HEARTLAND SNAPSHOT, JANUARY 2005

Minneapolis/St. Paul Office Market

There are three significant trends in the Minneapolis/St. Paul office market, according to Rob Thomas and Mike Honsa of Minneapolis-based Equity Commercial Services. First, tenants are purchasing buildings to become owner/users because of historically low interest rates. The demand for owner/user buildings and the amount of investment money in the real estate market has driven prices above historical price levels, and investment properties are trading above market fundamentals. This has created a market for a second trend: office condominiums in the Twin City suburban markets. These trends allow owner/users the tax benefits while keeping their monthly mortgage costs lower than lease rates. Finally, some office buildings are being converted to residential condominiums, most notably in St. Paul. The building conversions tend to be Class C buildings or in one case a difficult building to reposition in the Southwest suburbs. “These trends have generally removed tenants or buildings from the multi-tenant market, thus adversely affecting the

Twin Cities market data,” Thomas says.

New office construction is stagnant in Minneapolis/St. Paul. There have been some build-to-suit projects that have been completed in the past year as well as some speculative development which has been reserved for medical tenants. The most significant new developments have been build-to-suit and office condominiums. Build-to-suit properties have occurred closely to the companies’ current locations, while office condominiums are being developed in the outlying suburbs where land is less expensive and locations provide greater proximity to growing populations.

“Build-to-suit developments have, in some cases, increased vacancy in the marketplace because single tenant buildings are not included in the market data,” Honsa says. The most significant of the new build-to-suit developments in the Twin Cities is the St. Paul US Bank corporate campus. US Bank vacated multi-tenant buildings in the St. Paul CBD, thus adversely affecting the vacancy rate. The State of Minnesota is another example of this trend compounding the effects on the St. Paul CBD due to a consolidation of multiple locations.

The average rates for Class A properties currently range between $11 and $15 per square foot. The low average is a product of the Minneapolis and St. Paul CBDs, where the overall vacancy rates are the highest in the Twin Cities market. The market has continued to see a migration of tenants from Class B to Class A properties throughout the Twin Cities market, which has resulted in higher vacancy rates for the Class B properties and increased competition for tenants. Competition throughout the market has continued to support an environment of tenant concessions.

According to the 2004 NAIOP Office Market Update, the current vacancy rate for the overall Minneapolis/St. Paul office market is currently at 17.6 percent, which is slightly lower than 18.2 percent in 2003. At the time of this report, the sector with the largest vacancy is the St. Paul CBD, with a rate of more than 25 percent. This was caused by some larger users such as US Bank and the State of Minnesota vacating multi-tenant buildings in the St. Paul CBD. The lowest is the St. Paul suburban market, which is at around 9 percent. The Western metropolitan area has seen the first decrease in vacancy rates in several years.

No new significant developers have emerged in the Minneapolis/St. Paul area, but familiar faces, such as McGough Companies and Ryan Companies, continue to lead the market with significant office developments. McGough has several planned projects in the Southeast metro area which include Bloomington Central Station and Blue Gentian Corporate Center. Ryan is focused on the redevelopment of the mixed use Midtown Exchange, a former Sears multi-story warehouse in South Minneapolis, which is scheduled for completion in 2005. It will be Allina Health Care’s new corporate headquarters.

“Target Corporation has demonstrated the greatest need for expansion in the Twin Cities office market,” Thomas says. They have recently signed a lease in the Minneapolis CBD for approximately 150,000 square feet at 33 South 6th Street. Other large companies are beginning to expand but none of any great significance at this time. This demonstrates that these organizations are filling shadow space that they have carried through this down market.

“Although total market equilibrium is a few years away, the suburban markets are the areas to watch,” Honsa says. “With vacancy rates on the decline, there is greater opportunity for future office development. However, rental rates need to increase to justify new developments due to increased construction costs.”

Don’t overlook the St. Paul suburbs, which are closer to equilibrium and are less saturated. The Southeast market has three projects planned that total more than 1.5 million square feet. McGough controls two of these sites, which make up a majority of this proposed development with Bloomington Station at 1 million square feet and Blue Gentian Corporate Center at 400,000 square feet. “This is a small market with a lot more land available than the Minneapolis suburbs,” Thomas says. “It has good potential and great access to Minneapolis, St. Paul and the airport.”

Owner/user sales and build-to-suit activity continue to be strong. Although this has had a negative impact on individual multi-tenant markets, vacancy rates appear to be on the decline. However, with owner/user sales, build-to-suit activity and high vacancy rates, the Minneapolis/St. Paul office market continues to be very competitive, making it essential for landlords to continue to offer generous lease terms. Additional build-to-suit development will continue to stifle new multi-tenant construction, so it may take a few years before there is any significant new development. There are several planned projects that hope to kick off the next wave of new multi-tenant development.

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