The lively pace the Minneapolis real estate market has enjoyed over the past few years has slowed in recent months. The office and industrial development boom has halted. Hotel construction is losing momentum, while retail expansion continues to move forward, but at a more conservative clip. The only current hotbed of activity is the multifamily sector, which is thriving amid a tight housing market.

Minneapolis is no exception to the credit-tightening trend occurring across the country. The Twin Cities' commercial real estate market has exhibited signs of weakness in the office, industrial and retail sectors, particularly in the suburban areas, according to Ed Padilla, CEO of NorthMarq Capital Inc., which is based in Minneapolis.

“The good news about the Twin Cities area is that it continues to be a very stable region,” Padilla said. The $110 billion economy of the Minneapolis-St. Paul metropolitan statistical area (MSA) ranks as the 12th largest in the United States. The region's diversified business base includes 30 Fortune 1000 and 15 Fortune 500 companies. And, although unemployment has edged higher, it still registers a relatively low 3.6% in the Twin Cities metro area.

“The economic climate is slowing but remains reasonably healthy,” confirmed Dr. Sung Won Sohn, chief economist in the Minneapolis office of San Francisco-based Wells Fargo Co. Fewer jobs are being created and some major corporations, such as 3M, American Express Financial Advisors and ADC Telecommunications, have laid off more employees. “Clearly, the boom times are over, and some caution is in order,” Sohn said.

However, a diverse business base has buoyed the Minneapolis economy. The metropolitan area is home to a variety of service and manufacturing firms that make everything from snowmobiles to heart defibrillators. In addition, the fallout in the dot-com sector has not adversely affected the region. “Tougher times could be ahead, but I think we will be able to avoid an economic recession,” Sohn predicted.

Perhaps the biggest boost to the local economy has been a steady flow of new residents. Minnesota was the fastest-growing state in the Midwest over the past decade, with a population increase of 12%, or nearly 400,000 people, according to the 2000 U.S. Census. The Minneapolis-St. Paul metro area is the focal point of that growth. Nearly 2.6 million people — more than half of the state's residents — live in the seven-county metropolitan area.

A booming apartment market

The growing population base of the Twin Cities fuels the need for multifamily housing. “There is no question about the health of the apartment market,” Padilla said.

According to a mid-year market report by Bloomington, Minn.-based United Properties, approximately 8,545 apartment units and 3,145 senior housing units are either planned or under construction in the Twin Cities. Projects slated for completion this fall include the 200-unit Louisiana Oaks in St. Louis Park, the 186-unit Lincoln Parc in Eden Prairie and the 180-unit Arbor Glen apartments in Maple Grove.

Apartment developers are responding to the pent-up demand for housing. “We have been way behind the pace of new construction, going back as far as 10 years, in the number of units constructed,” Padilla said. The apartment vacancy rate hovers at about 2.5%, and the metro vacancy rate for all types of housing is 0.06%, the lowest in the country, according to United Properties.

Other factors driving new development include climbing rental rates and legislation passed in 2001 that reduced property taxes by 25%. New construction wasn't economically feasible for many developers because of the high tax rate, Padilla noted.

High barriers to entry make the Twin Cities attractive to both developers and investors. “It is difficult, time consuming and expensive to start a new apartment construction project in the Twin Cities,” said Scott Pollock, vice president of investment services at United Properties. Sites are hard to find and the city approval process is often challenging, he added.

As a result, the appetite for apartment investment in the Twin Cities is as strong as it has ever been. One notable deal this year is Chicago-based Equity Residential's purchase of the 394-unit Grand Reserve Eagle Valley in Woodbury for a reported $54 million. “Most investors view the Twin Cities as offering a lot of upside potential based on our recent history of strong rental growth and very low vacancies,” Pollock said.

Available: Sublease space

A surge of sublease space has dominated both office and industrial markets. “We were surprised by the amount of sublease space in Corporate America that came on the market in the first and second quarters, and that has affected the market,” said Whitney Peyton, senior managing director in the Minneapolis office of Los Angeles-based CB Richard Ellis.

An estimated 2.1 million sq. ft. of sublease space was available in the Twin Cities office market at the end of second-quarter 2001. At the same time, approximately 2.5 million sq. ft. of industrial sublease space — nearly half of which was bulk space — was available, according to a mid-year market report compiled by Minneapolis-based Colliers Towle Real Estate.

Corporate downsizing contributed to the jump in sublease space. Also, slower-than-anticipated growth and economic uncertainty have resulted in a sharp decline in demand, Peyton noted.

Market-wide office vacancy rates increased from 10% at year-end 2000 to 10.6% at mid-year 2001. And when sublease space is factored into vacancy calculations, the vacancy rate rose from 11.9% at year-end 2000 to 13.5% at mid-year, according to United Properties.

On the industrial side, vacancies rose from 10.4% at year-end 2000 to 11.4% at mid-year. With sublease space included, the industrial vacancy rate is 14.2%, according to United Properties.

The glut of sublease space has put the brakes on development. Lenders have become more cautious and will not finance without significant pre-leasing in place. As companies shop for bargains, traditional sublease deals are being completed at a 35% discount — or about 65 cents on the dollar of existing rents, according to Peyton.

Minneapolis office market: Vacancies anticipated

Rising vacancy rates in the Minneapolis CBD are anticipated due to the addition of more than 5 million sq. ft. of new office space to the market since 2000. Vacancy rates in the Minneapolis CBD hit 9.2% at mid-year, or 11.0%, including sublease space, according to United Properties.

“Even though some projections say vacancies will reach 15%, most disagree with that because of the phenomenal health of downtown,” Padilla said. Downtown Minneapolis is home to a diversified base of businesses ranging from investment firms to advertising agencies. In addition, major firms such as retail giant Target Corp. appear to be immune to the downturn and continue to expand, he added.

And tenants seem to favor the new space. The 630,000 sq. ft. 50 South Sixth St. is set to open this fall with 75% occupancy, while the 449,000 sq. ft. 900 Nicollet will be fully occupied when it opens in October. Corporate facilities under construction include the 1.2 million sq. ft. Target Plaza South, which is expected to open this fall, and the 1.3 million sq. ft. American Express II building, which is scheduled for a second-quarter 2002 completion.

Demand is down amid the new construction activity. Total absorption for the 12-month period ending in second-quarter 2001 was a negative 96,727 sq. ft., according to Colliers Towle. At the same time, sublease space in the downtown office market continues to rise. Colliers Towle also reported the CBD had 623,000 sq. ft. of sublease space available at mid-year.

“The big change has been the very significant amount of sublease space put on the market in the suburbs and downtown,” said Collin Barr, vice president of development at Minneapolis-based Ryan Cos. US Inc. The question remains whether additional blocks of sublease space will hit the market. “That might be more of an economic question, but my personal opinion is no,” Barr said.

In addition, no new major office projects have been announced for the Minneapolis CBD. “It will be quiet on the development front for the next year or two as part of the market balances itself out,” Barr said. However, a few smaller office projects have been proposed on the fringe of downtown, including Ryan's 82,000 sq. ft. River Parkway Place.

Lukewarm suburban development

The two primary corridors for suburban office development are the southwest sector along I-494 and the west submarket along I-394. Considerable construction activity has taken place in both areas in recent years. In the southwest, 780,000 sq. ft. of new space opened in the past year, including the 214,000 sq. ft. Norman Pointe I and the 130,000 sq. ft. Centennial Lakes V.

Nearly 800,000 sq. ft. of new space was introduced to the west submarket in the past year. Key projects include the 215,000 sq. ft. 301 Carlson Parkway, the 248,000 sq. ft. 1600 Tower and the 256,000 sq. ft. Crescent Ridge Corporate Center.

The steady flow of suburban office development has collided with the economic downturn. “Companies are not expanding as fast as they were,” Padilla said. “Some firms hurt by the downturn are going out of business or downsizing, and that has created additional supply of office space,” he said.

As of second-quarter 2001, the southwest was home to nearly one-fourth, or 434,000 sq. ft., of the office market's sublease space with a vacancy rate of 12.5%. Meanwhile, new construction in the west helped push vacancies to 14.1%, according to Colliers Towle.

Development has slowed while the backlog of excess space is being absorbed. In fact, little new construction is proposed or in progress outside of the Minneapolis CBD. Of the 5.1 million sq. ft. of office space under construction, only 800,000 sq. ft. is located in the suburbs, according to United Properties.

Major projects under way in the west metro area include the 215,000 sq. ft. 401 Carlson Parkway in Plymouth. In the southwest, Minnetonka-based Opus Northwest LLC plans a third-quarter completion for its 130,000 sq. ft. Flagship Corporate Center in Eden Prairie and the 125,000 sq. ft. Grandview Square in Edina.

In the coming months, a major deal could be brewing in the west market. General Mills Corp. is considering an expansion of its suburban Golden Valley campus in the wake of its recent acquisition of Pillsbury. If General Mills decides to consolidate workers at its suburban campus, downtown Minneapolis could lose a major tenant, Peyton noted.

Rising industrial vacancies

A decline in the technology and manufacturing sectors has produced additional sublease space and higher vacancies in the industrial sector. “There has been a slowdown in the market, first appearing last fall,” said Michele Foster, senior director at Opus Northwest LLC.

The overall industrial vacancy rate rose one percentage point to 11.4% at mid-year. And for the first time in more than six years, absorption for the first half of the year was on the negative side at 635,760 sq. ft., according to United Properties. In contrast, annual absorption for 2000 topped 3.3 million sq. ft. “We're certainly seeing a continued slowdown both in existing space and newly constructed space,” Foster said.

The industrial outlook varies depending on both product type and geographic market. Bulk warehouses in the southeast reported the highest vacancies at 18.6%, while office warehouse properties in the southwest accounted for the lowest vacancies at 7.7%, according to United Properties.

A soft industrial market is reflected in the decline of construction levels. Industrial development has fallen off from its 1998 peak of 3.7 million sq. ft. Slightly more than 665,000 sq. ft. of new construction was initiated during the first half of 2001, while approximately 1.5 million sq. ft. is expected to open in the second half of the year, according to United Properties.

“Industrial has gone full cycle,” Padilla said. After a building boom that delivered more than 17 million sq. ft. of new space between 1995 and 2000, the industrial market is in balance overall. “There is very little room for new development, and we won't see a large number of spec developments for at least a couple of years,” Padilla said.

Nevertheless, a few significant projects are in the works. Industrial Equities is developing Golden Valley Technology Center I and II, which will add a combined 164,000 sq. ft. to the west metro area submarket in the third quarter. Meanwhile, Liberty and Mount Properties is building the 127,000 sq. ft. West Bloomington Technology Park II.

“We are being cautious about starting new projects until the economy picks up again,” Foster said. However, Foster expects industrial activity to pick up in early 2002. “The industrial market has always been quicker to respond,” he said. “So we're not expecting the industrial market to stay slow for a long period of time.”

A healthy appetite for retail

Higher incomes and strong consumer spending have sustained a healthy appetite for retail space in the Twin Cities. Overall retail vacancy rates in the Twin Cities hovered at 5.5% at mid-year, up slightly from 5.1% at year-end 2000, according to United Properties.

The average annual pay for Minnesota workers rose 4.4% in 1999 to $33,487, according to the Minnesota Department of Economic Security, making it the 12th highest average annual pay in the U.S. In addition, four of the seven metro-area counties rank among the wealthiest in the country with average household incomes above $50,000, according to the U.S. Census Bureau.

“The retail sector is a little bit slower, but retail never gets the wild fluctuations that office or industrial markets experience,” said John Johannson, vice president of retail at Bloomington-based Welsh Cos. Overall, the retail sector is likely to see a lower volume of construction projects, but continued steady growth, Johannson predicted.

Although only 21,000 sq. ft. of new space opened during the first half of 2001, an additional 1.3 million sq. ft. is expected to come on line by year's end. Superstore discounters continue to drive much of the new construction activity as Target, Costco and Sam's Club vie for new sites in the metro area. Costco has added stores in St. Louis Park and Coon Rapids, while Target plans stores in Minnetonka, Shoreview and Chaska.

Other major retail developments under way include a new 2-story Target store scheduled to open this October in downtown Minneapolis. Another downtown project under construction is the 424,000 sq. ft. Block E retail and entertainment complex. Phase I of the project, which is anchored by Crown Theatres and Gameworks, is expected to open in summer 2002.

Meanwhile, existing regional malls — including Southdale Center, Eden Prairie Center, Burnsville Center and Brookdale Center — have begun major repositioning efforts to remain competitive in a growing market. “There is a trend toward renovating properties that are established in high-density demographic areas,” Johannson said.

For example, a major renovation of Southdale Center, which includes a new 120,000 sq. ft. entertainment wing, is under way. The expansion also includes a new 16-screen theater, which is scheduled for completion in December. A P.F. Chang's restaurant is slated to open in November.

Hotel sector not so hospitable

New hotel construction is beginning to taper off amid flat vacancies and a lack of development opportunities, noted Steve Dubbs, a vice president at St. Paul-based CSM Corp.

The bulk of new hotel development activity in recent years has been concentrated in the limited-service and extended-stay sectors. CSM opened two hotels this year at its Milwaukee Depot and Train Shed, a mixed-use entertainment complex located in Minneapolis. A Residence Inn opened in March, and a Courtyard by Marriott was completed in July. CSM also has four additional Marriott brand hotel developments scheduled to open this fall.

“We're still looking for deals, but markets are getting tougher,” Dubbs said. Occupancies and rates are either flat or declining, while construction costs remain high. Occupancies during the first half of 2001 averaged 63.9%, down 4.6% from the same period in 2000, according to Hendersonville, Tenn.-based Smith Travel Research. Room rates rose 5.5% to $86.62 during the first half of 2001, while revenue per available room increased just 0.6% to $55.33.

The slowdown is due in part to the economic dip, as well as the significant number of new hotel properties that were built over the past few years. Room supply across the area grew 3.6% during the first half of 2001, according to Smith Travel Research.

Nevertheless, developers continue to find development opportunities. TOLD Development Co. recently announced plans for a 120-room Hilton Garden Inn at its Wedgwood Commerce Center in Maple Grove. Madison, Wis.-based North Central Group will develop and manage the property.

The outlook for the hotel sector is similar to the big picture for the rest of Minneapolis real estate, meaning that the sector can expect slower growth in the months ahead.

But despite a noticeable drop in demand in the hotel, office, industrial and retail sectors, the Twin Cities market is well-positioned to withstand the slower economic climate. Peyton concluded, “Minneapolis continues to be a favorable market with a broad-based group of industries and businesses.”

Beth Mattson-Teig is a Minneapolis-based writer.