The commercial real estate markets are seeing clearer skies after weathering the perfect storm. A recession, quickly followed by the impact of September 11, 2001, led to the inevitable — business failures, and corporate downsizing, consolidations and relocations. Throw in the tech wreck, and the serious damage to the telecommunications sector, and the storm cloud really burst. The war in Iraq made the winds blow even harder.

Ultimately, companies shed office space and industrial space as they consolidated operations or simply went under, leading to a surplus of sublease space competing for tenants across the Midwest. This sublease space continues to put pressure on landlords as vacancies hover in double digits.

Mary Riley-Cheek, a senior vice president in the Kansas City office of Colliers Turley Martin Tucker (CTMT), calls the last 3 to 4 years the second worst she’s seen in her 20-year career as a broker. Only the overbuilding witnessed during the late 1980s, when the savings and loan industry nearly melted down, presented bigger problems in commercial real estate. However, this time, the development pipeline slowed to a trickle, helping the markets recover. Still, the recent recession was more prolonged and was caused more by outside factors than simply by economics, Riley-Cheek notes.

Fortunately, the amount of sublease space has been reduced by tenants taking advantage of generous leases and by remaining leases either becoming expired or becoming so short that no tenants wanted the terms. As a result, the space has been returning to the landlords.

Heartland Real Estate Business spoke with several managing principals at Colliers Turley Martin Tucker to find out how five major markets in the Heartland are faring as the storm clears.

Cincinnati

Consistent with other second-tier cities, Cincinnati has burned off some of its sublease inventory and begins the New Year with optimism. Major employers, such as Convergys, Fifth Third Bank, Provident Bank, Kroger and the law firm of Dinsmore & Shohl, all renewed and extended leases in the central business district (CBD). In addition to these significant commitments, Western Southern Life announced plans to construct a new office tower with about six floors of speculative space. All good news aside, tenants are still in control, according to Kevin Hughes, managing principal of CTMT’s Ohio/Kentucky operations.

Looking ahead, Hughes says that four more companies (occupying a total of more than 500,000 square feet) will make critical decisions about their downtown locations in 2004. In the suburbs, 2003 saw slightly negative absorption and a slide in effective rents, but the next 12 months should be better. Market activity has been improving since last fall, and the combination of minimal new construction and an improving job market will reduce vacancies this year, Hughes notes.

Cincinnati’s industrial market has also seen a gradual rise in sublease space. A few major tenants have built new facilities, allowing these companies to consolidate operations even though they still had time remaining on existing leases. Additionally, some companies have downsized and cut back production, placing some smaller spaces on the market as sublease space.

According to Hughes, industrial available space will increase slightly this year when L’Oreal/Redken moves to a new building. The company will vacate 484,000 square feet in the Northern Kentucky market, which will be marketed for sublease later this year.

“The greater Cincinnati industrial vacancy rate ended last year at nearly 9 percent, but this number was down from its peak of 9.92 percent last June,” Hughes says. “This vacancy rate, which includes space available for sublease, has dampened speculative construction and should improve to 8.5 percent by year-end.”

Indianapolis

The amount of sublease space available in the Indianapolis office market has been on the decline since its peak at the end of 2001. According to Jeffrey Henry, managing principal of CTMT’s regional office in Indianapolis, the office market reached a high of 1.2 million square feet of sublease space 2 years ago. “This amount represented more than 20 percent of the available office space,” Henry says. “By the end of 2003, sublease space had fallen to less than 700,000 square feet almost evenly split between the suburban and CBD markets. Today, sublease space represents only 12 percent of the total space available to office tenants.”

Some of this reduction is a result of “lease burning” as leases expired and returned to the landlord for direct lease. Tenants also absorbed some of the subleases. Clarian Health Partners signed a sublease for 61,711 square feet at Gateway Plaza, located at 950 North Meridian St., in downtown Indianapolis. The sublease was signed in December 2002 but did not start until January 2003.

As in other cities, sublease space is impacting rental rates. Effective rental rates have dropped, and landlords are offering concessions to attract and retain tenants. While the amount of available sublease space continues to drop, the market still has a wealth of product available. Consequently, existing pressure on rental rates will remain throughout the year, Henry says.

The equation on the industrial side has been far different. Sublease space has not been a significant factor. Instead, Henry credits the continued growth in the central Indiana industrial market to the area’s central location, its favorable cost structure, numerous tax incentives, a healthy supply of speculative bulk space and its excellent infrastructure — including its interstate system.

Developers have succeeded by adopting an “if you build it, they will come” philosophy. “Last year, 2.3 million square feet of new bulk space came online, and nearly 2.7 million square feet of speculative modern bulk space is scheduled for completion this year,” Henry notes.

Kansas City

The amount of sublease space in Kansas City’s office market peaked at 1.65 million square feet at the end of 2002, according to Frazier Bell, managing principal of CTMT’s regional office in Kansas City. “Sublease volume declined gradually last year, with 1.42 million square feet of sublease space available by year-end,” Bell says. “While some space continues to be added to the market, sublease space should continue to decline as tenants either absorb the space or as terms expire and the space returns to the direct-lease market.”

Sublease space now accounts for 13.5 percent of the 10.5 million square feet of available office space in Kansas City, according to Bell. The volume of subleases has an impact on rents, and direct-lease rates have been falling. “For both Class A and Class B space, the average rate for a direct lease is $18.46 per square foot, compared to an average of $12.77 per square foot for sublease space,” he says.

Some major deals have been made on sublease space. Last year, Horizon Mortgage subleased 50,000 square feet in the South Johnson County submarket, and H&R Block subleased 45,000 square feet in the Crown Center submarket.

Although total sublease offerings fell during 2003, some additional space was placed on the market. In November, Shook, Hardy & Bacon moved into a new 624,000-square-foot building in the Crown Center submarket. The company had planned to occupy the entire building, but at the time of the move it decided it did not need all of the space, Bell explains. It then put 80,000 square feet on the market for sublease.

New construction slowed during the last 2 years as vacancy rates hovered in the mid-teens and higher, depending on the submarket. According to Bell, the amount of available sublease space may drop by as much as 33 percent this year, based on expiration dates for existing subleases and anticipated leasing.

On the industrial side, sublease space inched up by 130,000 square feet last year, ending at 935,000 square feet. However, the overall market has 165 million square feet of total industrial space, and sublease space is a relatively small part of that, Bell says. “The amount of sublease space at year-end 2003 represented only 5 percent of the 19.2 million square feet of available space,” he says. “In fact, sublease space has remained fairly constant in Kansas City during the last few years, ranging from 4.5 percent to 5.5 percent of the available space. Speculative construction, while not impacted by subleases in the industrial sector, has been effectively inhibited by the 11.7 percent vacancy rate.”

Minneapolis/St. Paul

The Twin Cities area has seen its share of office sublease space during the past few years, but the space continues to burn off because many leases expire before the space is sublet. While the region will see some additional sublease space enter the market, the burn-off rate will outpace the influx of new space.

This pattern was evident during the past 2 years, says Mark Reiling, managing principal of CTMT’s regional office in Minneapolis/St. Paul. “At the end of 2002, about 2.4 million square feet of space was available for sublease; by the end of 2003, this amount of available space had almost dropped by half to 1.4 million square feet,” he says.

In past years, much of the sublease space that flooded the market typically had terms of 5 years or more. These long terms competed with direct available space. Today, landlords are more likely to accept lease buy-outs or one-time termination fees from troubled tenants.

According to Reiling, troubled tenants and corporate downsizing contributed most of the sublease space during the past few years. While there have been some corporate relocations, these mainly occurred when leases expired. The big exceptions have been Pillsbury/General Mills and Best Buy. Best Buy left two significant subleases, although one expired before any takers were found for the space.

“The industrial sector shows a similar pattern, with sublease space on the decline,” Reiling says. “At the end of 2002, nearly 1.7 million square feet of space was available for sublease but, by the end of last year, less than 1.2 million square feet was available.”

In both the office and industrial sectors, sublease space has played a part in negatively impacting rental rates and requiring landlords to sweeten deals with concessions.

St. Louis

Sublease space in St. Louis decreased through the first three quarters of 2003, then increased by 66,000 square feet during the fourth quarter, according to David Thiemann, managing principal of CTMT’s regional office in St. Louis. “Even so, the office market continues to see the amount of sublease space decrease, declining last year by 200,000 square feet and ending the year at about 1.18 million square feet,” he says. “The decrease reflects both refilling of sublease space and burn off of remaining space as lease terms expire.”

Thiemann predicts that even more sublease space will exit the market as a high percentage will expire during the next 18 months to 24 months. Tenants are less inclined to occupy such short-term leases unless they can use the space as is or if they have a temporary need. This further burn off will return the space to landlords for direct leasing.

During the past 3 years, subleases and direct-lease vacancies have placed pressure on landlords to lower rents and to increase tenant improvement allowances. “With vacancy rates at 17.2 percent, and many companies still holding space that they can backfill, landlords will still need to compete fiercely for tenants,” Thiemann says.

Fortunately for St. Louis, the high vacancy rate and low lease rates have curtailed speculative office construction. A few small buildings of 30,000 square feet or less are in the works but, even then, many of these buildings have space that has been preleased.

Major corporate relocations have been to build-to-suit facilities, including CitiMortgage’s move to a 515,000-square-foot headquarters in St. Charles County during last year’s fourth quarter. The move occurred at the end of its lease so its former space became directly available from the landlord, Thiemann says.

©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.