On the surface, the Minneapolis-St. Paul office market appears to be plodding along at a steady, yet unremarkable clip. But a closer look reveals a market that is bubbling with activity.

Minneapolis-St. Paul ranks 35th on Marcus & Millichap's 2006 National Office Index — down three spots from last year's ranking. The report, which scores 42 markets based on a series of supply and demand indicators, cited minimal rent growth and above average vacancy for the decline.

Both negative factors are true. The metro-wide vacancy rate as of the third quarter averaged 14.8%, which is above the national average of 13.2%, according to CB Richard Ellis. At the same time, rents have remained relatively flat over the past three years. Rents have bumped up only a nickel, in fact, in the past year to reach an average of $10.45 per sq. ft. in the third quarter.

Yet investors appear to have a much more positive outlook on Minneapolis-St. Paul's growth potential. More than 65 office buildings have changed hands in the past two years with another two dozen properties currently up for sale. “There is just a tremendous amount of office investment activity,” says Scott Pollock, vice president of investment services at Bloomington, Minn.-based United Properties.

In the Minneapolis CBD alone, 26 buildings totaling nearly 10 million sq. ft. — almost half of the 22 million sq. ft. total — have either sold in the past two years or are currently listed for sale. High-profile transactions in downtown Minneapolis in recent months include the sale of the IDS Center and 225 South Sixth — the two tallest buildings that help make up the Minneapolis skyline.

Certainly, sales activity is booming around the country. But a large part of what is piquing interest in Minneapolis-St. Paul is its track record of steady growth and an office market that is on the upswing. “Investors like this market in terms of the economic foundation here with the corporate presence and steady growth of this market,” Pollock says. The Minneapolis-St. Paul metro, or Twin Cities region, is home to 16 Fortune 500 and 30 Fortune 1000 firms.

“There's a lot to like right now in the Minneapolis office market. The rents in that market are holding their own, and occupancy rates are on their way up, which means there's room for rents to continue to grow,” says Joe Cosenza, vice chairman of The Inland Real Estate Group of Cos. Earlier this summer, Chicago-based Inland purchased the 1.4 million sq. ft. IDS Center from the John Buck Co. for $285 million.

“It's a vibrant downtown market, and a lot of businesses want to be there right now, which makes the numbers stronger for buyers like us than so many other office markets, including our own here in Chicago,” Cosenza says. “That's why so many major office buildings have changed hands in the area recently. [Investors] are recognizing an undervalued area.”

Other institutional buyers such as RREEF, Wells Real Estate Funds and ASB Capital Management have all purchased office properties locally in 2006. “The Twin Cities is higher on the investment list than it has been for several years based on our economic fundamentals related to job growth and employment growth, as well as the improving property fundamentals,” says Whitney Peyton, senior managing director at CB Richard Ellis in Bloomington, Minn.

Office space tightens

The Minneapolis-St. Paul office market is experiencing steady improvement in key fundamentals — namely positive absorption, declining vacancies and rising rents. After recording negative absorption in 2003, the office market absorbed 740,000 sq. ft. of space in 2004, 1.65 million sq. ft. in 2005 and a projected 1.5 million sq. ft. in 2006, according to United Properties.

The positive absorption has helped chip away at high vacancies that emerged as part of an ill-timed construction boom and economic downturn that surfaced in 2001. Vacancies have declined about 400 basis points since peaking near 19% in 2003. Quoted rental rates are finally beginning to inch higher along with those improving occupancy levels. For example, asking rents on Class-A office properties averaged $11.89 per sq. ft. as of the third quarter — a slight increase from the $11.77 quoted in the second quarter, according to CB Richard Ellis.

Much of that improvement can be attributed to the region's steady economic growth. The Minneapolis-St. Paul economy has earned a reputation as a solid performer that does not have extreme swings between its highs and lows.

“In the Twin Cities we have this steady, stable economy that has benefited from having diverse corporate headquarters here with firms such as Best Buy, Cargill, Ameriprise and Wells Fargo,” says Tim Murnane, senior vice president and general manager of real estate development at Minnetonka-based Opus Northwest.

Although there have been some ups and downs in job growth numbers in recent months, the overall economy is posting modest growth. Twin Cities employers added 46,800 jobs between August 2005 and August 2006, dropping the metro area's unemployment rate to a five-year low of 3.3% — well below the 4.6% national average. “The profitability of Corporate America over the last year and a half as a whole has been very good, and we have seen that manifest itself in the inventory of space burning off,” Murnane says.

Another factor that has bolstered investor confidence in the region is strong capital investment taking place in both downtowns in the form of public projects, theaters, libraries and transportation. Major public/private projects that will commence in 2007 include a new 42,000-seat baseball stadium for the Minnesota Twins, a new on-campus football stadium for the University of Minnesota Gophers, and an extension of the existing light rail transit line.

Return of development

Improving office fundamentals already have developers posturing for the next wave of construction activity. New multi-tenant office development has been virtually non-existent over the past four years. However, 771,000 sq. ft. of new multi-tenant office buildings are under construction with as much as 7.9 million sq. ft. on the drawing board. “We really do believe this is going to be a sustained period where office development is back as a very active product type,” Murnane says.

The key focus of that construction activity is in the southwest metro area, or Interstate 494 corridor. The I-494 submarket spans some 15.3 million sq. ft., making it second only to the Minneapolis CBD in size. The submarket is one of the premier office hubs locally, and it possesses one of the lowest vacancy rates in the metro at 11.23%. The Class-A vacancy rate is even lower at 7.27% as of the third quarter, according to CB Richard Ellis.

It was that strong demand for Class-A space that prompted Indianapolis-based Duke Realty Corp. to move forward with construction of the 322,000 sq. ft. Norman Point II in Bloomington. Duke broke ground on the speculative project in April with completion set for October 2007. Not only are Class-A vacancies in the southwest metro below 10%, but space within Duke's existing 675,000 sq. ft. Class-A office portfolio is even tighter with vacancies around 1%, notes Darryle Henry, a senior vice president in Duke's Minneapolis office group.

Although Duke has yet to sign any lease deals for Norman Pointe II, the firm has a number of proposals out for review, and Henry is confident that the company will get asking rents of $18.95 per sq. ft. “We are seeing pretty good activity from the user end,” Henry says. In particular, large blocks of Class-A space in excess of 50,000 sq. ft. are increasingly rare in the southwest. “We are going to continue to see the fundamentals improving, and the large blocks of space are going to continue to diminish,” he says.

Opus also is going forward with plans for Excelsior Crossings, a three-building, 625,000 sq. ft. Class-A office project in Hopkins that is expected to break ground next spring. Although Opus is in talks with three or four large tenants, Murnane anticipates that the company will start construction even without a significant tenant commitment.

“Our perspective is that we are very close to being ready to move forward with spec development,” he says. Opus also is looking at three to four different building sites throughout the Twin Cities for subsequent office developments — both in the southwest and northwest metro area where Class-A vacancies also have dipped below 10%.

Other office projects taking shape include The Oaks Business Park in the eastern suburb of Oakdale. Plymouth-based Carlson Real Estate Co. is developing the 50-acre business park that will feature 13 multi-tenant buildings and 650,000 sq. ft. of office and flex space. Carlson has broken ground on 36,000 sq. ft. of office condos, a 98,000 sq. ft. office/flex building and a 60,000 sq. ft. single-story office building. The project will be complete in several months.

A number of other projects in the pipeline are waiting for pre-leasing before they break ground. “I think we are at the very beginning of a development cycle, but I think it will be much slower than other development cycles we have seen in the past due to constraints that include higher construction costs, land availability and infrastructure challenges,” Peyton says.

Downtown recovery

Although development is returning to many suburban markets, it will be some time before building returns to either the Minneapolis or St. Paul CBDs. Both cities have more work ahead in terms of improving occupancies and boosting rents.

Minneapolis ranks as the dominant CBD with a 22 million sq. ft. market that is nearly three times the size of St. Paul. During the third quarter, downtown Minneapolis reported the largest leasing volume of any submarket with 235,000 sq. ft. of absorption, which pushed vacancies down from 16.5% in the second quarter to 15.31% in the third quarter, according to CB Richard Ellis.

“We're seeing a slow, but continuing recovery,” says Rick Collins, vice president of development for Minneapolis-based Ryan Cos. US Inc. Leasing activity has been dominated by small and mid-size deals rather than large space commitments.

“One of my larger concerns is the relative lack of activity, especially among sizable anchor tenants,” Collins says. Although there are large tenants out in the market looking for space, most of those firms are planning for moves that won't occur until 2008, 2009 or 2010, he says.

Another challenge in downtown Minneapolis is pinpointing when rents will be strong enough to justify new construction, Collins adds. Although Ryan has selected an architect to create a preliminary design for a new downtown tower at the corner of Eighth Street South and Marquette Avenue, the firm is still a long way off from breaking ground on the project.

“Whereas in the past we might have considered 10% vacancy as the trigger for new construction, there are a new set of circumstances that may demand a lower vacancy percentage than normal,” Collins says. “Because construction prices have gone up as substantially as they have, the incremental rent in a new building will need to be significantly higher than current market rents.”

Class-A rents in the Minneapolis CBD are currently averaging $10.63 per sq. ft., with premier buildings such as Wells Fargo Center charging rents ranging between $14 and $20 per sq. ft. Collins expects that any new office building would need to charge upwards of $20 per sq. ft. in order to justify new construction.

The St. Paul CBD is struggling with the highest vacancies. St. Paul experienced its fourth straight quarter of negative absorption, which increased vacancies from 21.11% in the second quarter to 21.76% in the third quarter, according to CB Richard Ellis. The upside is that a few large vacancies among Class-B office buildings have weighed down the average, making office vacancies appear worse than they actually are. Class-B vacancies are averaging 27.4% compared with 12.09% in Class-A space.

The high vacancies among Class-B buildings in this capital city have been compounded by large government relocations from multi-tenant properties into three newly constructed state buildings that total 837,421 sq. ft. The Minnesota Department of Agriculture, Department of Human Services and Metropolitan Council are among those tenants that have vacated space in multi-tenant buildings.

Another reason that St. Paul has experienced negative absorption and high vacancies is due to the relocation of several law firms and accounting firms. Minneapolis-based law firms such as Briggs & Morgan that once operated in St. Paul offices found that it was no longer necessary to have an office in each city, notes Craig Lien, a vice president at Bloomington-based Welsh Cos.

The good news is that St. Paul has likely bottomed out in terms of falling vacancies, adds Lien. “The dike is plugged on that kind of movement out of St. Paul, and now it is a matter of filling up those holes,” he says.

The fact that there are still sizable barriers to development in both the Minneapolis and St. Paul CBDs — subsequently limiting new competition — is yet another confidence booster for office investors. Local experts expect the recent buying trend to continue, at least in the short term, as firm's such as Inland search for opportunities to expand their local portfolios.

“We're always looking for more property, and we like the Twin Cities market,” says Cosenza of the Inland Real Estate Group. “So it's only a matter of time before we buy in the market again.”

Beth Mattson-Teig is a Minneapolis writer.

MINNEAPOLIS-ST. PAUL - BY THE NUMBERS

METRO POPULATION:

2.64 million

Source: Minneapolis Regional Chamber of Commerce

UNEMPLOYMENT RATE: 3.3%

Source: Minneapolis Star Tribune

LARGEST PRIVATE EMPLOYERS:

  1. Target Corp.*
    7,848 employees

  2. Wells Fargo
    6,398 employees

  3. Ameriprise Financial
    5,500 employees

Source: Minneapolis Downtown Council *downtown Minneapolis

METRO AREA VITAL SIGNS

Office:

14.8% vacancy, 3Q 2006

16.22% vacancy, 3Q 2005

$10.45 rent per sq. ft., 3Q 2006

$10.40 rent per sq. ft., 3Q 2005

Source: CB Richard Ellis

Multifamily:

5.5% vacancy, 3Q 2006

6.9% vacancy, 3Q 2005

$855 avg. effective rent, 3Q 2006

$850 avg. effective rent, 3Q 2005

Source: GVA Marquette Advisors

Retail:

5.97% vacancy, 3Q 2006

6.93% vacancy, 3Q 2005

$19.84 rent per sq. ft., 3Q 2006

$19.67 rent per sq. ft., 3Q 2005

Source: CB Richard Ellis

Industrial:

13.7% vacancy, 2Q 2006

13.0% vacancy, 2Q 2005

$4.47 rent per sq. ft., 2Q 2006

$4.39 rent per sq. ft., 2Q 2005

Source: United Properties

Hotel:

70.7% occupancy, July 2006

71.8% occupancy, July 2005

$106.75 average daily rate, July 2006

$97.26 average daily rate, July 2005

Source: Smith Travel Research

MAJOR PROJECTS:

The Oaks Business Park, a 50-acre business park in the eastern suburb of Oakdale. The phased development will feature 650,000 sq. ft. of office and flex space. Construction is underway on 36,000 sq. ft. of condos, a 98,000 sq. ft. office/flex building and a 60,000 sq. ft. office building.

Developer: Carlson Real Estate Co.

Completion: 2007

Excelsior Crossings, a three-building, 625,000 sq. ft. Class-A office project in the southwest suburb of Hopkins. Opus began demolition work on the existing, vacant warehouse in November. The developer plans to break ground on the 250,000 sq. ft. first phase next spring.

Cost: $160 million

Developer: Opus Northwest

Completion: Spring 2007