Making a daring redevelopment play in downtown Cleveland, Manhattan-based Sovereign Properties Ltd. led an investor group last November to buy the 1717 East Ninth Street office building and parking garage. Sovereign paid $12 million for the 320,000 sq. ft., 21-story building that enjoys a prime location in the Finance District. There was only one catch: The building stood 89% vacant.

The sale price of $37 per sq. ft. “is a very long dollar for an essentially empty building in this market. It raised eyebrows,” says Chris Smythe, president of Smythe Property Advisors, a Cleveland real estate consulting and investment group. The seller was a subsidiary of Regency Savings FSB of Chicago. The prior owner, Sterling EOB of Chicago, had given up on the city's office market and handed the keys back to the lender in 2004.

The fate of 1717 East Ninth reflects the fortunes of Cleveland on multiple levels. Sovereign is part of a wave of entrepreneurial and institutional investors drawn to the city and region by bargain-basement prices and modest improvement in vacancies and rents. Although 1717 East Ninth is a rare redevelopment in downtown Cleveland, the purchase by Sovereign shows how dramatic the turnaround has been. Five years ago Cleveland brokerage firms commonly said that the city had a black eye in the national investment market thanks to no population growth, weak job growth, little rent growth and scarce development opportunities.

Duke Realty Corp., the Indianapolis-based real estate investment trust, looks at the market differently. The REIT is voting with its feet and exiting the city's suburbs after 10 years in the market and has said it wants to redeploy its capital to areas with stronger development climates such as Savannah, Ga. and Phoenix, Ariz.

Meanwhile, other investors have decided to gamble on Cleveland. Besides Sovereign, several national players, many of institutional quality, have taken new positions in downtown Cleveland, where all three of the city's trophy skyscrapers changed hands over the last two years.

In November last year, Behringer Harvard Real Estate Investments of Dallas made the most recent purchase, paying $64 million for Fifth Third Center, a 500,000 sq. ft. office tower built in 1991.

The pinnacle of Cleveland commercial real estate is Key Center, which includes Key Tower, the tallest office building between New York and Chicago, and the attached Cleveland Marriott Downtown. With a tenant roster boasting the headquarters of KeyCorp and white-shoe law firm Squire Sanders & Dempsey, the 1992-vintage Key Tower drew Wells Real Estate Funds of Atlanta as a new 50% owner in 2005.

Joel Williamson, vice president and asset manager for Key Center at Wells, says his company bought into Key Tower because it is a high-quality asset that was available for less than replacement cost.

A painful exodus

The fire-sale prices are the culmination of an economic downward spiral that's occurred for the better part of a decade. The region missed out on the dot-com boom that reached its zenith in the late 1990s before the bust in 2000. What's more, many corporations have been lost to mergers and bankruptcies over the past 10 years.

Among the corporate casualties was BP America, formerly Standard Oil Co., which merged twice to wind up BP Amoco Inc. and relocated its headquarters to Los Angeles in 1998. The exodus left 300,000 sq. ft. of empty space at namesake BP Tower on Cleveland's Public Square. Two more big losses included TRW Inc. and Charter One Bank of Cleveland.

Northrop Grumman Corp. purchased aerospace and auto industry supplier TRW Inc. in late 2002 and then closed TRW's world headquarters in Lyndhurst, a Cleveland suburb, resulting in 350,000 sq. ft. of empty space. The complex was donated to the Cleveland Clinic Foundation health-care institution for offices. Royal Bank of Scotland in May 2004 acquired Charter One Bank of Cleveland, cut jobs and emptied another 200,000 sq. ft. of space downtown.

The following year, the region lost one of its new-breed companies after Boise Cascade Co. acquired superstore OfficeMax Inc., assumed its name and moved the headquarters to Chicago after slashing jobs and vacating OfficeMax's former 250,000 sq. ft. headquarters in Shaker Heights, another Cleveland suburb.

“When we went into the last recession in 2000,” Smythe says, “we went through an awfully tough stretch from 2000 to 2005.” The situation was so grim many Cleveland property owners and developers focused on other markets, Smythe explains, and created a void that out-of-towners filled on the acquisition front.

Although all the losses roiled the community, Alec Pacella, Northeast Ohio regional director for First Industrial Realty Trust, says the manufacturing-sector losses were slowly offset by growth at health-care institutions such as the Cleveland Clinic Foundation and University Hospitals and Progressive Insurance Co., an auto insurer based in Mayfield Village. Progressive employs 9,000 people and ranks as the fifth largest employer in Cuyahoga County, reports Crain's Cleveland Business. Cuyahoga County includes Cleveland and most of its suburbs.

The tide turns

The downtown office market was in such dire straits that it actually shrank, showing negative absorption from 2000 to 2004. The market then began growing, first a trickle in 2005, by absorbing 25,000 sq. ft. of office space, then a surge in 2006, when 400,000 sq. ft. were absorbed, according to Grubb & Ellis.

Vacancy in the CBD remains high at 20% for year-end 2006, down from 24% in 2005. Regionally, vacancy is at 18.5%, the lowest since 2001. “There was a tremendous spike in net absorption last year,” says Vicki Maeder, a senior vice president at CB Richard Ellis. “Rents went up slightly. Free rent and concessions are going away. Without a crane in the sky, there is less competition and a lot of tenants are expanding.”

For example, CB Richard Ellis estimates average asking rents for Class-A office space in downtown Cleveland climbed almost 5% in the fourth quarter of 2006 to $21.12 per sq. ft. from $20.13 the prior quarter. CBRE also estimates the Class-A market downtown will shift to a landlord's market within the year.

Meanwhile, the downtown office market went from an era of almost purely desperation sales to one that attracted new national real estate investment companies. For instance, a telling purchase came in 2003 when Minshall Stewart Properties of Bethesda, Md. — led by Cleveland native James Breen and Washington, D.C. transplant Werner Minshall — purchased the 40-story Tower at Erieview and the attached Galleria shopping center.

Breen and Minshall landed the 890,000 sq. ft. property for $30 million from Cigna Insurance. By offering low rents and aggressive tenant improvement packages, Minshall has wooed top-notch law firms to the tower. Occupancy now stands at 88%, up from a low of 70% when the complex changed hands in 2003, although leasing the retail complex remains problematic. “The price they paid for that building was really good,” Maeder says. “It had nothing but upside.”

That deal followed the 2005 purchase of a 50% stake and recapitalization by Wells Real Estate Funds of 57-story Key Tower and the attached Marriott Hotel Downtown for a total of $316 million. Also in 2005, Harbor Group International of Norfolk, Va. shelled out $141 million to buy the onetime home of BP America from Equity Office Properties Trust of Chicago. EOP had paid $144 million for the 41-story, 1 million sq. ft. tower which was 27% vacant.

In these cases, new owners said buying trophy assets was their primary consideration. The city's office market came second. So Behringer Harvard, Harbor, and Wells focused on value of the asset to potential tenants rather than trying to find an investment rationale in the city's dour, though improving, market.

“We got comfortable with this acquisition because of the quality of the asset and got under the skin of the market,” says Behringer Harvard Executive Vice President Jason Mattox of Fifth Third Center. “It's one of the quality projects in the Cleveland market. The tenancy of that project was what really attracted us.”

Although the vacancy rate is currently 20%, Fifth Third counts among its tenants the Northeast Ohio unit of the Cincinnati-based Fifth Third Corp. banking concern as well as blue-chip law firms. And Mattox is encouraged by what he sees in Cleveland. “We're in a kind of revolution in that market, given the developments of the 1990s,” he says. “It's been slow. We see a market that will grow for several years and sustain the asset. It may not be spectacular growth, but you won't see the spikes you have in other markets.”

“The market is tightening up,” says Williamson of Wells. He notes Class-A vacancy is down to 11% with direct vacancy — space held directly by landlords less sublease space — at 9.5%, nearly a 10-year low. “You're getting some new companies coming into Cleveland, as opposed to a few years ago when they were leaving.”

Harbor Group bought the former BP Tower two years ago and renamed it 200 Public Square. The tower fit the company's strategy of buying in secondary markets in search of less competition and more affordable pricing, says Brian Boehmcke, vice president for asset management. “We really felt that Cleveland was beginning to turn,” he says.

CB Richard Ellis' Maeder expects at least three more skyscrapers to sell within the year, including the AT&T headquarters building, Eaton Center and the Penton Media Building. The trophy sales are the most rarefied sign of a turnaround in the region's investment sales market.

Depth perception

Pacella of First Industrial Realty Trust of Chicago watched the market change from 2000 to 2006 as a vice president for investment sales at Grubb & Ellis' Cleveland office. “There is no comparison between the market today and five years ago,” says Pacella, emphasizing how much stronger the investment sales market has grown.

Real estate research firm Real Capital Analytics estimates that a total of $1.12 billion in office, industrial, retail and apartment properties valued at more than $5 million sold last year in the Cleveland metro area. A few years ago, notes Pacella, annual transaction volume in the region was about one-quarter of that amount.

First Industrial last year bought 2.6 million sq. ft. of Northeast Ohio industrial properties from Duke Realty Corp. of Indianapolis. Pacella says First Industrial bought Cleveland properties because it knows strengths of cities in the Midwest.

“There are a lot of companies, private as well as publicly held, that have weathered the storm in Northeast Ohio,” Pacella says. There is a lot of business breadth here, from companies such as lockmaker Swagelok Corp. to bearings maker Applied Industrial Inc., paint makers Sherwin-Williams Corp., ICI Paints, and Eaton Corp. Other sectors, such as biotech and medicine, have filled the void. It's not a home-run market. It's a market of singles and doubles, he says.

The other change is that investment interest from out-of-towners and locals has driven down cap rates from 10% to 8% or 9% over the past five years, Pacella says. With investors in growth markets such as Southern California or Florida paying cap rates of 4%, it is easy to see Northeast Ohio's allure.

Stan Bullard is a Cleveland-based writer.

CLEVELAND - BY THE NUMBERS

METRO POPULATION: 2.24 million

Source: Claritas

UNEMPLOYMENT RATE: 5.3%

Source: Ohio Job & Family Services, Office of Workforce Development

LARGEST PRIVATE EMPLOYERS:

  1. Progressive Corp.
    9,360 employees
  2. Ford Motor Co.
    6,832 employees
  3. KeyCorp
    6,397 employees
  4. National City Corp.
    6,051 employees

Source: Crain's Cleveland Business

METRO AREA VITAL SIGNS

Office:

17.25% vacancy, 4Q 2006

19.66% vacancy, 4Q 2005

$16.74 rent per sq. ft., 4Q 2006

$16.98 rent per sq. ft., 4Q 2005

Source: Reis Inc.

Multifamily:

6.5% vacancy, 4Q 2006

6.5% vacancy, 4Q 2005

$701 avg. effective rent, 4Q 2006

$689 avg. effective rent, 4Q 2005

Source: Reis

Retail:

9.4% vacancy, 4Q 2006

7.5% vacancy, 4Q 2005

$16.49 rent per sq. ft., 3Q 2006

$15.81 rent per sq. ft., 3Q 2005

Source: CB Richard Ellis

Industrial:

6.96% vacancy, 4Q 2006

7.32% vacancy, 4Q 2005

$4.50 rent per sq. ft., 4Q 2006

$4.45 rent per sq. ft., 4Q 2005

Source: CB Richard Ellis

Hotel:

58.2% occupancy, 4Q 2006

57.4% occupancy, 4Q 2005

$85.15 average daily rate, 4Q 2006

$79.02 average daily rate, 4Q 2005

Source: CB Richard Ellis

MAJOR PROJECTS:

Flats East Bank Neighborhood Located on the east bank of Cuyahoga River in downtown Cleveland, the project entails redevelopment of dual six-story buildings and includes more than 330 residential units, 250,000 sq. ft. of retail and entertainment space, and more than 200,000 sq. ft. of office space.

Developer: Wolstein Group

Completion: Spring 2010

Cost: $230 million

Stonebridge Plaza — A 12-story glass tower containing 108 condominiums and 50,000 sq. ft. of retail and office space in an attached, renovated foundry building on the west bank of Cuyahoga River in Cleveland's Flats. This is the fifth phase of Stonebridge. Prior and future phases include condominiums, office and retail space.

Developer: K& D Group

Completion: Spring 2007

Cost: $10 million