Real estate deal making and development are unfolding all around Chicago on a grand scale. The nation's largest convention center, McCormick Place, just opened a 470,000 sq. ft. addition, expanding the center to 2.7 million sq. ft. City officials are lining up billions of dollars in financing in a bid to lure the 2016 Olympics to town.

It's the office sector, however, that is really boiling over with investment this year. There are currently three residential towers exceeding 1,000 feet in height under construction downtown, led by the 2,000-foot Chicago Spire that will be the tallest building in North America when completed in either 2010 or 2011.

By the end of this past summer, there were a half-dozen high-rise buildings either planned or under construction in the Loop, the city's downtown business district, spanning almost 5 million sq. ft. Most observers figured that would be all the new office space the market could absorb in the next four years.

Then it was revealed that local developer J. Paul Beitler was planning a 1 million sq. ft. tower of almost 50 stories on Wacker Drive. Now there are five office towers of 45 stories or more being added to the Loop — more activity than at any time since before 9/11.

Matthew Ward, senior vice president of The Alter Group, a local builder, has noticed that younger office workers increasingly shun suburban employers in favor of downtown companies. “Chicago's downtown has a great mass transit infrastructure. That's what makes it such a desirable place to live and work.”

Vacancies shrinking

Developers and investors are betting on Chicago's improving office fundamentals. The Loop's vacancy rate was 13.9% at the end of the second quarter this year, down from 16.4% a year ago and 18.1% in 2005, according to brokerage Cushman & Wakefield. The falling vacancies have helped boost net asking rents to an average $28.93 per sq. ft., which is up 5% from $27.69 a year earlier.

These statistics tell only part of the story. Four years ago, some 7% to 9% of the 120 million sq. ft. Loop market was available for sublease. That ratio has declined to less than 1% currently, brokers estimate. “A few years ago, you had no problem finding 50,000 sq. ft. spaces available for sublease,” recalls David Wilson, an executive vice president with HSA Commercial in Chicago, a tenant representation firm. “Today the subleases involve mostly 3,000 to 10,000 sq. ft. spaces. That tells you how much the market has tightened up.”

And yet the market might not keep tightening. Interest rates are rising and many corporations are reining in expansion plans. A recent study by Marcus & Millichap Real Estate Investment Services forecasts that Chicago will gain 40,800 new jobs this year, down from 49,300 in 2006. The same study reports that employers with office workers will add just 14,500 jobs this year, down from 35,200 a year ago.

A white-hot merger market, moreover, is leaving many spaces empty. In the wake of the combination of the Chicago Mercantile Exchange and Chicago Board of Trade over the summer, for instance, 300,000 sq. ft. of offices and trading space are expected to go dark and be marketed to other tenants.

The acquisition of LaSalle Bank Corp. by Bank of America, expected to be complete this fall, could put 10,500 overlapping LaSalle jobs at risk — a huge number in a market where 76,600 people are employed in banking.

Marquee tenants in the newest office towers will leave behind sizable holes in older buildings. Jeff Samaras, an executive vice president with Cushman & Wakefield, predicts that landlords will be challenged to fill many of those empty spaces.

But Samaras isn't expecting a dire spike in vacancies anytime soon. “Chicago is a conservative business environment. Developers here won't allow supply to get way beyond demand.”

Law firms fill new towers

Who are the players currently in new office development in Chicago? The John Buck Co., based in Chicago, is constructing a 1.1 million sq. ft. tower, 46 stories tall, at 155 N. Wacker Drive due to deliver in July 2009. The law firm Skadden Arps Slate Meagher & Flom LLP is slated to take 200,000 sq. ft. as the anchor tenant.

Hines Interests LP of Houston is undertaking two large towers. A year ago it broke ground on a 60-story, 1.3 million sq. ft. building at 300 N. LaSalle Street, slated for completion in 2009. White-shoe law firm Kirkland & Ellis LLP signed on as anchor, taking nearly 600,000 sq. ft.

Nearby at 201 N. Canal Street the company is building a 50-story, 1.1 million sq. ft. building with brokerage firm William Blair & Co. taking 325,000 sq. ft. The project is slated to break ground next spring and be completed by 2011.

Over at 353 N. Clark Street, Loop-based Mesirow Financial Real Estate Inc. is erecting a 47-story tower spanning 1.2 million sq. ft. It is scheduled to deliver late in 2009. Mesirow, taking 710,000 sq. ft., will be a lead tenant along with the law firm Jenner & Block LLP, which is taking 417,000 sq. ft. Thomas D'Arcy, a Hines vice president, believes that the addition of about 6 million sq. ft. in a downtown market of over 120 million sq. ft. won't put serious downward pressure on lease rates that have been rising in favor of landlords over the past year.

“The market is enjoying positive absorption now and there is very strong demand for new Class-A space,” D'Arcy says. “We've had good pre-leasing and we believe that we're building without a lot of speculative risk. We have confidence in the local economy.”

How strong is the demand for the best Class-A space? Richard Schuham, an executive vice president with Studley Inc. in Chicago, estimates that vacancies in the newest Class-A buildings above the 25th floor in the Loop are running at a mere 6%. “There has been a flight to quality by tenants who aren't particularly concerned about the rents they are paying,” Schuham says. “That's why high-rise construction projects have moved ahead.”

The newest buildings have become highly valued. Hines finished work on an 820,000 sq. ft. tower at 1 S. Dearborn Street less than two years ago and in short order resold it for $420 per sq. ft. to a group of German pension funds. That's a record for any office building sale in Chicago, and reflects a growing demand for investment properties downtown.

A seller's market

Local dealmakers say that the prices being paid by investors for office assets are approaching $100 more per sq. ft. for many Class-A properties, which now regularly sell for $300 per sq. ft. and more.

“We haven't seen prices for existing assets rising like this since the late 1980s, which were heady times, too,” says Elliott Quigley, senior vice president of KeyBanc Real Estate Capital in Chicago, which helps finance deals. “At the cap rates buyers have been willing to bid at this year, almost every building owner is a potential seller. The question is: When does the music stop?”

Even with recent subprime banking concerns, Quigley and others haven't seen the appetite for Chicago assets dry up yet, though there is some consensus that the Hines deal at $420 per sq. ft. isn't likely to be topped by anyone else soon. Michael Watts, a senior vice president at J.F. McKinney & Associates in Chicago, notes that Loop high-rises are trading hands at capitalization rates of 6% and less today.

“Three years ago cap rates on deals for Chicago offices were 200 basis points higher,” Watts recalls. “With prices so high, it's a difficult time to be a buyer. New owners have very little flexibility to come off their pro formas. Still, some office buildings in New York are being sold for $1,000 a sq. ft. By comparison, Chicago looks like a safer play.”

Still, Christopher Wood, a senior vice president and managing director at UGL Equis in Chicago, warns investors in Loop office buildings not to expect lease rates to continue their upward spiral for too long. He thinks office rents will increase another 5% in the first half of 2008, then flatten out.

“Investors are buying office assets in Chicago with pretty rosy expectations,” Wood says. “Some of those expectations may be unrealistic. We aren't likely to see rents in the next five years keep rising at the pace of the past nine months. Many buyers have no room for error in their projections and underwriting.”

William Rogers, managing director in the tenant rep practice of Jones Lang LaSalle in Chicago, believes that too many investors from the East Coast have become spoiled by gross rents (net rents plus taxes and operating expenses) that have jumped to $100 per sq. ft. in Manhattan and elsewhere. The top gross rents in Chicago currently run about $55 per sq. ft.

“Some of these investors are coming from other big-city markets where supply is incredibly tight,” Rogers says. “They've got to adjust their thinking here.” He cites one higher-end Class-B building in the West Loop, at 101 North Wacker Drive, that had asking rents of about $15 per sq. ft. a year ago when it was owned by Equity Office Properties Trust. Then Tishman Speyer Properties acquired it as part of a $1.8 billion deal for part of the Equity portfolio and later resold it to Hines for $131 million, equal to $210 per sq. ft. Asking rents now are running at more than $20 per sq. ft.

Hotels paired with offices

One trend that promises to prop up office rental rates in the next few years will be decisions by some landlords to reconfigure their office buildings to mixed-use. The Prime Group Inc., based in Chicago, acquired a 21-story, 1914 vintage building at 208 S. LaSalle Street a couple of years ago after it had lost the Dutch bank ABN AMRO as an anchor tenant.

Prime's chairman and CEO, Michael Reschke, decided to convert the bottom 10 floors of the building into a JW Marriott Suites hotel, complete with 50,000 sq. ft. ballroom and spa. Remaining office tenants have been moved to the upper 10 stories of the building.

There are likely to be more conversions of older office towers into hotels in the next couple of years around the Loop, Reschke predicts. He also anticipates strong office absorption. Others agree, and some are even predicting more new construction starts on high-rise towers.

There are probably a dozen or more sites available for big buildings in and around the Loop, brokers say. And a half-dozen tenants, led by the law firm Baker & McKenzie LLP and the accounting firms KPMG LLP and Ernst & Young LLP, are already shopping for new spaces to replace leases due to expire in 2010 and after.

“There is a robust pipeline of large tenants with 2011 and 2012 lease expirations, and the buildings finishing up construction in 2009 aren't going to want to hold their space empty for two years,” says D'Arcy of Hines Interests. That leaves an opening for more new construction starts in the next year or two, he adds, though who will take the plunge is anybody's guess at this point.

Count on one thing, however: This is Chicago, and in the city of Mayor Richard J. Daley development is rarely done on anything less than a grand scale.

Lee Murphy is a Chicago-based writer.

CHICAGO - BY THE NUMBERS

METRO POPULATION: 8.4 million

Source: U.S. Census Bureau

UNEMPLOYMENT RATE: 5.9%

Source: Illinois Dept. of Employment Security

LARGEST PRIVATE EMPLOYERS:

  1. Jewel-Osco
    35,000 employees

  2. Advocate Health Care
    27,000 employees

United Parcel Service of America Inc.
20,000 employees

Source: NREI estimates

METRO AREA VITAL SIGNS

Office:

13.9% vacancy, 2Q 2007

16.4% vacancy, 2Q 2006

$28.93 rent per sq. ft., 2Q 2007

$27.69 rent per sq. ft., 2Q 2006

Source: Cushman & Wakefield

Multifamily:

4.6% vacancy, 2Q 2007

3.5% vacancy, 2Q 2006

$2.30 avg. rent per sq. ft., 2Q 2007

$2.23 avg. rent per sq. ft., 2Q 2006

Source: Appraisal Research Counselors

Retail:

7.6% vacancy, 2Q 2007

6.9% vacancy, 2Q 2006

$19.31 rent per sq. ft., 2Q 2007

$18.63 rent per sq. ft., 2Q 2006

Source: Reis

Industrial:

8.4% vacancy, 2Q 2007

8.7% vacancy, 2Q 2006

$4.43 rent per sq. ft., 2Q 2007

$4.29 rent per sq. ft., 2Q 2006

Source: CB Richard Ellis

Hotel:

73.4% occupancy, 2Q 2007

72.6% occupancy, 2Q 2006

$134.87 average daily rate, 2Q 2007

$125.53 average daily rate, 2Q 2006

Source: Smith Travel Research

MAJOR PROJECTS:

River Point — The 50-story office tower spanning 1.1 million sq. ft. is rising at 201 N. Canal Street, overlooking the Chicago River in the West Loop neighborhood. The lead tenant will be investment firm William Blair & Co., which is taking 325,000 sq. ft.

Developers: Hines Interests LP; real estate investor Larry Levy

Completion: Summer 2011

Cost: $400 million

Chicago Spire — Installation of footings for the corkscrew-shaped 2,000-foot tall building designed by the Spanish architect Santiago Calatraya began in late summer in a residential neighborhood a block off Michigan Avenue. Plans call for 1,300 condominium units spread over 2.5 million sq. ft. Prices are expected to top $1,200 per sq. ft.

Developer: Shelbourne Development Ltd.

Completion: 2010

Cost: $1.2 billion

Suburban office market remains in doldrums

In the Chicago downtown office market landlords have clearly gained the upper hand this year, but in the suburbs the story is much different. The overall vacancy rate remains at 18.5%, with net absorption in the first half of this year a negative 873,000 sq. ft., according to brokerage Cushman & Wakefield.

Asking rents inched up 2% to $22.16 per sq. ft. on a gross basis compared with year-earlier levels. But there was so little confidence in the market — which spans 95 million sq. ft. — that just 650,000 sq. ft. of new construction was underway earlier this year, compared with 1.1 million sq. ft. in mid 2006. Tenants changing spaces are frequently demanding — and getting — free rent and other incentives.

Suburban office fundamentals have been weak since 2000, when the technology and telecom sectors crashed. Big suburban employers such as Lucent Technologies Inc., Tellabs Inc. and Motorola Inc. together shed thousands of jobs and put entire buildings up for sale that still haven't found buyers seven years later. Meanwhile, landlords have struggled to fill office spaces.

Once a big builder in the suburbs, Skokie-based The Alter Group put up its last local office structure spanning 225,000 sq. ft. in the western suburb of Downers Grove five years ago. Vacancy there is running a fearsome 25%, which has forced Alter to put off plans to start a 450,000 sq. ft. mid-rise.

“Net rents in the western corridor are running around $15 a foot right now,” says Matthew Ward, Alter senior vice president. “We can't deliver a new building for less than $19 or $20 a foot in net rents.”

Duke Realty and Opus North Corp. have both launched speculative office projects: Duke is erecting a 125,000 sq. ft. building near O'Hare International Airport; and Opus is building a 240,000 sq. ft. building in Downers Grove.

But many observers wonder how either expects to make any money on those projects. TCB Development delivered a 77,000 sq. ft. spec low-rise in the summer of 2006 in the southwest suburb of Tinley Park, and so far has leased just 20,000 sq. ft., says Randy Tieman, a TCB executive vice president.

“New buildings need a minimal $19.50 per sq. ft in net rents to just break even, but that's not the market rent right now,” says Jason Volpe, managing director at brokerage Studley.

He expects vacancies to actually rise in the 'burbs over the next couple of quarters, leading to a shutdown in new construction and shrinking prices for the sale of existing assets, most of which have changed hands for $200 per sq. ft. and less recently. “We may see no new development at all in suburban offices in 2008.”
Lee Murphy