FEATURE ARTICLE, OCTOBER 2009

MIDWEST OFFICE & INDUSTRIAL SPOTLIGHT

Detroit Office

Few parts of the country have been harder hit than Detroit in the current recession. While it appears at first glance that the industrial sector has had it worse, the office sector has felt the pinch as well. Vacancies and downsizing are seen at the office buildings occupied by third-party vendors, advertisers, lawyers and accountants related to the auto industry.

“There is a large trickle-down effect in just about every segment of the office market,” says Fred Klugman, president of Detroit-based Klugman Commercial.

Office vacancies continue to creep up in the Detroit office market, but new leases are hard to come by. “There just have not been that many tenants in the market to fill up all the vacant space that is available,” Klugman says. “What’s happening is there are not many new tenants in the market, and most of the existing tenants’ landlords are able to retain them by offering aggressive deals. So, you’re not seeing a bunch of movement.”

Landlords have not given up, though. As a way to persuade tenants to sign at their properties, many landlords are offering bigger and bigger concessions in the form of lower rental rates and increasing amounts of free rent. This has created a prime tenant’s market for those that are looking for good deals. Unfortunately, those tenants in the market are being more cautious.

There are still national tenants that have their eye on Detroit, but few are making moves right now. One notable exception is the General Services Administrations which completed several large lease renewals earlier this year. The government entity also recently sent out another proposal looking for approximately 86,000 to 87,500 square feet in Detroit.

“They are one of the few bright spots in downtown Detroit, as far as new tenancy coming into buildings,” Klugman says.

While the news may not be as sunny for Detroit as many would like, there is cause for some optimism. When national tenants search for space, they almost always take a look at Detroit, because even though the market has declined, it really is the perfect time to move to the city.

“The fact that we have all this vacancy and all this unemployment is not really a bright spot, but I think there are some national tenants that are looking at Detroit because of the availability of high-quality, inexpensive office space and the availability of a skilled labor force that is in desperate need of jobs,” Klugman says, adding that incentives being provided by the state of Michigan to out-of-state companies to relocate only adds to the appeal of Michigan cities such as Detroit.

— Coleman Wood

TWIN CITIES INDUSTRIAL

Caution is the course that many industrial tenants are pursuing in the Twin Cities of Minneapolis and St. Paul, especially when it comes to leasing or acquiring new space. This is partly to do with simply being prudent and partially to do with the continued inability of companies to dislodge money from the frozen capital markets.

“More so than I have ever seen in the market, companies are very reluctant to consider relocating,” says Bill Ritter, senior vice president of Welsh Companies. “Any company that has the ability to consolidate or renew is looking at that versus the cost associated with physical relocation.”

For those that are in the market for space, Ritter has optimistic news. “I have never seen a better time to be a tenant in over 25 years of experience leasing and selling industrial real estate,” he says. Ritter goes on to say that a unique trend is developing in which landlords are trying to get their tenants to renew 12 to 18 months before the end of their lease terms, and they are willing to rewrite the current rental agreement—with discounted rates—if the tenant agrees.

“Sure, the landlord is giving something up, but if that tenant leaves in a year or 18 months, they certainly could have 6 months to 2 years of down time,” Ritter says, adding that the costs to re-lease the property, along with the often-expected tenant improvement allowance, will set a landlord back much more than trying to renew the tenant with a reduced rental rate. “So, there is an immediate cost impact to the landlord, because they are reducing rent, but they are offsetting that by security the tenant to a new, long-term lease.”

Significant sales activity has halted in the Twin Cities market. What is driving the market today is deals  for less than 10,000 square feet. Ritter explains that his company’s transaction volume is up nationally from both 2008 and 2007, but the total revenue and square footage of these deals are down. His brokers are busy working smaller deals to remain active, even though those transactions come with lower commissions. Ritter does not think the market has bottomed out, either. He says that he receives calls daily from industrial users looking to sell their properties. He sees the current downturn leveling off over the next year then growth coming on slowly.

In Ritter’s opinion, market improvement will most likely come in 2011. “The difficulty and the complication of seeing growth throughout the next couple of years is the existing shadow space that each business continues to maintain,” Ritter say. He adds that most businesses have seen no hiring at best and layoffs at worst during this recession. Before businesses will need additional space, they will have to internally absorb their space that currently sits empty. “In light of that, we do not see any type of significant need for build-to-suit projects or new construction at all.”

— Coleman Wood

CHICAGO DOWNTOWN & SUBURBAN OFFICE

Chicago’s downtown and suburban office markets continue their dynamic path through an unpredictable and unprecedented economic environment. Although no one can predict the future, it is difficult to argue with the opportunities of a tenant in the current market.

With year-to-date net absorption at an 8-year low for metro Chicago, the mid-term outlook seems cloudy for landlords. New supply in Chicagoland has increased by 3.9 million square feet in the last 2 years. Historically, new space is absorbed quickly; however, 2009 met this new supply with a different embrace than before. Space demand has not been as robust and positive absorption enjoyed in the years past has decreased.

This excess space coupled with added sublease space is contributing to Chicago’s pain. Given the tumultuous economy, the sublease market (both CBD and suburban) soared to 6.5 million square feet in second quarter 2009. The sublease market has become such a force in volume and quality that it competes with direct space, resulting in a downward push of overall effective rates. 

The sublease market has seen a flurry of activity in the last year but now we are seeing a decrease in the velocity. July revealed 21 new subleases (175,207 square feet) in the CBD and 15 (126,142 square feet) in the suburbs, while in May, there were 32 (287,774 square feet) new subleases in the CBD and 16 (105,169 square feet) in the suburbs. While sublease space continues to be added, it is obvious that the acceleration has slowed. The slowdown indicates that negative absorption felt between first quarter and second quarter has created the imbalance of supply and demand.  

While tenants stand to reap the benefits of the subleases available, current market dynamics reveal the risks associated with leasing and subleasing space. A tenant’s credit has never been scrutinized more closely. Furthermore, the credit of the landlord/sub-landlord and tenant/sub-tenant is a major concern. A Subordination Non-Disturbance & Attornment Agreement (SDNA) is increasingly important for tenants to protect their rights in the event of an ownership change, loan default and change in the function of a building.  

Both the CBD and suburbs continue to have steady leasing activity, albeit below historical norms. In the CBD, the City of Chicago extended its 263,000-square-foot lease at 30 North LaSalle; Chicago Trading Company signed a new lease for 87,400 square feet at 440 South LaSalle; and Smurfit-Stone Container signed a 51,000-square-foot sublease at 222 North LaSalle. In the suburbs, DeVry secured 150,000 square feet at Highland Landmark V in first quarter and an additional 66,000 square feet at 814 Commerce in second quarter.

Suburban demand from larger tenants could position the area for positive absorption in fourth quarter. Those active tenants include Career Education Corporation (350,000 square feet), Tru Value (120,000 square feet) and US Cellular (45,000 square feet). The overall consensus in the suburban markets is that numerous opportunities have sparked an increase in tenant activity. In the CBD, several large requirements are pursuing options including UBS (400,000 square feet), William Blair (325,000 square feet) and Baker & McKenzie (250,000 square feet).  

In both the CBD and suburbs, tenants have been hesitant to secure that long-term lease or sublease in the first half of the year due to the lack of clarity in the economy. Knowing Chicago and how it is less impacted by market fluctuations, Jones Lang LaSalle expects activity to turn into real absorption in the latter half of the year as tenants regain confidence and take advantage of historically low market rents.

Sean Reynolds and Luanne Reedy are executive vice president and senior associate, respectively, at Jones Lang LaSalle’s Chicago office.

CHICAGO INDUSTRIAL

One relative bright spot among the avalanche of negative absorption defining the Chicago industrial market is the resiliency of the north side of the city and near north suburbs. 

The north market, with 150 million square feet of inventory, has a vacancy rate of 7.47 percent, as opposed to the overall metropolitan Chicago rate of 11.68 percent.

Vacancy is likely to decrease in the third quarter as second showings have increased and usable product for lease in the 40,000 to 80,000-square-foot range is hard to find.

Several factors contribute to this stability.

• The north market has the highest percentage of owner users and local ownership. Unlike the institutionally owned markets where the spaces average 100,000 square feet or more, the north market has smaller spaces and is more oriented to entrepreneurial and small businesses.

• Land has been constrained for decades, and with infill conversions to residential and retail, the inventory did not expand as other markets experienced during the bubble years. Even the recently constructed Niles Industrial Center is now on the verge of 100 percent occupancy.

• It is often repeated that no company has ever moved farther from the decision maker’s residence. That trend certainly protects the north market’s occupancy as this submarket is surrounded by affluent communities.

• There is pent up demand for 20,000- to 50,000-square-foot functional buildings from users who want to own and shorten their commutes.

• Concurrently, the decline in the cost of construction is motivating users who have been priced out of the new building market to look for existing properties that can be demolished and rebuilt into dream facilities.

• Investors are scouring the streets to acquire leased properties and those that can be repositioned.

As the economy improves and the excess capacity is consumed this market will see increases in lease rate and sale prices.

— Steven Kohn is senior vice president at Colliers Bennett & Kahnweiler in Chicago.

INDIANAPOLIS INDUSTRIAL

The hottest trend is to simply not develop! This holds true for all types of speculative development and is currently the case for build-to-suits. There is just nothing being built. Contemplated projects are more complex than ever. To get a development out of the ground, it now takes a true partnership between the user, developer, broker and lender. Having all the parties at the table to structure the deal is key to success in this environment.

Four speculative projects, totaling approximately 1.45 million square feet, have been built since third quarter 2008—the projects are currently 5.3 percent occupied. Facilities include the 533,520-square-foot Allpoints Midwest Building 2 built by Duke and Browning in Plainfield;  two buildings built by Browning in Mt. Comfort—a 423,000-square-foot modern bulk facility and a 250,000-square-foot hybrid-bulk facility; and Precedent’s 245,041-square-foot building, which is  also in Mt. Comfort. These projects added 2.5 percent to the vacancy in the modern bulk product type and no other projects are slated to begin.

The above projects are located within the southwest and east submarkets of Indianapolis and situated along the Interstate 70 corridor, which is the jugular vein for commodities flow.

Browning is the most active with involvement in three of the four previously mentioned projects. Duke is also active with involvement in one speculative project and recent build-to-suits for MedCo and Prime Distribution Services.

The overall industrial vacancy is at 10 percent. The average warehouse distribution rate is $3.18 NNN, and flex industrial space is $6.52 NNN.

The south submarket is expected to see a significant increase in occupancy as well as the southwest. This will not necessarily lead to additional development in the foreseeable future. Look to the southwest of the northwest market to be the first submarkets to break this trend when it ultimately happens.

The overriding theme and comment from owners, developers and professionals dealing on a national playing field is that Indianapolis is one of the few active markets in the nation. It is a bright spot in an otherwise bleak industrial marketplace.

— Jeremy Woods, CCIM, SIOR, is senior vice president - industrial services at Summit Realty Group in Indianapolis.

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