COVER STORY, FEBRUARY 2010

MIDWEST CBD OFFICE REPORT
Forecasts of the CBD office sector for St. Louis, Detroit, Indianapolis, Minneapolis and Chicago.
Compiled by Amy Bigley

Heartland Real Estate Business touched base with commercial real estate experts in St. Louis, Detroit, Indianapolis, Minneapolise and Chicago to see what 2010 holds for the respective cities’ central business district office sector.

St. Louis

The St. Louis central business district (CBD) weathered the economic downturn of 2009 with a significant drop in net absorption, approximately 107,000 rentable square feet. The major contributor to this negative absorption was the move of law firm Husch, Blackwell Sanders to office space in Clayton, Missouri. The ripple effect of this significant move out and other firm contractions caused vacancy rates, including sublease, to increase to a year-end of 18.2 percent, which is an almost 200 basis point increase.

While average rental rates dropped by 1 percent to $16.70 per square feet gross, the real story is a marked increase in concessions offered by CBD landlords to retain or attract tenants in an anemic market. Savvy tenants in the market took advantage of these once-in-a-lifetime deals to either renew leases or trade up to better quality buildings in the market. Significant transactions that support this trend are law firm Lewis Rice’s move to One City Centre and accounting firm BKD’s move to Metropolitan Square.

Landlords are looking forward to an increase, as economic incentives and companies switch from cost containment to judicious growth mode. The St. Louis CBD is expected to begin to turn the corner from the bottom of 2009. While it will continue to be a landlord’s market in 2010, experts expect to see more reasonable economics, driven partly by the market, but also driven by lender requirements. If the deal does not make reasonable economic sense, it will not be done.

Downtown St. Louis has increased its appeal as a place to locate a business. The quality of life, urban feel and amenities are driving many companies to consider the CBD. Expect to see continued increase in retail infill and additional focus on quality of life improvements. The opening of the $25 million CityGarden across from Bank of America Plaza is an example of this qualitative improvement to CBD office environment.

The big development question in 2010 remains—when will the long awaited Ballpark Village break ground? This ambitious mixed-use project has been on the drawing boards for many years and is stalled because of the financing market.

The greatest challenge facing the CBD is lack of job growth to fuel either existing tenant expansion or new businesses moving downtown. Rental rates are attractive relative to the rest of the market and landlords are still willing to make attractive deals. Without increased demand, downtown buildings will continue to compete among themselves by attracting tenants from the competition and competing on price and concessions.

The CBD needs to keep up the momentum of continuous improvement to the look and feel of the area. The area around One City Centre and the convention center needs improvement. If the residential market comes back to life, even modestly, downtown will regain some momentum as a true urban environment. This will help attract industry clusters from other submarkets such as advertising, creative and biotech. Additionally, the city of St. Louis needs to focus on attracting new businesses to downtown through increased incentives applied aggressively and equally to all buildings in the CBD. This is especially important for job creation as the economy begins to recover.

The St. Louis CBD has ridden the economic downturn and has another year or two of a slow recovery. The long-term prospects of this market are good, as there is a community consensus and desire to see the CBD become the economic and cultural center of the region. St. Louis is home to three major league teams, the iconic Gateway Arch, numerous theaters and a burgeoning loft district. As companies recognize the quality of these amenities and the importance in retaining and attracting knowledge workers, the CBD office market will once again thrive.

— Henry Voges is senior vice president and St. Louis market director with Jones Lang LaSalle.

Detroit

As 2009 came to an end, the national recession and restraints in the credit markets postponed many local developments, building sales and refinance activities. The metro Detroit office market also saw an increase in sublease availability as corporate layoffs caused many office users to find ways to reduce space footprints. Comerica Bank has been consolidating its remaining Michigan operations, and recently announced that it will completely vacate 285,000 rentable square feet of leased CBD space. The uncertainty of unemployment rates, population growth and lending also continue to drive real estate prices downward. 

Last year also saw major consolidations and space reduction in the automotive industry. Lear Automotive filed for bankruptcy and gave back 150,000 rentable square feet of office space. However, tax credits and other economic incentives opened the door for film and alternative energy sectors to announce several major redevelopment projects such as the purchase and conversion of a former Ford Motor Company plant into a 320-acre renewable energy park.  

The new year is likely to see more stagnation as many commercial property owners await a surge in employment and an overall market recovery. As capital markets begin to improve, corporate spending should increase and may facilitate expansion in some sectors. Office users currently have an abundance of supply to choose from and will continue seeking ways to cut occupancy costs. Metro Detroit is not likely to see any major construction projects until the credit markets have fully recovered.

In the coming year, users hoping to dispose of excess space through subleasing will be competing with an abundance of subleases and discounted direct office product in a tenant-favorable climate. Developers in this market will not likely see adequate user demand to justify investing in new projects because of the lag time associated with a market recovery. Additionally, landlords and building owners will have to endure the effects of an uncertain labor market and the hurdles of accessing capital through traditional means.

Developers should position themselves to take advantage of public funding opportunities and cultivate partnerships with nonprofit organizations and public funding agencies. Meanwhile, landlords must focus on retaining tenants by continuing to offer extremely aggressive incentives to attract prospective tenants. Landlords must also practice flawless cash-flow management, as access to traditional capital and refinancing mechanisms will be very limited.

Many metro Detroit tenants will likely continue to delay making long-term real estate decisions and look for ways to cut occupancy costs through consolidations and downsizing. The health of the metro Detroit real estate markets will be directly impacted by the outcome of the current restructuring of the auto industry.

— Joseph Pigott is an associate with Jones Lang LaSalle’s Detroit office.

Indianapolis

As 2009 closed, the Indianapolis CBD saw a 4 percent increase in vacancy to a year-end total of 19 percent. Very few deals were completed in the market but some deals were negotiated, including Price Waterhouse Coopers relocation from 300 North Meridian to 22,000 square feet at National City Center, and Regions Bank downsize to 67,000 square feet at One Indiana Square.

There will be no speculative office development in the CBD in the foreseeable future due to the challenging economy and recent large vacancies, as well as a scarcity of vacant land in the heart of the market. The market will look to fill existing large tracts before anybody dreams of new construction.

Expect negative absorption in 2010, as the CBD pillages tenants from one property to the other. There has been little to no movement of suburban tenants to the CBD and there are no signs of that changing in the near future. 500 North Meridian, the former headquarters of Safeco Insurance, came available in August of 2009 and added 300,000 square feet of vacancy to the market. Couple that with Eli Lilly’s plan to vacate the 450,000-square-foot Faris campus at the third quarter of 2010, and there is an additional 8 percent of the market coming vacant in a 12-month span. The main challenges facing the CBD in 2010 are for the Class B buildings. Class A product such as Chase Tower and One American Square have historically been 95 percent or more occupied and will continue to be so. There is a glut of Class B space available. 500 North Meridian, One Indiana Square and M&I Plaza all have 100,000-square-foot tracts of Class B office space available.

Landlords will probably break down into one of two groups. Those with solid occupancy will focus on retaining existing tenants and keeping out-of-pocket expenses and tenant improvement dollars at a minimum to ensure the necessary cash is available to maintain properties and refinance any maturing debt. For landlords, being able to weather the storm will be a key part to renewing any upcoming expirations and attracting scarce new tenants. Experts expect tenants to grow increasingly weary of cash-strapped landlords and foreclosures. The other group consists of landlords with large pockets of vacancy in properties, which need to be stabilized prior to debt maturity. These landlords will most likely end up in a bidding war, as there are considerably more vacant tracts of 25,000 to 50,000-square-foot space than tenants to fill those vacancies. These landlords will need to think outside of the box and look to attract users from a diverse pool of prospects. As traditional CBD office space users—legal, financial and insurance companies—continue to feel the squeeze, landlords will look to non-traditional uses such as trade schools, universities, federal and local government, medical groups and suburban users to fill large tracts of vacancy.

Expect to see the gap in rates and concessions widen between the Class A and B product. There are approximately 15 multi-tenant buildings of 275,000 square feet or more, totaling approximately 8 million square feet, that are the major assets in the CBD market. Of those, the Class A product is 91 percent occupied, while the Class B product is 69 percent occupied. Tenants in the market will have to decide between the prestige of the Class A product or a lower class product at a bargain rate, as desperate landlords struggle to fill vacancies in the older high rises. Overall vacancy is 19 percent, with full-service rental rates ranging from $16 for low-end Class B properties to $26 for Class A+ product.

The lack of new construction in the CBD has helped keep the market in a somewhat stable condition. The Class A+ buildings should continue to widen the gap in product type and continue to garner the highest rates and hold on to the largest, highest credit tenants. Focusing on maintaining the property, increasing efficiencies to minimize operating expense costs and adding additional amenities will continue to separate these select properties from the rest of the market. The Class B properties will have the toughest year, as the properties continue to have high vacancy rates and struggle to stabilize cash flow.

The Indianapolis CBD has historically strong fundamentals. The state of Indiana made an investment in the CBD many years ago and houses a majority of its agencies in the CBD. This critical mass of people has helped grow the office market, which, in turn, allowed the infrastructure of the CBD to flourish. The CBD offers office, restaurant, hotel and entertainment venues, including the Indianapolis Colts’ new stadium, the Indiana Pacers’ arena, Circle Center’s offering of restaurants and retail, the NCAA headquarters and 4-star hotels. These amenities are typically reserved for first-tier markets and set the Indianapolis CBD apart from other like-sized cities. Once the economy turns, these strong fundamentals will ensure the Indianapolis CBD remains strong for many years to come.

— Adam Broderick is vice president, agency leasing with Jones Lang LaSalle’s Indianapolis office.

Minneapolis

As 2009 came to an end, the Minneapolis economy continued to struggle causing many companies to reduce workforces. The overall unemployment rate rose to more than 10 percent and real estate markets continued to soften as a result of decreased office space requirements. This decrease in required office space led to more than 470,000 square feet of shadow space.

Vacancy rates across all building classes in the CBD experienced increases largely due to corporate consolidation and downsizing. The overall vacancy rate rose from 14.1 percent in 2008 to 17.2 percent in 2009. Last year experienced very little new construction with the majority of work completed being build-to-suit offices; however, two notable projects in the CBD are the Macy’s and Ameriprise single-building tenant conversions to multi-tenant spaces with large availabilities.

In a continuation from 2009, 2010 is likely to see landlords struggle with vacancy levels rising and rental rates decreasing. Landlords will need to be positioned to offer very lean deals in response to the current and continuing market dynamics. As the capital markets begin to improve, some owners will look to lenders to restructure loans and stabilize buildings. Office users currently have an abundance of supply to choose from in all classes and will continue to look for ways to trim costs, as property managers work to maintain or lower operating expenses. No major developments have gotten past initial planning stages and most will be stalled until vacancy rates reach levels less than 7 percent.

Space users with excess space will be challenged with right-sizing and subleasing to create an optimal real estate footprint. As the economy slowly starts to turn, users will need to consider how to keep expenses low while still maintaining market presence and long-term stability.

Tenants should consult with a real estate professional that understands the opportunities that exist in current buildings, as well as relocation options. Companies should consider approaching landlords 1 to 2 years prior to lease expiration to negotiate savings through favorable renewal and restructuring terms, as this will create strong leverage for tenants. Additionally, as landlords continue to feel the pinch of the market, a shoot-for-the-moon approach to terms may prove beneficial to tenants.

Developers should be positioned for the recovery and public funding opportunities, which may be presented in 2010. Large users will continue to be looking for upgraded opportunities for future employment growth and employee attraction. Developers will need to be proficient in existing and growing trends towards green buildings. Landlords should be focused on current and not past markets, as tenants will continue to push the envelope on lease terms—rents, tenant improvements and rent concessions. Additionally, landlords should retain tenants at all costs and offer aggressive incentives to attract new tenants.

— Brian K. Ginkel is vice president at Jones Lang LaSalle’s Minneapolis office.

Chicago

The Chicago CBD overall vacancy rate reached a 4-year high of 15.8 percent at year-end as the market witnessed below-average demand, sizeable construction deliveries and rising sublease offerings. Some landlords fared well, while others stalled or worse—lost tenants. Successful landlords included those in the West and Central Loop districts whose space continued to command rents supportive of targeted pro-formas. Additionally, winning landlords were able to retain and attract new tenants. Parkway Properties, for instance, retained Health & Human Services, Clear Channel and Young & Rubicam at 233 North Michigan Avenue while also luring Combined Insurance to 111 East Wacker.

Tenants with lease expirations or termination options have benefited from the current market conditions. Many have been able to renegotiate leases 3 to 5 years prior to expiration and either right size or reduce any remaining lease obligation in exchange for a lease extension. Whether a renewal or relocation, the lack of deal volume has supported aggressive deals for tenants.

The construction pipeline will dry in the first quarter of 2010 when the last of this cycle’s projects are delivered. An uptick in leasing activity is expected when compared to 2009, but an expansion in space needs is not anticipated. Tenants will continue to reduce costs, while landlords will continue to try to stabilize tenancy through aggressive renewal terms. Landlords without capital constraints will lure tenants by offering significant concessions, and there will not be an increase in rents for the foreseeable future. Sales activity should return as the capital markets have started to open up and the appetite for risk has increased in recent months.

The financial trouble that is facing a number of landlords is obviously impacting deals. A tenant of any size is expecting concessions that will help offset relocation and construction costs. If a landlord cannot offer concessions then it has a significant disadvantage in the market. Owners without debt issues and those that have cash will be much better positioned in the 2010 market. Also, landlords will continue to compete with sublease alternatives, as there is currently nearly 4 million square feet on the market in the Chicago CBD.

Tenants that have flexibility on location and space layout will be able to find very aggressive deals. Tenants need to be aware of the financial stability of landlords or prospective landlords. Good news for all landlords is the lack of new development for the next several years, which will cause tenants to look at existing inventory options.

The Chicago CBD direct vacancy rate was 13.4 percent in the fourth quarter of 2009, and with sublease space it hit 15.8 percent. Average full-service asking rental rates declined by 3.2 percent during the year to close at $30.42 per square foot.

Although tenants can continue to secure aggressive deals by taking advantage of the current market conditions, the Chicago CBD leasing market is in much better condition than other major markets. The lack of further development and the influx of tenants to the market has soften the blow to landlords. Additionally, Chicago benefits from a diverse tenant base and a growing futures, options and proprietary trading industry, which has contributed unexpected absorption. Furthermore, during the last 2 years, several notable deals have signed in the CBD, which will bring significant new employment into the downtown area.

— Matt Carolan is managing director with Jones Lang LaSalle’s Chicago office.

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