COVER STORY, FEBRUARY 2008

2008 INVESTMENT OUTLOOK
Marcus & Millichap provides a survey of the real estate landscape in five major Midwestern markets.
Greg Moyer

The diverse metropolitan areas comprising the Midwestern commercial real estate market have been impacted to varying degrees by the credit crunch and subsequent devaluation of the U.S. dollar that occured in the last quarter of 2007. Despite a decline in transaction velocity throughout the Midwest in the wake of the credit crisis, prices for well-located Class A product have remained relatively stable and will continue to increase steadily in 2008, particularly in anchor cities such as Chicago. Meanwhile, there has been a noticeable decline in value for Class B and C assets. As a result, expect to see the continued cap rate decompression for Class B and C assets this year. And when it comes time to sit down at the negotiating table, buyer and seller expectations for these mid- and lower tier assets will be more closely aligned.

Chicago
Apartment Investment Trends

Operating conditions in the Chicago apartment market will remain reasonably strong in 2008. Employment growth will sustain renter demand, and difficulties in the residential mortgage market will add to a large pool of potential renters, leading to a slight decline in vacancy.

Additionally, rents are expected to rise at a healthy rate. Among the demand-side trends to watch for in 2008 is employment in the financial activities sector, which tapered off in late 2007. This year, the Chicago Mercantile Exchange will cut 380 positions, and Bank of America will reduce local payrolls due to the firm’s merger with LaSalle Bank. The possibility of financial firms continuing to trim staffing levels, along with a 1.3 percent gain in supply, will likely cause the downtown vacancy rate to lag slightly this year compared to the overall metro market.

Consequently, Class B and C properties in the downtown area will likely fare better in the short term due to their working-class tenant mix. Meanwhile, vacancy in the suburbs is forecast to remain at less than 5 percent this year, and rents will climb at a pace greater than the market-wide average, as no new stock is scheduled for completion by year end.

Office Investment Trends

This year, the vacancy rate for assets located downtown is expected to fall 40 basis points to 13.5 percent. Class A tenants will target the Central and West Loop areas, where space continues to be absorbed quickly. Accordingly, building owners are expected to raise rents aggressively in 2008; Class A asking rents in both the Central and West Loop submarkets are forecast to rise approximately 4.5 percent this year, with additional rollbacks of concessions projected. Rents for Class B and C space will grow at a marginally slower clip, but could accelerate later in the year if tenants become priced out of high-end properties. Investors may act to take advantage of this trend by purchasing lower-tier properties where rents have languished below market level.

Retail Investment Trends

Developers will trim new property completions in the Chicago market this year, but a slower rate of economic growth and consumer spending will reduce tenant demand, leading to a slight increase in vacancy. The vacancy rate in urban submarkets is expected to rise nearly 50 basis points to the low 6 percent range this year due to the projected easing in demand generators, and rent growth will total approximately 2.5 percent. On the supply side, several land parcels were purchased in the city of Chicago over the past year, including a combined 12 acres at 1101 South Wells Street and 1000 South Clark Street. The buyer plans to develop 1,000 condos and a 400,000-square foot retail component. Builders will continue to target attractive sites in the year ahead, but existing property investors will maintain a strong interest in single-tenant net-leased assets. Deal flow may ebb in the next few months, however, due to lingering concerns over credit quality.

Cleveland
Apartment Investment Trends

Although home prices in Cleveland remain affordable, the renter pool is expanding, due in part to residential foreclosures. In addition, employment is expected to add jobs again in 2008, with the educational and health services sector experiencing some of the strongest growth. Renter demand will likely build momentum, while development of new units is expected to remain muted. Additions to inventory are forecast to run approximately 35 percent below the 5-year average, with most builders delivering small projects that contain fewer than 60 units. With limited amounts of new construction scheduled, vacancy should improve somewhat, enabling owners to increase rents at the most significant rate recorded in nearly 10 years.

Office Investment Trends

The Cleveland office market will improve subtly in 2008. Economic growth continues to support demand for office space in the metro, driving occupancy to levels not witnessed since the beginning of the decade. Development efforts downtown, including a new convention center and a county administration building, have renewed tenant interest in the area. Much of this year’s projected vacancy improvement is the result of business expansion within Class A properties. The vacancy rate in top-tier assets downtown, for example, is forecast to fall to nearly 10 percent, sparking market speculation about plans for a new high-rise. Development activity will likely remain quiet in 2008, as completions are forecast to add just 1 percent to inventory. Rent growth will also be minimal, as owners await greater occupancy improvements before adjusting lease terms.

Retail Investment Trends

Cleveland’s retail market will experience some softening due to new supply and slowing sales growth this year. Fortunately, the market is nearing the end of a recent spike in retail development, and there is only 1.3 million square feet in the planning phases for delivery beginning in 2009. The Flats East Bank and the Warehouse District, two substantial projects in the downtown area, are expected to include more than 500,000 square feet of retail, as well as nearly 1 million square feet of office space and approximately 1,000 residential units. While the scheduled completion of these developments is 2 years away, they are expected to renew interest in the downtown area, jump-starting retailer demand in and around the city. Beyond the city’s core, the Avon/Westlake submarket remains a focal point for retailers, following the area’s considerable residential growth.

Detroit
Apartment Investment Trends

Improving healthcare and gaming industries should stem the tide of job losses in Detroit this year, a trend that will benefit local apartment owners. The metro’s aging population is elevating demand for healthcare workers, many of whom may choose to rent, given the uncertainty surrounding the local housing market. In addition, the leisure and hospitality sector, which is buttressed by the local gaming industry, will add 1,500 traditionally lower-paying positions in 2008, supporting demand for local apartments. On the supply side, the rate of inventory expansion has slowed significantly, while apartment builders are struggling to find sites where rents justify higher construction costs. Subsequently, many developers are concentrating on condos. Nearly 80 percent of multifamily units slated for completion this year are condominiums, most of which will be located in the downtown submarket.

Office Investment Trends

The transitioning Detroit office market will continue to recover from the exodus of several major employers and the loss of thousands of jobs over the past few years. Employers are expected to add to payrolls in 2008, and supply will remain in check as stock is removed from inventory due to obsolescence and conversion. Vacancy is declining toward the 20 percent threshold, while rents are forecast to post a modest uptick by year end. The city center will experience much of the fundamental improvement. Several companies, such as Quicken Loans, Marketing Associates and Health Plan of Michigan, are migrating to the CBD from suburban locales. As a result, some cities will have to offer greater tax incentives to keep current employers in existing facilities.

Indianapolis
Apartment Investment Trends

An uneasy housing market and steady employment gains will support the Indianapolis apartment market this year. Potential job losses in the manufacturing sector will be more than offset by gains in other industries, particularly the education,  health services and government segments. Comparatively low business costs are attracting health care companies such as Arcadia Resources Inc., which plans to move its headquarters to Indianapolis this year, adding 400 positions by 2010. Years of growth north of the metro have congested traffic leading to the city center, driving renters to seek apartments in the western suburbs. As a result, effective rents in the Hendricks/Boone submarket are projected to advance a metro-leading 4 percent this year.

 Additionally, the above-average gap between rents and mortgage payments in popular Hamilton County will facilitate healthy rent gains in the area. On the supply side, apartment development will again be restrained this year, as there are a limited number of sites where asking rents justify current construction costs.

Office Investment Trends

A healthy local economy will boost the Indianapolis office market this year, lowering vacancy and sustaining modest rent appreciation. Office-using employment growth is accelerating, led by the expansion of major insurers Hartford Fire Insurance and Selective Insurance. Additionally, companies such as AT&T and Affiliated Computer Services Inc. are choosing to locate some of their customer support positions to Indianapolis. The metro’s favorable business costs, as well as its central location and low cost of living, continue to attract companies seeking to relocate their back-office positions. As such, leasing activity in Class B and C properties should gain momentum this year, after the vacancy gap between Class A space and the lower tiers climbed 300 basis points over the past 3 years. In top-tier assets, some pent-up demand by large employers for large blocks of space will drive vacancy lower, though medium-sized spaces will become available. On the supply side, construction will remain limited again this year, with a modest amount of speculative space coming online; Duke Realty Corporation, for example, plans to deliver 120,000 square feet of speculative space in the North/Carmel submarket by year end.

Retail Investment Trends

Relatively steady demand drivers will be offset by robust supply growth in Indianapolis this year, leading to a short-term shift in fundamentals. The vacancy rate will push higher as new developments lure retailers away from existing space, especially in the North submarket, where much of the construction is concentrated. Nevertheless, vacancy levels in the submarket should remain 350 basis points lower than the metro average, as many retailers are still drawn to this affluent trade area. West of the city, new developments are coming online largely vacant. Brownsburg Station, for example, was less than 50 percent leased when it was completed late last year. Elsewhere in the market, Indiana’s new “racinos,” or racetracks that also have casinos, are affecting the northeast and southeast regions. Nearby racinos have generated more traffic on Interstates 69 and 74, spurring demand for assets located between Indianapolis and the communities of Anderson and Shelbyville. In the city center, a few condo projects are still under way, which will increase population density and retailer demand. Additionally, properties near the new Lucas Oil Stadium will receive elevated foot traffic during major events.

Minneapolis/St. Paul
Apartment Investment Trends

Solid gains in the Minneapolis/St. Paul job market will offset elevated construction and support healthy apartment fundamentals in 2008. Job gains this year will be concentrated in the education, health services, leisure and hospitality industries. Many of these positions will be located in the downtown Minneapolis submarket, where apartment vacancy is below 3 percent and several for-sale projects have been scaled down or canceled. Plans for the 222 Hennepin project, for instance, which originally consisted of a 33-story condo tower, have changed to include top-tier rental units. Indeed, demand for condo units has dissipated in Minneapolis, and many residents are turning to premium apartments as an alternative. This trend is generating demand for Class A units in outlying suburbs, where some vacancy in the top tier persists.

Office Investment Trends

The rate of supply growth will outpace demand for office space in Minneapolis/St. Paul this year, leading to slightly weaker fundamentals. Despite overall economic growth, office users are expected to shed jobs this year, mostly in the professional and business services sector. The fastest-growing segment of the job market, however, will be the educational and health services sector, which is projected to increase demand for medical office space. Developers have already moved more medical office space into the pipeline, including a 150,000-square-foot property in Edina and the Haraeus headquarters in White Bear. Construction of competitive office space will be centered around office park expansion. Additions to the Normandale Lake and Two MarketPointe office parks in Bloomington will add 525,000 square feet to inventory, increasing the submarket’s stock by 3 percent. Both of the projects were put on hold during the last downturn in the economy, though the land was already purchased.

Retail Investment Trends

The supply-demand balance will begin to stabilize in the Minneapolis/St. Paul area this year, though new construction will outpace absorption modestly. Much of the new space coming online is big-box development in suburban areas, which will cause vacancy to inch higher this year. As such, conditions will remain tight in suburban areas, and owners will enjoy healthy rent gains. Around the metro area, robust tenant demand for new space in the East Hennepin County/Minneapolis submarket will be met with limited construction. Several condo projects in the area that included ground-level retail have been canceled in the wake of a softening housing market. In the Anoka/Southeast Sherburne County submarket, retailers are following the significant housing construction over the past few years, particularly in Blaine. The planned SportsTown USA, for example, will double in size to keep pace with demand. Elsewhere, owners in the Interstate 94 corridor in the West Hennepin County submarket should get a revenue boost from vacancy improvements, as retail space delivered in 2007 is absorbed due to demand generated by the future Northstar Commuter Rail line.

The repricing of commercial investment real estate and cap rate increases in so many Midwest markets will require savvy brokerage and real estate services companies to return to the basics in terms of underwriting and valuating properties. Marcus & Millichap welcomes that trend, which will allow us to continue to underwrite transactions based on real net operating income. In 2008, properties will be valued based on their current or achievable pro forma income. By all accounts, that will be a positive trend that is embraced in the new year.

Greg Moyer is the senior vice president and managing director in the Chicago office of Marcus & Millichap Real Estate Investment Services. Moyer wrote this article in conjunction with Michael Glass, Steven Chaben and Solomon Poretsky.

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