One clear sign that the Chicago industrial market is gaining traction is that speculative development has returned from a nearly three-year hiatus.

A handful of spec projects are underway with more announcements expected to surface in the coming months. “It is not a broad-based recovery for spec development, but we’re definitely seeing a return of spec development in very select product types, user sizes and submarkets,” says Mark Saturno, chief operating officer at McShane Development Co. in Rosemont, Ill.

So far, there is an estimated 1.7 million sq. ft. of spec and build-to-suit development that is slated for completion in 2012, according to Marcus & Millichap. Although that volume is down from the 2.5 million sq. ft. that was built in 2011, what is notable is that spec developments are back in the mix. For example, DCT Industrial Trust recently broke ground on a 604,000-sq.-ft. distribution center in Boldt Park in Romeoville. Also, Pancor Construction & Development is building a 166,000-sq.-ft. spec building in the Randall Point Business Park in Elgin to be completed this summer.

The return of spec development is further proof that Chicago is making progress in absorbing its hefty supply of vacant space. After peaking at 11.6 percent in second quarter 2010, vacancies have declined to 10.1 percent at the end of first quarter, according to CBRE.

But while that recovery is encouraging, Chicago has a tough haul ahead. Chicago’s 1.2-billion-sq.-ft. market has produced an overhang of some 120 million sq. ft. of empty space—a surplus that is about the equivalent of the Austin and San Antonio industrial markets combined. “I think we are going to have to chew through a significant amount of that space before we see a full recovery,” says Scott Marshall, senior managing director at CBRE in Chicago.

Fortunately for Chicago, there are plenty of firms with large appetites for industrial real estate. Supersized leasing transactions have given absorption numbers a boost. During the first quarter, a dozen companies inked new lease deals greater than 250,000 sq. ft. for a combined total of 4.7 million sq. ft., reports Newmark Grubb Knight Frank.

That activity helped to generate positive absorption for the quarter of 2.7 million sq. ft. Those mega deals are concentrated in the I-55 corridor, South Cook and Central Will submarkets due to the access to transportation and modern cross-dock facilities. The largest transaction featured M Block & Sons, which leased 915,000 sq. ft. of space in Tinley Park.

Big blocks disappear

From 2002 to 2008, Chicago averaged between 17 million sq. ft. and 18 million sq. ft. of new construction each year—about 70 percent of which was spec, notes Brian Carroll, senior vice president at Newmark Grubb in Chicago. When the recession hit, a lot of that new space still had to be absorbed. That is finally starting to occur. In fact, large space in excess of 400,000 sq. ft. has become increasingly scarce over the past 12 months, particularly along the I-80 and I-55 corridors. “Across the whole market, large blocks of space are being absorbed, mostly by default because nothing new is going up,” says Carroll.

For example, the short list of buildings that can accommodate a 500,000-sq.-ft. tenant along the I-55 and I-80 corridors has shrunk from as many as 20 down to three to five buildings, notes CBRE’s Marshall. “The balance sheets of these users are looking healthier, and they are looking to make some bets on expansion,” he adds. Companies have been moving to snap up the large blocks of newer space, while the second-, third- and even fourth-generation space continues to drag on the market.

“When markets start to recover, it is the large chunks of space that become difficult to find. Chicago is not quite there yet, but it is moving in that direction,” says Patrick Gallagher, a senior vice president at The Alter Group in Skokie, Ill. That demand is prompting The Alter Group to look at land options, particularly in the I-55 corridor.

Even so, big blocks of space remain widely available in the broader market. At the end of the last construction cycle, some large buildings were constructed along the I-80 corridor. “Some of that space has been slow to absorb, but those buildings will get leased up in the next part of the cycle,” says Gallagher.

Also, there are a couple of buildings expected to return to the market in the next 12 to 24 months. For example, Home Depot plans to vacate a couple of its large distribution facilities in Romeoville, both of which contain about 700,000 sq. ft. Those buildings would be attractive alternatives to build-to-suits for some companies, notes Gallagher.

Demand drives development

Although spec development is returning, build-to-suits will continue to drive much of the construction activity, especially for users that have very specific requirments. “Build-to-suits are happening and are focused on larger more financially secure companies such as Home Depot, Amazon.com and Apple,” says Saturno. “There is still a notable lack of activity among small and mid-size companies.”

For example, McShane Development Co. is building a new 362,000-sq.-ft. facility for Edward Don & Co. at Union Pointe, McShane’s new 100-acre office and industrial park located at the northeast quadrant of I-355 and I-55 in Woodridge. Edward Don opted for new construction to satisfy a unique requirement that called for a distribution facility with 52,000 sq. ft. devoted to corporate office space. The project will is scheduled for completion in late June.

The bulk distribution sector is leading the way in leasing and development. Chicago is seeing robust activity on the “mega deals” sized about 400,000 sq. ft. to 500,000 sq. ft. and greater. “There seems to be a strong amount of activity in that category right now in multiple markets,” says Gallagher. “Some of that may spark some large build-to-suits that might be announced over the next few months.”

There is a smaller mid-bay spec building slated for construction in Northern DuPage. “That is encouraging, because it is a sign of life in the small-to-medium bay, 40,000-to-50,000-sq.-ft. category of tenants,” says Gallagher. The driver there is the demand for buildings with more modern requirements related to clear ceiling heights, trailer parking, sprinkler systems and loading docks.

Another leasing hotspot is the O’Hare sub market, which is experiencing robust demand for its newer class-A buildings. Tenants are typically looking for space ranging between 75,000 sq. ft. and 250,000 sq. ft. That demand could spark spec development in that submarket in the coming months.

Investors favor class-A

The recovery in the industrial market is reigniting investor demand, but industrial sales activity has been relatively sedate compared to last year. As of June 1, industrial investment transactions totaled $450 million, which is lagging the pace set in 2011 when $1.5 billion in industrial sales occurred, according to CoStar.

A strong pipeline of class-A, institutional quality portfolio sales fueled activity in 2011. “Last year, cap rates compressed quickly on class-A product. Now owners are looking to sell off more of their [class]-B product,” says Michael Tenteris, senior director at Cushman & Wakefield in Chicago. “Those properties are trading, but there are fewer bidders and the market is not as frothy as it was last year.” Class-A space is seeing cap rates of 6 percent to 6.5 percent, while solid class-B transactions are generating cap rates of about 7.5 percent.

Much like the tenants that are out shopping for space, buyers are gravitating towards newer class-A properties. “Smaller companies have not rebounded as fast as the bigger companies. They have been more reluctant to take on additional space, and that has hurt the fundamentals of the [class]-B product,” says Tenteris. Investors are not as confident that rents and vacancies are going to rebound as quickly in lesser quality properties.

Buyers continue to aggressively bid for quality, well-located real estate. Case in point is the sale of a 747,000-sq.-ft. single-tenant warehouse building in Bolingbrook that closed in April. Ten bidders were vying for the deal, which eventually went to Heitman for $34.5 million or roughly $46 per sq. ft. The price is notable considering the fact that the building’s sole tenant, Home Depot, has indicated that it plans to vacate the building when its lease expires at the end of 2013. Investors were confident in their ability to re-lease that facility due to its quality and location in the I-55 corridor, where there are very few available class-A buildings in excess of 500,000 sq. ft., adds Tenteris.

Although the return of investor demand for space and spec development highlights both important bright spots in the market, Chicago still has a big job ahead to absorb its excess space. The vacancy, which is even more pronounced in older class-B and class-C properties, has kept concessions in place and rents relatively flat. The asking lease rate averaged $3.99 per sq. ft. at the end of first quarter, which is up nominally from the rate of $3.91 a year ago, according to CBRE.

“The underlying current of momentum is positive, but cautious from corporate America, because every time you start feeling more positive about the economy, we have news that spooks corporate America and spooks the capital markets,” says Gallagher.

SIDEBAR: Buyers Vie for Chicago Apartments

Chicago apartment owners couldn’t have scripted current market conditions any better. Strong demand and limited new supply are setting the stage for substantial rent hikes.

The apartment market is in the midst of a “perfect storm,” says Greg LaBerge, regional manager at Marcus & Millichap Real Estate Investment Services in Chicago. Strong renter demand is expected to push apartment vacancies down a further 50 basis points in 2012 to 4.1 percent, while rents are expected to rise by 4.9 percent, reports Marcus & Millichap. That, together with the availability of debt, has produced a very active investment market.

In 2011, $2.2 billion in apartment properties traded hands in the seven-county Chicago metro, which is more than double the $1 billion in sales that occurred in 2010, according to CoStar. “We’re seeing that same trend continue in 2012,” says LaBerge.

Newport Beach, Calif.-based KBS Legacy Partners Apartment REIT is a newcomer to Chicago, making its first foray into the market by acquiring the 196-unit Avalon at Poplar Creek in Schaumburg for $27.2 million, and the 256-unit Avalon Lombard in suburban Lombard for $36 million.

The properties, which have since been renamed Legacy at Poplar Creek and Legacy at Martin’s Point, offered the chance to buy high-quality assets in high-barrier-to-entry submarkets at a significant discount to replacement cost, notes W. Dean Henry, president of Legacy Partners Residential Realty. “We believe the combination of proximity to jobs and limited new supply will underpin strong rent growth for both assets for the near future,” he says.

Although Chicago apartment sales are generating average cap rates of 7.7 percent, cap rates have dipped below 5.5 percent on coveted class-A properties. Plus, heightened competition for deals is pushing buyers to take on more risky class-B properties in order to place capital. Marcus & Millichap recently sold an 84-unit apartment building in the northwest suburb of Palatine that attracted nearly a dozen bidders. The property sold for $100,000 higher than the list price at $6 million to an all-cash buyer.

The strong occupancies and rent growth are also sparking new development. An estimated 900 new apartment units are expected to be completed this year, about triple the amount delivered in 2011. Opus Development Corp. broke ground this spring on a new luxury apartment complex in Lisle, Ill. The four-story Arboretum Landmark will feature 310 residential units. But announcements of new projects remain limited due to Chicago’s high barriers to entry.

“As long as interest rates stay in the same realm as they are now, I think we are going to see continued increase in transaction volume,” says LaBerge. The caveat, he says, is that a major European or U.S. economic event could halt the current demand for property. —BMT