The Minneapolis-St. Paul region has long boasted of its strong base of Fortune 500 and 1000 firms that include Target, American Express, US Bancorp, Best Buy and General Mills. But over the past few years these giant corporations have compounded the problems of a struggling office market by vacating millions of square feet of space and moving to shiny new corporate headquarters.

Historically, a diverse economy that includes a strong base of financial, medical technology, healthcare and personal service businesses has buoyed the region. The problem in the Twin Cities, as with the rest of the country, is that business spending has been dismal for the last three years, notes Michael Swanson, senior economist with Wells Fargo & Co. in Minneapolis. On a national level, business spending plummeted by about $90 billion between the fourth quarter of 1999 and the third quarter of 2001.

Up to this point, a lack of spending and job growth have slowed leasing activity in the office, industrial and apartment sectors. However, there are signs that a turnaround is unfolding. National business spending recovered to a positive $10 billion in the second quarter of 2003.

“We are lucky to be home to a number of large corporate headquarters,” Swanson says. That prestigious list includes 3M, Medtronic, Target, Carlson Cos. and Cargill. “Those corporations will be very valuable in the next business expansion.”

There's more good news: the national economy has experienced positive economic growth over the past seven quarters. The Commerce Department reported that Gross Domestic Product (GDP) in the second quarter rose at a 3.3% annual rate, up from 1.4% in the first quarter. Economists expect GDP to grow at a 4.5% rate in the third quarter. “To the extent that the overall U.S. economy continues to rebound, we will mirror it,” says Tim Murnane, vice president and general manager of real estate development at Opus Northwest LLC. “That is what we believe will happen in 2004.”

But for the moment, both the office and industrial markets in the Twin Cities continue to be plagued by double-digit vacancies and soft rental rates. Even the historically strong apartment market has taken a hit due to explosive single-family home sales. “The challenge for the real estate industry is that we are out of the recession, but we don't have positive job growth yet,” says Whit Peyton, senior managing director with CB Richard Ellis in Bloomington, Minn.

A booming retail market is one of the few bright spots on the Minneapolis-St. Paul real estate landscape. Retail vacancies across the metro registered 5.3% in the second quarter, down from 6.1% at mid-year 2002, according to Bloomington-based United Properties. In addition, more than 2.8 million sq. ft. of retail shopping center space was under construction at the end of the second quarter, with 2.1 million sq. ft. scheduled to open by the end of the year.

Sustained Office Slump

The most beleaguered sector remains the office market. With a mid-year vacancy rate of 18.4%, the biggest question facing the office market is whether the situation will get worse before it improves. “We are near the bottom,” Peyton says. “We have seen activity among the small players, and traditionally they are the people who lead us out of the recession.”

In past recessions, Minneapolis relied on its enviable base of Fortune 500 and 1000 firms to insulate the real estate industry from market dips. “This time, the big users of space were also cutting back,” Peyton notes. A wave of corporate consolidation left a slew of vacancies: Combined, American Express and Target vacated more than 1.3 million sq. ft. in the Minneapolis CBD when they consolidated to new corporate facilities downtown. Meanwhile, Best Buy vacated 800,000 sq. ft. in the southwest suburbs when it consolidated to a 1.5 million sq. ft. campus in Richfield.

“The good news is that the market did absorb about 25% of the available sublease space during the first six months of the year,” says Dan Gleason, a vice president at United Properties. Overall, available sublease office space shrank from 2.4 million sq. ft. at year-end 2002 to 1.8 million sq. ft. through the second quarter, according to United Properties.

Virtually no new office development is planned over the next six months. The only sizable project under way is the 138,000 sq. ft. Depot Office Center in the Minneapolis CBD. St. Paul-based CSM Corp. is developing the building, which is 85% pre-leased and will open in December.

Office properties that are well-leased continue to attract investor interest and premium pricing. For example, Wells Real Estate Investment Trust bought US Bancorp Center in Downtown Minneapolis this spring for $174 million, or $187 per sq. ft. The 929,000 sq. ft. building was 99% occupied.

Rental rates continue to decline. Net quoted rates are down to $11.89 per sq. ft. overall compared with $12.56 per sq. ft. at year-end 2002.

Industrial Remains Lethargic

The vacancy rate for industrial properties in the Twin Cities increased from 14.6% at year-end 2002 to 15.9% at mid-year 2003, according to United Properties. The market was hit hard by negative absorption of 1.04 million sq. ft. in the first half compared with the 410,000 sq. ft. that was absorbed in 2002. Corporations taking advantage of low interest rates to buy, rather than lease, space also compounded the vacancy problem.

“We still have too much vacant space in the market, and we will have to burn off a fair amount before the market improves,” says Raymond Reese, a senior vice president in the Minneapolis office of Colliers Turley Martin Tucker. Roughly 20 million sq. ft. of vacant space is on the market, Reese notes, a whopping figure considering the total rentable universe in the Twin Cities is about 77.3 million sq. ft.

The good news is that activity is picking up, particularly in pockets such as the northwest submarket, where vacancies fell from 21.6% in the second quarter of 2002 to 8.9% in the second quarter of 2003, according to Colliers Turley Martin Tucker. LDI Distribution Center in Brooklyn Park, for example, is now 100% leased thanks to a 128,000 sq. ft. lease by Xpedx, a printing supplies distributor. “The cautious optimism of some companies will build as their business rebounds,” Reese says.

An estimated 424,443 sq. ft. of industrial space was under construction at mid-year, including the new Energy Park Corporate Center in the Midway area of St. Paul. Minneapolis-based Ryan Cos. completed the 108,000 sq. ft. office showroom in August, which opened 60% leased. Office showroom buildings offer smaller bay sizes and a higher degree of office space compared with office warehouse space.

Retail Flourishes

Strong consumer spending and a growing population have helped fuel retail expansion. Population in the seven-county Minneapolis-St. Paul metro reached 2.64 million in 2000, and is expected to grow by more than 30,000 people each year to reach nearly 3 million by 2010, according to U.S. Census data.

Competition in the grocery sector is heating up with the addition of Pewaukee, Wis.-based Roundy's, which recently entered the market with the purchase of 30 former Rainbow Foods stores from Dallas-based Fleming Cos. Inc.

At the same time, another key player in the grocery sector is beefing up its presence. Cub Foods, owned by Eden Prairie, Minn.-based Supervalu Inc., plans to add six new stores in the Twin Cities by early 2005, boosting its total number of stores in the metro area to 50.

“Our reliance on the grocery-anchored centers has declined a little bit,” says John Johannson, a senior vice president of retail at Bloomington-based Welsh Cos. Although grocers have fueled much of the retail growth in the region, expansion is occurring in all sectors with the exception of regional malls.

In addition, the region's first lifestyle center opened in the northwest suburb of Maple Grove in September. The 411,000 sq. ft. Shoppes at Arbor Lakes is a joint venture between Opus Northwest and Kansas City-based RED Development. Tenants include Williams Sonoma, Pottery Barn, Talbot's and P.F. Chang's.

So far, the lifestyle center concept has been hailed as a tremendous success. “Financing is impossible for regional malls. So lifestyle centers are a good way for these stores to expand,” says Murnane.

Retail investment sales have been slow during the first half of the year due to the lack of available properties. However, six sizable properties are expected to hit the sale block before year-end, says Scott Pollock, vice president of investment services at United Properties. Cap rates for top-tier grocery-anchored centers are trading slightly above 8%, while unanchored strip centers are trading between 9% and 9.5%.

Meanwhile, the on-again, off-again expansion of the Mall of America may be slowed thanks to a court ruling that stripped Simon Property Group of a 27.5% stake in the Bloomington megamall and its managing general partner position. Over the years, Simon has proposed a myriad of options ranging from a futuristic expo center to recent plans for a modest lifestyle center.

The decision, which was handed down in September, ended a four-year lawsuit between Simon interests and the Ghermezian family of Canada over control of the 2.8 million sq. ft. shopping center. The Ghermezian-owned Triple Five of Minnesota Inc. had contested Simon's 1999 purchase of a 27.5% interest from co-owner Teachers Insurance and Annuity Association. Simon still owns 22.5% of the mall, and plans to appeal the ruling.

A Quick Recovery for Multifamily?

Apartment vacancy rates have risen amid stagnant job growth and ongoing development. The vacancy rate hit 6.7% in the second quarter, up 1.9% from the 4.8% recorded in the second quarter of 2002, according to GVA Marquette Advisors in Minneapolis. The average rent has increased $5 or 0.5% to $843 in two years.

“While we have seen some softening, I think our market will recover quickly due to its diversity and the job growth that is expected,” says Brent Wittenberg, vice president at GVA Marquette Advisors.

Although Wittenberg expects vacancies to reach 7% by year-end, he predicts that it will begin to recede by next spring as the economy picks up steam. About 2,400 apartment units are scheduled to come on line this year with another 1,400 units slated for completion in 2004, according to GVA Marquette Advisors.

Apartment sales are the most active they have been in a decade. “Buyers believe in this multifamily market long-term despite the fact that we have some softness here that we haven't seen in a while,” Pollock says. Top properties are trading at cap rates in the low- to mid-6% range because investors are underwriting properties with the expectation that the market will recover within two to three years, he adds. Two years ago, quality properties would have sold at cap rates of 7.5% to 8%.

Hotel Struggles

The Twin Cities hotel market has struggled mightily in the aftermath of 9-11 and the weak economy. Occupancies have dropped significantly from nearly 70% in 1999 and 2000 to a flat year-to-date occupancy of 59.3% as of July, according to Hendersonville, Tenn.-based Smith Travel Research.

Room rates also have declined. Average daily room rates (ADR) through July registered $80.72, a decline from the $83.22 recorded during the same period in 2002, according to Smith Travel.

“These are trying times,” says Stephen Sherf, a senior vice president at GVA Marquette Advisors. “Hotels have continued to drop rates and provide packages. But at the first sign of an uptick, we will see room rates increase.”

Beth Mattson-Teig is a Minneapolis-based writer.

TWIN CITIES - BY THE NUMBERS

POPULATION:

7-County Metro Area: 2.64 million

UNEMPLOYMENT RATE: 4.3%

LARGEST EMPLOYERS:

  1. Target Corp.
    31,731 employees

  2. University of Minnesota
    30,823 employees

  3. Allina Health System
    22,261 employees



Source: The Business Journal, 2001-2002 Book of Lists

METRO AREA STATS

Office:

18.4% vacancy, 2Q 2003

15.9% vacancy, 2Q 2002

Rent per sq. ft.: $14.25 2Q 2003

Source: United Properties

Multifamily:

6.7% vacancy, 2Q 2003

4.8% vacancy, 2Q 2002

Rent per unit: $843 2Q 2003

Source: GVA Marquette Advisors

Retail:

5.3% vacancy, 2Q 2003

6.1% vacancy, 2Q 2002

Rent per sq. ft: $61.06 2Q 2003

Source: United Properties

Industrial:

15.9% vacancy, 2Q 2003

14.6% vacancy, 2Q 2002

Rent per sq. ft.: $4.27 2Q 2003

Source: United Properties

Hotel:

59.1% occupancy, YTD as of July 2003

59.3% occupancy, YTD as of July 2002

Source: Smith Travel Research

MAJOR PROJECTS UNDER CONSTRUCTION:

Heritage Park, a four-phase project featuring 440 rental units, including 200 public housing units; 360 ownership units; and 100 public housing units for the elderly

Cost: $225 million

Owner: McCormack Baron & Associates Inc.

Completion: Completed in phases through 2008

Shoppes at Arbor Lakes, a 411,000 sq. ft. lifestyle center in Maple Grove

Cost: $100 million

Owner: Opus Northwest LLC

Completion: September 2003

Savage Crossings, a 285,000 sq. ft. center in Savage

Cost: $32 million

Owner: Fairmark Development LP

Completion: October 2003

Depot Office Center, a 143,000 sq. ft. office building at the edge of the Minneapolis CBD

Cost: $20 million

Owner: CSM Corp.

Completion: December 2003