MARKET HIGHLIGHT, FEBRUARY 2006

SUBURBAN CHICAGO CITY HIGHLIGHTS
Doug Shehan, David Bercu, David L. Liebman, Gregory A. Moyer and Tyler Quast

Suburban Chicago Office Market

As 2005 drew to a close, the suburban Chicago office market was a picture of stability. With an inventory that totaled approximately 119 million square feet of Class A, B and C space in buildings measuring 50,000 square feet and larger (excluding owner-occupied buildings), the suburban office market ended the year with a direct vacancy rate of approximately 16.7 percent. When factoring in sublease availabilities, the overall vacancy rate was 19.4 percent. For the most part, current vacancies have been hovering near these levels for the past several quarters with few large swings in either direction.

If you see the glass as half-full — or perhaps represent an institutional owner in lease negotiations — you might see several encouraging signs. Certainly, the current level of activity does not reflect the dearth of transactions that followed the economic upheaval of late 2001. Today, tenants of all sizes are definitively in the market and completing transactions, both new leases and renewals.

This activity, coupled with the lack of new speculative construction, enabled the suburban office market to record positive net absorption of approximately 115,000 square feet during 2005. Another positive indicator has been a renewed appetite by tenants for longer-term leases. A few years ago most tenants were looking only for short-term space solutions. Increasingly, however, tenants are showing more confidence in both the economy and their own balance sheets, with a willingness to commit to 5- and 10-year leases.

There have been other positive signs as well, including several large transactions that were inked in 2005. For example, Sara Lee Corporation absorbed approximately 350,000 square feet of the former Spiegel Headquarters in Downers Grove, thereby taking a large block of sublease space in the East-West Corridor submarket. Another notable transaction was the consolidation and relocation of the OfficeMax headquarters into approximately 370,000 square feet at a former AT&T building in Naperville. These transactions have been positive for the suburban office market.

Additional strength is also visible in the north suburban market, where lease transactions are being signed in the $14- to $18-per-square-foot range triple-net. Much of this activity is being driven by the healthcare and pharmaceutical sectors, which represent a strong and growing segment of the economy. Takeda Pharmaceuticals is building a new location in Lincolnshire, Illinois, and although this specific transaction may have some fallout when the tenant vacates the 228,000 square feet it currently occupies at the Millbrook Business Center, it also illustrates underlying demand in this submarket.

Yet the overall suburbs are not without their trouble spots. Skeptics might point to several locations to argue that the suburban office market needs to make further strides before becoming truly healthy. The O'Hare and far northwest submarkets ended the year with overall vacancy rates of approximately 23.4 and 24.6 percent, respectively. Meanwhile, the far western edge of the East-West Corridor registered an overall vacancy rate of 22.3 percent. These statistics are significant and illustrate the number of alternatives that tenants have for leasing spaces.

Direct rent abatements appear to be less common, and overall rates have stabilized across the suburbs, ending the year at $20.78 per square foot. However, construction allowances and other concessions are still widespread and range from $15 to $40 per square foot depending on existing conditions.

Another concern might be the source of new demand this year. The financial services sector, including lenders such as Ameriquest Mortgage Company and Washington Mutual, has been a significant driver for the suburban market during the past few years. As interest rates creep higher and the housing industry looks poised to pause, there is some fear that this sector will contract. Already some of these firms have announced workforce reductions. Demand from the educational sector, which has signed numerous noteworthy leases in recent quarters, may also decline.

Although the suburban office market ended 2005 as a picture of stability and has even shown signs of improvement through positive net absorption, continued recovery will be dependent on new demand drivers emerging.

— Doug Shehan is a vice president in the Chicago office of Trammell Crow Company.

Suburban Chicago Industrial Market

The Chicago industrial market experienced explosive transaction growth in 2005, with sale and leasing activity totaling approximately 60 million square feet of space. While the leasing of 35 million square feet was impressive, more noticeable was the approximately 25 million square feet of sale activity. Additionally, absorption of space increased more than 35 percent, to 19.4 million square feet, resulting in a vacancy decline to 8.66 percent in 2005, down from 9.11 percent in 2004.

Demonstrating the depth of the overall market, year-end 2005 statistics show that eight Chicago submarkets experienced absorption levels of more than 1 million square feet. A year ago, only three markets had similar activity.

Clearly, the market leader is the southwest suburban area, where 14.9 million square feet of lease and sales activity produced 8.4 million square feet of positive absorption. This represents an increase of 40 percent to 60 percent compared to last year. This is not surprising, since within this market are the Interstate 55 and Interstate 80 corridors, which are recognized as the distribution hub of Chicagoland. This submarket's vacancy rate remains the highest in the area at 14.65 percent, down from 17.18 percent a year ago.

The market that provides the greatest concern is in the southern suburban market, which is one of only two submarkets to have negative absorption for the year. Rising real estate taxes in Cook County and the continued slow-down in the manufacturing sector have plagued the southern suburbs. Weakness in the manufacturing sector has had a profound impact on this submarket; manufacturing operations that have recently closed or moved overseas have contributed to increased supply and less demand for this product type. Additionally, the distribution needs of manufacturers have diminished, as fewer products are produced and distributed in Chicago.

On a positive note, industrial user sales remain strong and have been driven by low interest rates. In 2005, the market saw a significant increase in properties being purchased by users who had previously leased their space. This trend is especially true for privately held firms whose owners perceive owning real estate as a wealth-creation vehicle that also provides a cash-on-cash yield superior to other investment alternatives.

Domestic pension fund capital also continues to view Chicago as a viable market for investment-grade acquisition of assets. As a result, income-producing industrial real estate is selling at historical highs. This demand for product has created a very unique phenomenon in the marketplace today. Currently, there is a significant disparity between rental rates and capitalization rates. While leasing market fundamentals continue to exert downward pressure on rental rates, values are increasing because of compressed capitalization rates. For example, in the I-55 corridor, a new building with a $2.50 per square foot net rent will probably sell at a 6 percent capitalization rate, producing a value of approximately $42 per square foot. The same newly constructed building 5 years ago likely leased for $3.25 per square foot, but was valued at an 8 percent capitalization rate, producing an approximate sale price of $40.63 per square foot. If 10-year Treasury rates rise, it will be interesting to observe whether purchasers remain as aggressive in pursuing product.

The prognosis for the year is that the leasing market will continue to improve at a slow and steady pace. Investment activity will continue to flourish as long as interest rates remain stable. It will be important to monitor the intense jockeying for land positions as developers pursue the perceived next hot market along the I-80 corridor. The rising cost of vacant land in and around the O'Hare market is another developing trend. Many buyers are looking at the airport expansion as the catalyst that will reshape segments of the market from Melrose Park on the south to Des Plaines on the north.

— David Bercu, SIOR, is a principal with Rosemont, Illinois-based Colliers Bennett & Kahnweiler.

Lake County, Illinois, Industrial Market

In a submarket that offers few available large land sites, developers are finding renewed life in Lake County. The area has seen limited speculative construction since the late 1990s. However, several prominent developers have initiated new projects during the last 24 months that will stimulate both sales and leases of industrial properties.

Several factors have served to revive developer interest in Lake County. As a historically owner-occupied market, institutional owners generally shy away from Lake County, while developers enjoy niche build-to-suit and spec opportunities as long as well-located, reasonably priced land sites are available. An increasingly high quality labor force supports businesses in the area. More than 85,000 workers travel daily from southern Wisconsin into northern Illinois to work primarily at Lake County businesses. Location advantages and amenities, such as new or planned Metra stations, a steadily rising new housing stock, and the proximity of major roads and highways such as Interstate 294 are major draws; and favorable real estate taxes for industrial properties, typically in the 70 cents- to 90 cents-per-square-foot range, attract developers' attention to the area.

Two prominent developers, CenterPoint Properties Trust and Panattoni Development Company, are generating new projects that aim to fulfill the niche created by the dynamics noted above. The CenterPoint Business Park in Gurnee, Illinois, is a 135-acre master-planned business park, located near a full interchange at Grand Avenue and I-294 The park is already home to several significant facilities and boasts room for another 600,000 square feet of industrial product. In the park now are the new 270,000-square-foot Watson Pharma warehouse; Ta Chen Corp.'s new 182,000-square-foot facility; Herbert Stanley Company's 103,000-square-foot building; and a speculative 133,258-square-foot building, which is already one-third leased.

Trumpet Industrial Park in Zion, Illinois, is a 400-acre planned industrial park located less than 3 miles east of I-294 on Rosecrans Road and Route 173, minutes south of the Illinois/Wisconsin border. Panattoni Development, as master park developer, is planning a 700,000-square-foot speculative industrial building in the park. Additionally, land sites for users of all sizes will be ready with full infrastructure in the near future.

On Sunset Avenue in Waukegan, Illinois, Panattoni is seizing a unique niche opportunity by developing a speculative 130,000-square-foot, divisible, high-cube warehouse. The pre-cast, 30-foot clear ceiling height building, with 30 exterior docks and two drive-in doors, is scheduled for delivery in the spring.

Again seizing upon a niche land play, Panattoni acquired two 6-acre land sites in Oak Grove Business Park in Waukegan near both Route 41 and I-294 in an established industrial area. The firm is building Oak Grove Woods I, a 122,500-square-foot facility, and Oak Grove Woods II, a 66,720-square-foot speculative building. Both properties are amply docked and nearly ready for occupancy.

The former Meyer Farm property in Libertyville, Illinois, is the newest opportunity in mid-Lake County. Panattoni is developing the property with delivery set for the fourth quarter of this year. Subject to installation of infrastructure improvements, Panattoni is developing the 63-acre parcel, which is located north of the Libertyville Commerce Center at Peterson Road and Route 45, into for-sale and for-lease build-to-suit opportunities on 3- to 5-acre lots. Land pricing is anticipated in the $5-per-square-foot range.

Despite a perceived scarcity of available land, Lake County is providing a revival of sorts for new industrial development, serving a largely owner-oriented clientele with capable developers providing key resources and expertise to service this demand.

— David L. Liebman, SIOR, is a senior associate with Rosemont, Illinois-based Colliers Bennett & Kahnweiler.

Suburban Chicago Multifamily Market

Investors in Chicago's suburban apartment market can look forward to improving conditions, thanks to a recovering metropolitan economy. A strengthening labor market coupled with a healthy stream of condo conversions, especially along the North Shore, will finally launch a more robust recovery.

On the employment front, 2005 was the first positive year in terms of job growth in the past 5 years. Looking ahead, local businesses are expected to add more than 67,000 positions this year, an increase of 1.5 percent compared to 2005. Many of these jobs will be lower paying, thus pricing a sizable portion of the new hires out of homeownership, a positive sign for owners of apartment properties.

Last year, vacancy in the Chicago apartment market reached its lowest point since 2002, and it is expected to continue improving on the strength of robust job growth. In addition, the reduction of supply due to condo conversions helped firm occupancy in 2005. Further removals of apartment stock resulting from condo conversions may occur, which could place even further downward pressure on vacancy rates. At year-end 2005, several suburban submarkets reported decreasing vacancy rates, including southwest Cook County (4.7 percent), Schaumburg/Hoffman Estates (4.8 percent) and Glenview/Evanston (4.8 percent).

Revitalization efforts in some suburban markets, as well as the development of new commercial space, have fueled growth in the multifamily sector. For instance, a 184-unit apartment property in Elgin recently sold for $11.8 million, representing strong investor interest in Elgin, a community that has suffered in past years but is now on its way to a solid recovery. Also in that city, a number of new condos and for-sale residences are being developed downtown, such as the recently announced 95-unit, eight-story Fountain Square on the River project.

In Barrington, the 110-unit Barrington West condo conversion traded for $16 million. Another major transaction involved the 180-unit Royal Oak Apartments, which commanded $18.1 million in Wildwood. Both deals were negotiated by Marcus & Millichap brokers.

Preliminary estimates show the number of sales surged across the Chicago metro area in 2005, as buyers flocked to Chicago to take advantage of its comparatively affordable pricing and condo conversion opportunities. Investor demand pushed the median price up 17 percent last year to more than $82,000 per unit. Prices for conversions in these areas are currently more than $175,000 per unit, trading at a 43 percent premium over non-conversion assets. The condo trend is expected to continue this year, but converters may reconsider their plans if ground-up development accelerates further. Rising interest rates and occupancy costs are beginning to result in a slowing of condo sales for developers, a trend they will monitor in the upcoming year.

As prime central business district assets are increasingly priced out of reach for institutional investors, REITs and other institutions have turned to the suburbs for acquisition opportunities. Some of the active buyers include AvalonBay Communities, Morgan Stanley and AIMCO, which are all real estate investment trusts.

Improvements in the local economy, rising interest rates and continued gains in tourism are expected to help the apartment market, as hiring in the leisure and hospitality sector leads to expansion of the renter pool.

— Gregory A. Moyer is a managing director and a regional manager in the Chicago office of Marcus & Millichap.

Suburban Chicago Retail Market

The proliferation of Wal-Mart Supercenters in the suburban Chicago market initially raised concerns about competition with smaller retailers, but unlike the category-killer big boxes of the past, these retail centers are not so much squashing the competition as stimulating retail development in their wake.

Wal-Mart Supercenters are one of the more active products for big-box development in the growing Chicago-area market, targeting areas of rapid population growth and the demand for retail that follows. In the collar counties surrounding Cook County, including Lake, McHenry, Kane, Kendall and Will, 12 Supercenters are slated for development.

Once a Supercenter has proven the viability of a new market, other retailers quickly follow. This rapid colonization brings familiar names, usually in a predictable order. Big box home improvement heavyweights such as The Home Depot and Lowe's Home Improvement Warehouse move in, capitalizing on the most immediate needs of the area's many new residents, followed by mid-sized box retailers such as Staples, Petco, Jo-Ann Fabrics & Crafts and Best Buy. Smaller soft-goods and service-oriented retailers, including Payless ShoeSource, GNC, Ritz Camera and Dollar Tree, soon fill in the strip center developments around these Supercenters, while food establishments including Chipotle, Noodles & Company, Chili's and Raving Brands concepts look for outlot opportunities in or near these projects.

The residential boom fueling Supercenters and related developments is also spurring the growth of fitness centers in the Chicago area. Those most active in the market include LA Fitness, XSport and Life Time Fitness, which is now building two-story, 80,000-square-foot prototypes.

Furniture showrooms also are in a growth mode, with Wisconsin-based Ashley Furniture entering the market and Chicago's Walter E. Smithe expanding its local presence with stand-alone locations. IKEA is adding a second area megastore in Bolingbrook, Illinois, and Wickes Furniture, based in Carol Stream, Illinois, is undertaking ground-up development of new showrooms.

Even retailers competing for market share with Wal-Mart — the nation's largest grocery chain — continue to explore opportunities for expansion. Wisconsin-based Woodman's Food Market, boasting a 210,000-square-foot grocery concept, and Indiana-based Marsh have recently ventured into the market, where they compete head-to-head with local stalwarts such as Safeway's Dominick's and Albertsons' Jewel.

All of this development adds up to impressive numbers for retail under construction: 34 centers totaling 6.6 million square feet were underway as of third quarter 2005, according to figures posted by CB Richard Ellis. Kane County leads the market with 14 projects totaling nearly 2.4 million square feet under construction. This added inventory has pushed vacancy rates up as high as 17.9 percent in the south suburbs, compared to 7.7 percent for the six-county metro area, and nudged gross asking rental rates down slightly. However, any setbacks are likely temporary, as residential growth continues to drive demand for retail.

As the population surges, the boundaries between suburbs blur, creating “huburbs” in the collar counties. Areas that were once thought to be secondary and tertiary markets, such as Channahon, Minooka and Yorkville, up through Sugar Grove and Woodstock, have now become part of the Chicago metropolitan area. These areas have experienced significant growth during the past 5 years, and will likely become notable population centers in the near future. And, as the residents come, so too will the retail.

— Tyler Quast is an executive vice president and principal at Chicago-based Zifkin Realty & Development.

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