CITY HIGHLIGHT, JUNE 2004

TWIN CITIES CAPITALIZE ON ECONOMIC IMPROVEMENT
Raymond Reese, Jim McCaffrey, Mark Kolsrud, Mark Globus,
Roger Lenahan and Amy Barth

The Twin Cities area is following the general path of improvement seen across the country. Industrial and retail vacancy rates are decreasing, and projected interest rate increases are expected to improve occupancy in the multifamily sector. While office vacancy rates in the area are high — more than 20 percent of the total office space is available for lease — office condos are doing very well, and developers are making the most of the trend.

Office

In the Minneapolis/St. Paul office market, developers have become much more conservative in this real estate cycle with few, if any, speculative office projects moving forward without a significant lead tenant identified or with the developer/leasing team reaching a designated threshold of pre-construction lease commitments.

One significant trend in development is the active market for small office condominium buildings. Tenants are now purchasing their office space at rates competitive with lease rates. Developers are positioning these projects, which are designed for the small business owner and occupant, with the emphasis on “own your office or showroom.” This type of office condominium product is association-managed, with both landscaping and snow removal handled by the association. Some of the options in this type of office condominium development include zoned heating and cooling, additional bathrooms and showers, cabinetry, kitchens, wet bars, decks, fireplaces and custom millwork.

There are trade-offs when purchasing office condominiums as contrasted with traditional leasing. Generally, office condominiums tend to be less centrally located and are not built for great access and high visibility. Also, tenants become their own landlords and are responsible for many of the concerns of owning office property. The tradeoff is equity in their own office building and projected appreciation of the property.

After a long period of contraction by office space users and an overall softness in the office leasing market, the market is slowly heating up. Building owners, who have seen their vacancy rates peak, are breathing a sigh of relief as net absorption is on the increase. Companies already present in the market are expanding their offices. Also national companies, such as Mobility Technologies (Traffic Pulse Networks), are entering the Twin Cities Market for the first time. Several companies including Fios, Inc. and The Garrigan Lyman Group have used only “virtual offices” in the Twin Cities, and their firms now feel the need for actual “bricks and mortar” office locations. The expanding economy also seems to be having the effect of pushing companies to be less conservative with their real estate but this has been an incremental change.

Two significant trends that could affect the Twin Cities office market are the outsourcing of jobs formerly held by American workers to foreign areas and the increasingly difficult traffic in the metropolitan area.

There is a great deal of vacancy in the office market with upwards of 20 percent of the total space vacant and available for lease. April’s new job numbers were decent but the economy is lacking the strong demand it needs to replace displaced workers. There are 500,000 fewer private sector jobs today than there were in November 2001.

One area that is receiving more press coverage is the transfer of American white collar, and client service jobs overseas to countries such as India, China and Brazil. With the increased amount of fiber and cable bandwidth, companies are now able to quickly and effectively communicate with remote offices.

This development is significant because these displaced U.S. workers occupy significant amounts of office space for their employers. On average, the typical office employee working in a workstation environment occupies 64 square feet, and a private office on average represents 120 square feet. Obviously, if these jobs are eliminated and sent offshore, there is a corresponding reduced need for office space and building complexes. How this new wild card factor is going to trickle down into the need for office space in our market and across the United States is unknown. This issue, however, has been receiving a great deal of national media attention with the upcoming presidential elections in November.

Traffic in the metropolitan area has become a significant quality of life issue. It affects productivity and how business gets done as more and more Twin Cities commuters adjust their driving patterns to avoid both the morning and evening rush hour traffic. Traffic flow will become a more significant issue with office building developers. The Hiawatha Light Rail Line is scheduled to open this month, but it is not predicted to impact the increasingly heavy traffic levels. The rail line may influence office projects along routes since proximity to the line is going to be a benefit for office building owners and tenants. Office building owners who are along the rail line are likely to see this as a way to distinguish their building and make it more marketable to future and current tenants.

Development activity has been light during the last year with significant preleasing required on the majority of proposed projects. The areas seeing the most proposed projects in the northeast ring include Arden Hills, Lake Elmo, Little Canada, Oakdale, Vadnais Heights and Woodbury. In the northwest market, there are proposed projects in Maple Grove and Plymouth. In the South/Airport market, the suburbs of Burnsville, Eagan and Mendota Heights have projects in the preleasing stage. In the southwest market, the suburbs of Bloomington and Eden Prairie have significant projects in discussion and at the prelease stages.

The vacancy rates in the Twin Cities metropolitan area, which include sublease space, vary by 15 percentage points depending upon the geographic area. The submarkets and their corresponding rates are Minneapolis CBD, 22.2 percent; southwest suburban market, 19 percent; western suburban market, 19.5 percent; South/Airport market, 16.3 percent; St. Paul CBD, 28.2 percent; and the St. Paul Suburban market, 12.3 percent.

The net rental rates for office buildings are $13.50 for Class A space, $10.21 for Class B space and $8.05 for Class C space.

Brokers and potential tenants should keep their eyes on the Minneapolis Central Business District (CBD). Tremendous amounts of values are still to be found downtown in both Class A and Class B properties. These CBD buildings have the entire downtown infrastructure to offer companies, and the downtown core and warehouse district allow companies to leverage their sales activity. This is possible because of the high concentration of potential business partners/clients that are within a few blocks’ radius. On a pure economic basis, a number of buildings in the Minneapolis CBD are offering measurably more aggressive net leasing rates and packages than office buildings in the suburban markets.

— Mark Globus, vice president, GVA Marquette Advisors

Industrial

Despite a variety of challenges, the Twin Cities industrial market is well on its way to recovery. However, some obstacles remain: namely, downsizing and consolidation by tenants, and businesses looking to purchase space rather than lease space. The good news is that the market experienced a boost thanks to the improving economy, continued low interest rates and earlier optimism that the war in Iraq was winding down.

The rebound is occurring as space gets absorbed and low interest rates allow users to take advantage of lowering occupancy costs by buying buildings.

Vacancy rates are trending downward, helped along by limited speculative development. The area’s direct vacancy rate stood at 14 percent at the end of 2002 and finished last year at 12.4 percent. With a sustained recovery, the Twin Cities may see its base of more than 350 million square feet of industrial property drop to a vacancy rate of less than 7 percent by the end of 2005.

Each of the three major sectors faces challenges as well as opportunities.

The bulk warehouse sector has been impacted as large users look elsewhere to consolidate operations in more modern and efficient warehouse and distribution centers. Realizing the loss of jobs to more business-friendly states, the Minnesota legislature passed a JOBZ tax-free zone program, which may help reverse the migration. The bulk sector ended last year with a 16.1 percent direct vacancy rate, which was an improvement from the nearly 20 percent direct vacancy rate posted at the end of 2002.

Rental rates for the warehouse portion of bulk space averaged from $3.13 per square foot in Anoka County to $5.15 per square foot in Scott County.

The office showroom/business center multi-tenant sector showed encouraging results last year, with positive absorption of nearly 283,000 square feet and a direct vacancy rate of 10.4 percent at year-end. The Twin Cities has had success in attracting bio-tech companies, with many medical supply firms now occupying space formerly vacated by dot-com ventures in the office showroom/business center sector.

Rents for the office portion range from $8.50 per square foot to nearly $10 per square foot, while the warehouse space averages between $4.25 per square foot and $5.05 per square foot.

The third leg of the industrial stool — office/warehouse space — improved slightly last year. After record positive absorption of nearly 413,000 square feet during the first half of 2003, this sector experienced negative absorption of 46,647 square feet during the second half. The direct vacancy rate improved nearly 1 percent, ending the year at 11.8 percent.

Average net lease rates for the office space portion averaged from $7.61 per square foot to $9.36 per square foot throughout the Twin Cities area and from $3.77 per square foot to $4.63 per square foot for warehouse space.

The pharmaceutical, medical device and bio-science industries are driving demand for space. Upsher-Smith, Protein Design Laboratories, Sur-Modics and Boston Scientific have either expanded or plan to expand. Boston Scientific recently announced a 200,000-square-foot office/manufacturing build-to-suit project in Maple Grove. RR Donnelly, one of the nation’s largest printing companies, just finished a 100,000-square-foot build-to-suit project with Duke Realty Corporation.

Overall, development is primarily relegated to the northwest and northeast metropolitan areas. Real Estate Recycling has a 109,000-square-foot office/ warehouse facility under construction in the France Avenue Business Park Phase III in Brooklyn Center. Marfield, Belgarde & Yaffe has a 461,300-square-foot office/warehouse facility going up in the Rogers Industrial Park Center in Rogers.

Other projects under construction are smaller in scope: a 29,000-square-foot office/warehouse by BMB R.E. Advisors in the Chan Lakes Business Park in Chanassen and a 98,000-square-foot office/service center by CSM Corporation in the Westgate Business Center V in St. Paul.

While another nearly 4.5 million square feet of industrial space has been proposed and planned, developers face a number of challenges moving forward: well-located industrial land available with municipal services is in limited supply in proven market locations; qualified sites have seen values climb; construction costs are starting to rise; lease rates have not rebounded because landlords aggressively re-lease existing vacancies at somewhat lower rates; and the wild card — the uncertainty and huge increase in steel availability and pricing that may make some proposed projects economically unfeasible.

Once again, challenges present opportunities. In this case, existing buildings may become great values for users looking to expand. At the end of 2003, buyers could select from more than 100 buildings on the market, offering more than 8.5 million square feet of space. It just may be the ideal time to purchase industrial property.

St. Louis-based Commercial Development Corp. took advantage of the robust investment market in mid-March when it purchased a portfolio of 23 industrial buildings and two office buildings throughout the Twin Cities. Commercial Development’s $57 million purchase from Duke Realty represents one of the biggest industrial transactions in recent years.

As the economy shows signs of life, demand for industrial space should continue in the right direction. Positive absorption of 3 million square feet to 4 million square feet should occur by year-end. Fears remain about the cost of new construction, but the long-term effect on existing facilities may act as a stimulant in 2005 and later to dramatically drive up lease rates and the values of vacant buildings. The next couple of years will be interesting to watch as investors, developers and space users all jockey for their best positions.

— Raymond Reese is senior vice president at Colliers Turley Martin Tucker in Minneapolis/St. Paul.

Multifamily

The central business district condominium fever seems to be slowly spreading into the suburbs. For example, a developer recently announced that its 280-unit apartment property under construction will be brought on line as a condominium project rather than as a multifamily market-rate rental.

Class A product in the Twin Cities area continues to harness unprecedented demand from institutional buyers. The low interest rate environment has continued to provide a strong demand for quality product and downward pressure on cap rates. No doubt, as interest rates begin their ascent into “normal” ranges during the next 2 to 3 years, it will be more of a blessing than a curse for multifamily owners.

The fantasy land of low interest rates has driven more renters into for-sale housing than ever before, which has hurt apartment occupancy. While values have not been affected, vacancy and rents have been affected. This typically lethal combination has not slowed investor demand. Once rates and the economy escalate to more normal ranges, this stampede for home ownership, including condominiums, will diminish. The results should drive apartment vacancy back into 94 percent to 97 percent occupancy levels and generate more stabilized net operating income.

Only a small amount, if any, of the new construction product built in the last few years has been converted into condominiums. To rental owners, this lack of conversions could be a blessing as conversions become more popular and more apartment product disappears into the ownership clouds. However, owners who have locked into artificially low interest rates should be set to reap the benefits of higher yields as a result of lower debt service, better rents and lower vacancy.

Apartment complex owners will see continued demand for the next two quarters. Historically when interest rates rise, they do so quickly. As Alan Greenspan has made clear, interest rate increases are inevitable in order to control inflation concerns and keep growth of the economy in check. Although the stock market reflects unwarranted trembling as a result of this inevitability, real estate investors will reap the rewards.

— Jim McCaffrey and Mark Kolsrud are senior vice presidents at Colliers Turley Martin Tucker in Minneapolis/St. Paul.

Retail

The Minneapolis/St. Paul retail market continues to thrive with more than 2 million square feet of retail space added last year, and continued interest from international, national and local retailers. The overall retail vacancy rate is 5 percent, which is below the national rate of 6.8 percent.

The Minneapolis/St. Paul market boasts almost 50 million square feet of leasable space with relatively low vacancy rates. The regional malls’ 2.3 percent vacancy is the lowest rate in the market. Community centers are next with a 3.3 percent vacancy rate. The neighborhood centers have the highest vacancy rate with 7.3 percent.

The most activity in retail growth during the past year occurred in the suburban markets such as Blaine, Coon Rapids, Lakeville, Maple Grove, Savage, Shakopee and Woodbury. Strong residential growth in these and other areas has stimulated development of community and neighborhood shopping centers. In the cities of Savage, Blaine and Champlin, SuperTarget anchored the three largest and most recent retail developments in the market. Southdale Center, located in Edina, is planning an expansion this year, which will feature a women’s health center and additional restaurants and retail.

Retailers that are new to the Twin Cities include Lowe’s Home Improvement Warehouse, IKEA, Sportsman’s Warehouse, Ultra Electronics (Audio King) and Roundy’s with the acquisition of the Rainbow Foods chain from Fleming Corporation. New restaurants that have entered the market include Balimby Bay, Zyng Noodlery, Qdoba Mexican Grill, Potbelly Sandwich Works, Louis XIII, Mission Bar & Restaurant and Figaro’s Take & Bake Pizza and Camille’s Sidewalk Cafe.

The most active developers in the Minneapolis/St. Paul market include Ryan Companies, with several Target and SuperTarget developments, and Opus North and RED Development, which continue to team up in lifestyle developments such as Woodbury Lakes. Woodbury Lakes, located in Woodbury, will be similar in concept to the Shoppes of Arbor Lakes in Maple Grove. North American Properties, Told Development Company, Robert Muir Company, CSM Corporation and Paster Enterprises also have built high quality projects.

— Roger Lenahan, Principal, Cambridge Commercial Realty; and Amy Barth, Managing Director, Cambridge Commercial Realty

©2004 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.