CITY HIGHLIGHT, JUNE 2007

MINNEAPOLIS/ST. PAUL CITY HIGHLIGHTS
Amy Senn, Bob Pounds, Nathan Arnold, Kevin O’Neill, Keith Collins and
Laura Hanneman

Minneapolis/St. Paul Retail Market

The Twin Cities retail sector has outperformed all other property types in recent years, driving vacancy rates into the low single digits and spurring new development. Rental rates and property values have increased and, as a result, property taxes have escalated. In late 2006, the retail frenzy reached its peak, and activity began to slow down and level off as the market corrected itself. Thus far in 2007, the market has continued to be sluggish. A modest 5,232 square feet of space has been absorbed, bringing vacancy to 3.21 percent metro-wide in the first quarter of the year.

For smaller tenants, the combination of high rent and tax costs has made it challenging to turn a profit. Some tenants are downsizing to counteract rising expenses, and concessions are being reintroduced to the market to attract and retain smaller tenants, particularly upon renewals. Despite these challenges, service-oriented tenants continue to occupy an increasing share of the available retail space and transactions are closing, albeit at a slower pace than what was experienced in recent years.

Development has tapered off due to a decrease in demand for space and the decline in residential growth. Through master planning, cities are taking an increasingly active role in development in order to ensure all new projects are in keeping with the area’s overall vision. In some cases, this increased involvement is hindering development, as cities are applying restrictions as to which stores or chains are allowed in the area. Big box companies, which often self-develop, are instituting further limitations by restricting what can be developed within a specified proximity to their stores. Most of the development that will go up in the immediate future will be built for larger users.

The Minneapolis central business district (CBD) led the metro area in the first quarter, with 12,921 square feet of positive absorption. Downtown retail has historically lagged behind the stronger-performing suburban markets, but a slow and steady shift in the tenant mix seems to be turning the market around. Discount retailers are beginning to outnumber the more traditional upscale stores, and service-oriented businesses are occupying an increasing share of the available retail space.

E*Trade Financial recently announced plans to open its first local retail location this quarter. The firm will occupy roughly 4,000 square feet at the Fifty South Sixth building and will fill the property’s last retail vacancy, bringing the retail component of the tower to full occupancy for the first time since its opening. Traditional sit-down restaurants are another subset of retailers that have struggled in the CBD, but several new restaurants are slated to open in the near future and try their hand at turning a profit in the downtown market. The Brazilian-themed steakhouse Fogo de Chao opened in City Center in April; R. Norman’s, a traditional steakhouse, is expected to open this summer in the Stimson Building at 700 Hennepin Avenue; and Bank Restaurant, a restaurant featuring American cuisine and locally produced, seasonal ingredients, is opening in the new Westin Hotel within the historic Farmers and Mechanics Bank Building.

In a market in which the pace of development has slowed, the Northeast is one submarket that is still seeing the addition of space. The region, which experienced 9,082 square feet of positive first-quarter absorption, enjoys a low vacancy rate of 2.57 percent. Roseville, Minnesota, is among the cities scheduled to see new product in the near future, and will soon have a new 18,400-square-foot Golfsmith store on the site of the former Frank’s Nursery. Plans also call for a 7,800-square-foot M&I Bank branch and a Starbucks Coffee to be added to the site.

The Northwest submarket turned in one of the stronger performances for the metro during the first quarter, thanks to 10,040 square feet of positive absorption. The submarket currently boasts a low 3.54 percent vacancy rate. Investors have demonstrated a strong interest in the region with two Northwest retail centers changing ownership in the first quarter. Maple Ridge Center in Maple Grove, Minnesota, was purchased by Florida-based Village West LLC. The 26,983-square-foot retail and office facility sold for $6.1 million. Also in Maple Grove, Kimco Realty Corporation purchased the Fountains at Arbor Lakes for more than $100 million.

Ridgedale Mall is seeking to entrench its position as one of the top regional shopping centers in the Twin Cities with a multimillion-dollar upgrade to its interior. In undertaking the renovations, mall ownership hopes to make the mall brighter and more modern. Exterior improvements are also planned for 2008.

First-quarter activity in the Southeast submarket was relatively flat. The area finished the quarter with 1,604 square feet of negative absorption, raising the vacancy rate to 4.26 percent. L.A. Fitness opened its first Twin Cities location in Apple Valley, Minnesota, in May, with more locations in the works. The chain is looking to become a major player in this market and hopes to rival existing fitness stronghold Life Time Fitness Inc.

The Southwest submarket will also be welcoming several new retailers in the coming months. Lucy Activewear, a women’s clothing retailer, opened its first Minnesota store at the Galleria in Edina at the end of the first quarter. Bar Louis, an upscale bar and restaurant chain out of Chicago, is reportedly scouting sites for several new locations. Uptown, Eden Prairie, and St. Louis Park are all possible target markets for Bar Louis. Finally, DaVita Inc., a California-based company that specializes in neighborhood dialysis centers, has announced plans to convert a former gas station at 3601 Lyndale Avenue South into a 5,400-square-foot clinic. The clinic is scheduled to open late second quarter. The Southwest submarket is currently the tightest of the metro retail markets, with a 1.57 percent vacancy rate. During the first quarter, the area saw 25,207 square feet of negative absorption activity.

Despite the challenges that high rental and tax costs have presented to local retailers in the last 6 months, activity is still strong and the market is tight. Throughout the remainder of the year, the market will continue to correct itself. The softening of the housing market should slow development in the outer suburbs, although it may present new development or redevelopment opportunities for retail within the core. 222 Hennepin, a high-rise condo in downtown for example, is now being re-evaluated for retail use.

— Amy Senn is a senior associate with Minneapolis-based NAI Welsh.

Minneapolis/St. Paul Retail Investment Services

According to Real Capital Analytics (RCA), the investment market for retail properties is continuing at a vibrant pace, at least on a national level. RCA reported there were more than $3.3 billion dollars of new property introduced to the investment market in February alone, the largest such influx in the past 6 months. The demand for high-quality retail investments continues to be strong. On a local level, the supply has been waning for the past 6 months. Whenever this imbalance occurs, the conventional wisdom is that pricing will remain very sharp. However, many are of the opinion that pricing will slide somewhat from the recent levels, as investors are concerned with the level of consumer spending and slowly rising interest rates. Although retail fundamentals are still very good, the prospect of flat or diminished retail sales is usually all it takes to cool the investor market.

RCA has an interesting take on real estate investment, reporting that the perception that real estate is a long-term investment is no longer a reality. In the retail sector, 40 percent of properties that were sold in 2006 had been held for less than 6 years. Changes in both buyer composition and investment strategies provide some insight into the trend. New buyer groups such as private equity funds and syndicators (private REITS & TICs) target much shorter holding periods than traditional investors. They are often compensated for exceeding return rate hurdles, which is often achieved by selling as soon as practical, then rolling the investor’s capital into a subsequent fund.

The level of activity occurring in the Minneapolis/St. Paul marketplace is largely driven by portfolio acquisitions. Centro Watt has purchased the assets of Heritage Real Estate Investment Trust, which included 15 properties in Minnesota. Of those 15 properties, Centro Watt immediately flipped two — Har-Mar Mall in Roseville and Fashion Place in St. Cloud — to private New York-based group Emmes Asset Management. The Minnesota properties were part of the privatization of Heritage Real Estate Investment Trust. Centro Watt reportedly paid a 7.3 percent cap rate for the entire portfolio. Continuing in this vein, everyone has now seen the press release whereby Centro Watt is in contract to purchase the assets of New Plan. In the past 4 years, Centro Watt has gone from owning zero properties in the United States to, upon closing of the New Plan acquisition, owning approximately 800 shopping centers, making them one of the top five owners of strip retail in the United States. And, finally, Developers Diversified Realty has purchased the assets of Inland Retail (their Eastern REIT only); however, the transaction involved no Minnesota properties. Inland is still very much involved in the ownership of retail properties and is diversifying its portfolio by making large acquisitions of office properties as well.

Some recent notable transactions include the sale of Oakdale Village by Kelly Doran and Robert Muir to Centro Watt for $37 million, or $195 per square foot. This acquisition included a partially improved pad that is ready for additional construction. Oakdale Village is located off Interstate 94 in Oakdale, Minnesota, and features Best Buy, Home Goods, Sports Authority and Guitar Center. Additionally, Gabbert & Beck sold Centennial Lakes to Boston-based pension fund advisor TA Associates for approximately $48.66 million, or $212 per square foot. Centennial Lakes benefits from a prime location on France Avenue, one of the metro area’s most desirable addresses. Finally, Kimco Realty Corporation has purchased The Fountains at Arbor Lakes from Opus North for $95 million, or approximately $192 per square foot. With this purchase, Kimco increases its ownership of retail properties in the suburb of Maple Grove to just under 1 million square feet.

Recently, Southdale changed hands again — The Mills Corporation sold the assets to Simon Property Group. It will be very interesting to read the announcement of Simon’s plans for this underperforming property. Many in the industry are speculating that Southdale will be home to the second Nordstrom or that Neiman Marcus will join the center. With all the improvements occurring at The Galleria, and the city of Edina’s interest in positioning the Southdale corridor as a more resident-friendly area, observers are hopeful that the plans will be in keeping with this property’s potential.

As we all know, pricing for retail property has been increasingly sharp throughout the past few years — the reasons are numerous. Investment in real estate, in general, has been rabid due to low interest rates, the opinion that real estate is a mainstream investment vehicle and because the stock market was considered to be unstable. Locally, the retail real estate universe has enjoyed very good fundamentals. Rents are rising, land prices are soaring, and overall vacancy is low and has been for some time. The result is that it is a very good time to be a seller in this market.

Recent pricing suggests a cap rate range of approximately 5.9 percent for high-quality, well-located and leased grocery-anchored strip centers. Expect a cap rate around 7.5 percent for older, well-occupied centers that are not as well located. Though pricing will likely cool off from its present level, it probably will not be as dramatic as the market pessimists lead us to believe.

— Bob Pounds is a senior vice president with Minneapolis-based NAI Welsh.

Minneapolis/St. Paul Industrial Market

In 2006, the Minneapolis/St. Paul industrial market was in line with the 5-year trend of positive absorption at 2.85 million square feet, although this success was paltry when compared to 2005 numbers (7.35 million square feet absorbed). Industrial absorption excelled in 2005 due to extraordinarily large deals. Conversely, there was not the same hefty turnovers last year and larger, individual owner-occupied sales helped contribute to the lack of absorption.

The vacancy rate remained fairly constant from 2005 (5.58 percent) to fourth-quarter 2006 (5.69 percent). Industrial users experienced difficulty finding functional, quality options, which, coupled with the low vacancy rate, encouraged speculative construction for the first time in a number of years. The immensely successful leasing of bulk distribution space helped drive the market to the highs of 2005, but the same was not true for the following year, which has lead to the decreased level of absorption. Rent, for the first time in decades, saw considerable increases, and net effective rates continue to rise due to decreased concessions in the form of free rent, tenant improvement packages and moving allowances.

Average asking lease rates have increased slightly to $4.18, with upper-bound prices as high as $9 per square foot for office/flex product and $4.50 per square foot for warehouse space. This increase in asking rents is expected to fuel new construction. Because construction costs are up approximately 15 percent, landlords must ask more for their spaces, and tenants will be forced to pay more for new product. These contributing factors have lead to asking rates of $10 to $12 per square foot for office/flex space and $5 to $6 per square foot for warehouse facilities.

In 2007, absorption in Minneapolis/St. Paul’s industrial market will continue along at this reserved, positive pace, as opposed to the aggressive activity experienced in 2005. Prospective users are compelled to lease instead of own, because building prices continue to rise. A move away from the owner-occupied properties will help absorption reach a healthier threshold. Also, for the first time in recent history, companies are expanding their spaces instead of downsizing, which will result in an additional 10 to 15 percent of the available space being absorbed.

Vacancy rates will continue to decrease as more companies reap the benefits of newer, higher-quality buildings in the first half of the year. However, in the second half of the year, as speculative properties are completed and available for occupancy, vacancy rates will increase. Expect higher asking rates this year, as new construction will see pinnacle market prices of $12 per square foot for office/flex and $6 per square foot for warehouse space.

An overriding difference in today’s Minneapolis/St. Paul industrial market is that developers and owners are aggressively seeking and acquiring raw land to develop, as well as existing buildings to retrofit. Some developers are actively building spec projects, while others are waiting on the sidelines ready to provide the next large user with its specifically desired space needs.

— Nathan Arnold is a senior associate in brokerage services in the Minneapolis office of CB Richard Ellis.

Minneapolis/St. Paul Office Market

Minnesota’s economy experienced robust job growth during the first quarter thanks to the addition of 13,000 jobs, which equals the employment growth for all of 2006. Unemployment also dropped to 4.2 percent at the end of March, which is just below the national average. According to an annual report by the Minnesota Department of Employment and Economic Development, white-collar and managerial jobs in particular are on the rise. Technology, accounting and finance positions are areas in which high growth is projected, which should have a positive effect on the commercial office market in the coming years.

The Twin Cities office market absorbed 115,054 square feet during the first quarter, with overall market vacancy dropping to 14.22 percent. Class A space continues to outperform the rest of the market, boasting a vacancy rate of 11.67 percent. Each of the seven office submarkets is experiencing the tightening of the market at its own unique pace, but across the metro area, concessions are decreasing and rents are stabilizing or on the rise. Transactions have been slow to close, but activity has been steady. In some submarkets, development is already underway in anticipation of continued demand for quality space.

Throughout the remainder of the year, the market will steadily improve with more development to be announced by the end of the year.

Airport South of the River

As the smallest office market in the Twin Cities, the Airport South of the River submarket currently has one of the lowest vacancy rates in the metro — 12.26 percent — with Class A vacancy at a low 8.91 percent. Net absorption is down and asking rents are flat. First-quarter activity was slower than in other parts of the metro area, which led to 25,940 square feet of negative absorption. Concessions in the form of free rent are still commonly offered to good credit tenants in this submarket, and landlords are investing in common areas as a means of attracting quality tenants.

In the near future, development will begin to break ground in the Airport South of the River submarket. The Bloomington Central Station office project is currently pre-leasing. Also, Grand Oak 10 and Mendota Heights Business Park, the two newest developments to come online in the submarket, have experienced significant positive activity. The new developments are welcome additions to this relatively tight Class A market.

St. Paul Suburban

The St. Paul suburban submarket is ahead of the rest of the marketplace in terms of development, as new construction changes the landscape of this submarket. A number of new projects are underway in the Woodbury, Minnesota, area, and the addition of projects such as the City Center Professional Building, Inver Grove Medical Building, Tamarack Village, and The Oaks business park is opening up what has historically been a tight market. Vacancy rates in the St. Paul Suburban submarket are on the rise as a result of all the new construction, but in the older buildings, landlords are working hard to retain existing tenants that might be lured away by the upgraded amenities of the newer spaces. Because there has been such a flood of new development, the new space may be slow to fill, but the market should be able to steadily absorb the current supply.

Minneapolis CBD

The Minneapolis central business district (CBD) office submarket continues to improve with slow, steady activity. The area experienced 38,034 square feet of negative net absorption in the submarket, but vacancy rates are at 15.48 percent and are closing in on the overall market average. Net absorption is down and asking rents are rising. Class A high-rise space continues to outshine the other property types, with most of the available space found in mid- and low-rise buildings. In order to attract and retain tenants, landlords are renewing tenants early, extending leases and investing in common-area renovations. Concessions are also being offered in the form of free rent and tenant improvements. From a cost standpoint, the downtown office market has the advantage over its suburban competitors, but downtown parking is an obstacle for many employers.

Investors continue to place high confidence in the downtown market as the ongoing trend of office tower sales continues. This quarter, Triple Net Properties of Santa Ana, California, purchased the two-building Northstar Center, a 637,000-square-foot Class B office complex. Also, Minneapolis-based Turnstone Group acquired the 103,275-square-foot Carmichael Lynch building.

Notable lease transactions that have been completed so far this year include Minute Clinic’s 53,000-square-foot lease at the International Centre; The Regus Group taking 20,000 square feet at 100 S. 5th Street; and John Ryan Performance securing a 15,000-square-foot space within Thresher Square.           

Southwest

The Twin Cities’ Southwest submarket saw an increase in leasing activity in the first quarter, which bodes well for the remainder of the year. The vacancy rate in the submarket is currently at 12.84 percent following 28,231 square feet of negative first-quarter absorption. Class A vacancy in the Southwest is extremely tight at just 6.76 percent, so developers are working to add office space to the submarket as quickly as they can get tenants to commit. Normandale Lake Office Park is planning a new 11-story, 285,000-square-foot building. The tower, known as the 8200 Tower, is already 50 percent leased to Benfield Group. Also, Ryan Companies is considering the development of Market Pointe II, a 212,000-square-foot office building, but will not start construction until a few tenants have signed on to the project. Norman Point II, a 10-story, 322,000-square-foot building, is already under construction and is slated for completion this fall.

Investor confidence in the Southwest submarket has been extremely high, with a number of large sale transactions closing this quarter. Hempel Properties acquired One Corporate Center I and II for a total of 221,765 square feet, and the Geneva Group completed a $42 million purchase of One Southwest Crossing, a 237,000-square-foot, multi-tenant office building in Eden Prairie, Minnesota.

There have been some significant lease transactions completed in the Southwest this year, including SuperValu’s 345,299-square-foot deal at 7075 Flying Cloud Drive; United Health Group’s 70,000-square-foot lease at One Market Pointe; and Wells Fargo Insurance’s renewal and expansion to 54,000 square feet at Metropoint Office Complex.

St. Paul CBD

The St. Paul CBD saw an increase in activity during the first quarter, but the submarket still lags behind the rest of the marketplace in terms of vacancy. Right now, the St. Paul CBD has a 19.16 percent vacancy rate, following a modest 14,820 square feet of positive first-quarter absorption. The city of St. Paul is doing its part to attract new businesses to the downtown by offering forgivable loans to new companies, and covering costs for moving, renovations and other relocation expenses.

As the state capitol, St. Paul is home to a large number of government agencies. In recent years, the downtown office market has suffered as the state has vacated multi-tenant space in favor of new state-owned buildings. The state is currently shopping for roughly 170,000 square feet of multi-tenant space for its more than 700 workers in the Department of Public Safety and the Office of Homeland Security. While it is a positive sign that the state is looking to the multi-tenant market for space, it is reportedly considering proposals from suburban office sites in addition to downtown locations, which would be a significant setback to the St. Paul CBD.

The investment market in downtown St. Paul, while slower than the Minneapolis CBD market, has nevertheless garnered interest from a number of buyers in recent months. The First Bank Building was bought out of foreclosure this quarter for approximately $27 million and Gallery Tower recently changed ownership. Also, 180 E. 5th Street, the largest building in downtown St. Paul, and 375 Jackson are currently for sale.

West/Northwest

The West/Northwest submarket has enjoyed the largest positive absorption of all the metro submarkets this quarter at 200,106 square feet. Vacancy in the West/Northwest currently sits well below the metro average at a low rate of 11.02 percent. The healthcare industry is driving much of the office market activity right now, and the West/Northwest is seeing significant office development geared towards medical users. Most notably, Ryan Companies’ project The Grove seeks to capitalize on the opportunities presented by the new hospital that is under construction in Maple Grove, Minnesota. Ryan’s 157-acre, mixed-use project will feature a variety of medical and retail space, and will serve as the ideal location for physicians and clinics that want to be close to the new $120 million hospital being developed by Fairview Health Services and North Memorial Health Care. The hospital is slated to open in late 2009.

The town of Brooklyn Park, Minnesota, is also experiencing a surge of development in response to Target Corporation’s plans to build 8 million square feet of office space, along with a host of retail, hotel and residential space, as part of its planned 335-acre corporate campus. Developer Steve Hoyt has a contract to buy an 84-acre site from Church of the Living Word for $9.5 million near Target’s proposed project, and is contemplating a business park with a mix of office, retail, hotel and senior housing uses.

— Kevin O’Neill, senior vice president, works in the Minneapolis office of NAI Welsh.

Minneapolis/St. Paul Multifamily Market

The Twin Cities apartment market continues to track steady improvement on the operational side. According to GVA Marquette Advisors, the average vacancy rate measured 4.4 percent in the first quarter of the year, compared to 5.5 percent a year ago. The average rental rate increased from $855 to $876 during the same period. In addition, the average effective rent (net of concessions) increased 3 percent in 2006. Also, the Minneapolis/St. Paul metro market absorbed more than 3,000 units last year, compared to 2,600 in 2005.

Local economic indicators continue to remain positive for the Twin Cities, as 54,580 new jobs were added last year. This 2 percent job-growth rate outpaced the national rate of 1.4 percent. Minnesota finished with 2.8 million jobs, up from 2.74 million in 2005.

Despite the strong apartment fundamentals, the development pipeline for construction of new apartments remains modest. According to GVA Marquette Advisors, 400 market-rate units came online in 2006, and CB Richard Ellis is tracking approximately 1,550 apartment units currently under construction. Village Green continues to expand its Twin Cites portfolio by embarking on two new apartment projects in the downtown Minneapolis area (Eitel City Apartments, 213 units, and Lake Calhoun City Apartments, 158 units). New construction appears to be confined to unique locations — such as downtown/uptown Minneapolis — where rents can justify new construction costs.

Significant projects that have or will in the near future come online include Calhoun Artist Lofts, City Walk, and Saint Anthony Mills Apartments. The Carlton Artist Lofts, located in the University-Raymond Historic District of Saint Paul and developed by Plymouth, Minnesota-based Dominium, is a unique project targeting the artist community by offering amenities such as wet and dry artist studios, gallery, dance studio and rehearsal spaces. The development entails the adaptive reuse of three historic warehouse buildings that are being redesigned into 169 apartments. The project is expected to be complete this year.

City Walk, developed by LeCesse Development of Winter Park, Florida, and originally a condominium and townhome community, has repositioned 208 homes as rental units due to the downward swing in the condominium market. Located in the commercial heart of Woodbury, Minnesota, this community is within walking distance of shopping and restaurants, offers a comprehensive amenity package and has over 13,000 square feet of retail space on the premises. LeCesse sold its rental community to Boston-based TA Associates last year.

Saint Anthony Mills Apartments is part of the redevelopment of the historic Minneapolis riverfront along the Mississippi River; the community will consist of 93 newly constructed apartment homes in a five-story building, as well as two commercial spaces. Ground was broken in 2005, with completion scheduled for this year. Brighton Development of Minneapolis is spearheading the project.

Despite the slowdown in the condo conversion market and the threat of rising interest rates, investors are still paying aggressive prices for assets located in the Twin Cities. Cap rates remain at historically low levels, especially for Class A and B properties. Class A properties that were developed in or after 2000 are currently trading in the 5 to 5.25 percent range, while Class A properties built prior to 2000 are in the 5.25 to 5.75 percent range. Class B product is trading in the 6 to 6.5 percent range, while Class C product has edged up slightly in the 7.25 to 7.75 percent range.

During the past 12 months, there has been a record number of Class A properties traded — 16 properties sold for a total in excess of $600 million. Henderson Global was the most active, acquiring four properties (three from Equity Residential and one from Dominium) for $138 million in 2006. We anticipate this velocity will subside significantly in 2007. In addition, little value-added apartment product traded last year. The strengthening apartment fundamentals are luring the value-added players back into the marketplace. We anticipate more activity in this sector during 2007. For example, Laramar recently closed on International Village, a 321-unit, value-added apartment community in Bloomington, Minnesota.

— Keith Collins, first vice president, and Laura Hanneman, client services specialist, work within the  multi-housing group of investment properties in the Minneapolis office of CB Richard Ellis.


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