsich explains. “Owners of Class A space have been aggressive in trying to fill spaces, and when a Class B renewing tenant is quoted a similar deal on a Class A building with more amenities, they've been moving over to Class A space.”

Suburban and CBD multi-tenant, non-owner-occupied buildings of 20,000 square feet or more ended the year with a vacancy of approximately 16.4 percent, the same level as fourth quarter 2004. “[Vacancy rates] stayed about the same this past year, but overall [they are] trending downward when you look at the last 2 or 3 years,” Firsich says. Absorption in 2005 measured approximately 149,000 square feet, down approximately 70 percent from 2004. Rental rates have remained about the same at $16.51 per square foot on average, compared to $16.89 per square foot in fourth quarter 2004 .

“Leasing activity overall was softer [in 2005] than in 2004,” Firsich says. “In 2005, there were a total of 612 deals done that involved 2.7 million square feet of space, compared to 904 deals done in 2004 [involving] 3.7 million square feet of space. So the leasing activity, statistically, is down about 30 percent.” With 600,000 square feet of new Class A office space currently scheduled for completion this year, the Indianapolis market should see more absorption.

“Corporate profits are up, business spending and hiring are up, residential and commercial spending is up, so this year should be much better for leasing activity,” Firsich says. “Perhaps we'll get the absorption necessary to decrease vacancy rates if all the new construction can get absorbed with expanding and growing tenants.”

According to Augustin and Firsich, rental rates continue to be aggressive. Currently, there is more than 6 million square feet of vacant office space in Indianapolis. “With another 300,000 square feet coming online this year, we will need to see significant job growth to maintain positive absorption,” Firsich says. Building owners will still need to be competitive with regard to rental rates and concessions if they want to lease their space first. These concessions include more free rent, lower first-year rental rates, moving allowances and/or higher tenant improvement allowances. Owners of new construction should budget for a one- to two-year lease-up period that would allow them to be aggressive in attracting quality tenants early.

Activity in the Indianapolis market is, in part, driven by the increases in corporate profits, business spending and hiring. Financial companies, including insurance, accounting and banking, were most aggressive in leasing space in 2005, along with law firms and healthcare companies. Most of these companies are looking for Class A suburban multi-tenant, multi-level product.

The suburban market has attracted the most attention, with 177,500 square feet of new space delivered last year. “The Class A suburban product is definitely in higher demand,” Firsich says. The CBD has not seen new construction in more than 10 years. “Unless a company needs to be close to a state agency or local government, it's hard to have a compelling reason to be downtown,” Firsich notes.

The Indianapolis market, once broken down into specific categories, paints a different picture than the overall statistics would suggest. “For instance, when you hone in on suburban office product, specifically Class A, vacancies have decreased significantly —15.2 percent at the end of fourth quarter 2005 compared to 16.8 percent fourth quarter 2004 and down from 20.8 percent in the fourth quarter of 2003,” Firsich says. “We saw negative absorption in Class B and C space, which further supports my earlier comment about the flight to quality.”

Additionally, if long-term interest rates remain low and rental rates increase, more tenants will want to pursue the purchase of an office building for their use.

Indianapolis is not at a loss for new developments. For the first time in several years, Indianapolis is seeing a 100 percent speculative office building development. Opus Landmark at Meridian, a 350,000-square-foot office campus, is being developed by Opus North Corporation in Carmel, Indiana. Opus broke ground on Building I, a 106,158-square-foot office facility, in October 2005. Additionally, Duke Realty Corporation is developing Parkwood Nine, a 205,000-square-foot building, which will come online this year with American Family Insurance as the anchor tenant.

Minneapolis/St. Paul

KanAm US-grundinvest Fonds recently acquired a 689,500-square-foot tower at 50 South Sixth Street in Minneapolis for approximately $194 million.

The most desired product has been Class A and B, with Class C product not being met with much enthusiasm. The St. Paul submarket is seeing very little activity in its office market, apart from the state of Minnesota leasing space in the area.

Both urban and suburban properties are drawing interest. However, with the exception of St. Paul's CBD, downtown is the place to be. According to Kolsrud, in Minneapolis, the south section of downtown seems to be receiving most interest. In the suburban office markets, the southwest and western parts of the city have the most opportunities. Kolsrud anticipates improvement around the airport and the Mall of America. The light rail stops in those areas are improving, thus fueling interest in office, retail and hotel space.

Recent activity includes KanAm US-grundinvest Fonds' purchase of the 29-story, 689,500-square-foot office tower at 50 South Sixth Street in Minneapolis for approximately $194 million ($282 per square foot), the largest price-per-square-foot deal in the past year. In St. Paul, Frauenshuh Companies sold the 436,342-square-foot Lawson Commons to Behringer Harvard for $84.5 million.

“We have a lot of users pursuing the acquisition of office product, so we're seeing the users buying the buildings as well, not just the institutions,” Kolsrud says. “The most successful [buildings] are the ones that have some lease-up opportunity.” Cap rates continue to be on the low side, with the idea that well-leased properties will continue to trade even with the rise in interest rates.

The current trends have seen office space leasing up.   “Absorption is improving,” Kolsrud says. “Tenants are still in the driver's seat but that's possibly going to change very soon — the conditions for landlords are greatly improving. There's a possibility of new development coming that could swing the pendulum back the other way.”

The lack of new construction and pent-up demand will drive current activity. Expansion can no longer be avoided. Medical developments have had great success, such as the 1.5 million-square-foot headquarters building being built for Medtronic Inc.

Kolsrud believes the outlook is positive for the coming year. “We're going to see a lot of action this year [since] investors have owned properties for a period of time. I think that makes a lot of people believe that 2006 is still going to be a good year to achieve a high price.”   However, there is some concern for 2007. “The cap rates might dramatically rise and the sellers may have a harder time,” he adds. For many investors, it becomes a matter of watching the market and deciding when to take the chips off the table. Investors will purchase office portfolios at a price that reflects much higher than existing occupancy, in a sense, capping tomorrow's money today. “Cap rates can jump in a blink,” Kolsrud says.

St. Louis

Stability has been the key to success for the St. Louis office market this past year. The competition for institutional money and quality real estate has driven the investment market to a level rivaling the larger markets such as Chicago. The stability of St. Louis' market attracts investors and brings a comfort level to the investments. “Our market trends tend to avoid the peaks and valleys that you might see in some of the larger markets,” explains Chris Fox, managing director of Gateway Commercial, a member of the Cushman & Wakefield Alliance in St. Louis. Each year is an improvement over the previous one, and Fox thinks the improvement seen in 2005 will continue into 2006. “We're seeing vacancy rates start to stabilize. We're not seeing any significant growth in rental rates, but we are starting to see some of the incentives subside a bit and we're seeing improvement that's going to continue,” he says.

The most sought-after properties are quality buildings with a fairly stabilized income stream. Active value-added buyers are willing to spend the capital to improve a property in the hopes of seeing appreciation of rent and increased activity.

The stabilization trend has been predominant in the office market, especially with vacancy. “People aren't giving back space,” Fox explains. “We've seen an increase in larger leases — leases north of 20,000 square feet. Most of the movement has been from one project to another for a host of reasons. That's why our vacancy rate has stabilized more than improved.”

While net growth and absorption have been at a minimum, corporations have been able to forecast to the point that they can sign larger leases for longer terms, instead of going through the process and electing to renew a lease for 6 months to a year as they have done in previous years. “Tenants are going through the process and making the capital decision to relocate,” Fox says.

Leasing activity has been driven by a few factors. The trend upward in employment is beginning to solidify some of the leasing activity. Another factor is the high level of capital chasing investment real estate. “St. Louis positions itself really well [due to] our employment base. I think our market is seen as more stable, and that's driving a lot of the capital our way,” Fox says.   St. Louis is still a tenant's market, despite the reduction in some incentives.

Fox believes St. Louis positions itself as a good location for corporate consolidation, noting that the cost of living, housing index and employment zone are factors that help create a strong regional market.  

The suburban market continues to outpace the CBD; there has not been a Class A office development built in the CBD since 1989. “Clearly, it's an office market that hasn't seen net growth to the point where it's justified new development,” Fox says. Being in the suburbs makes it easier to recruit and retain. The suburbs tend to be closer to where people live and are attractive to the young employment base.  

The construction of the new stadium for the St. Louis Cardinals, which will open this year, is also having an impact. Commercial developments are planned for the areas surrounding the stadium. “We're seeing less tenants leave the city for a suburban location,” Fox notes. “[However], we haven't seen a big influx into our CBD, but again, I'd say that's [due to] stabilization. They're doing a good job of retain[ing] the tenants that they already have.”             However, the CBD has been getting some attention. Tenants continue to upgrade their spaces, as well as seize the opportunity to relocate from Class B to Class A spaces, or move to a submarket that is more appealing. Businesses are attempting to own user-driven projects. Fox has noticed that the creative services, such as architectural and engineering firms, have been trying to rehab user-driven projects. Additionally, there has been a push in the CBD to convert older office/industrial buildings into multifamily projects, which has been a big driver of downtown stabilization. “I think ultimately, [the conversions] will translate into some improvement in the office market,” Fox says.

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