The high-rise construction cranes around Chicago's skyline have been mostly absent this year, as the marketplace suffers its highest office vacancy rates in at least two decades. In recent months, however, dealmakers have swung into action, signaling the beginning of an investment rebound in the Windy City's capital markets.

The new cycle kicked off in late July when a real estate investment trust sponsored by KBS Realty Advisors LLC paid a mountainous $655 million for the 300 North LaSalle building erected by Hines Interests LLC only a year earlier. The price paid by KBS, headquartered in Newport Beach, Calif., amounted to $503 per sq. ft., an all-time Chicago record, smashing the old standard of $403 per sq. ft. that Hines paid for the landmark One North Wacker building back in 2008.

The transaction appeared to spur others in the market to act. The Pritzker family, owners of the Hyatt Hotel chain, announced in early August that they were putting the Hyatt Center at 71 S. Wacker up for sale with an asking price of $575 million, equal to $390 per sq. ft. for the 1.5 million sq. ft. tower, which is 95% leased.

That was followed a few weeks later by revelations that the massive Merchandise Mart, at 3.5 million sq. ft., one of the largest commercial buildings in the world, was being put up for sale by its owner, Vornado Realty Trust, based in Paramus, N.J. In fact, the Mart, which encompasses offices, retail shops and home furnishings showrooms, drew a rapid offer of $1.25 billion, though that deal has reportedly died.

Meanwhile, the suburbs saw the biggest deal in years when Navistar Inc., the maker of trucks and engines, announced that it was moving its headquarters from west suburban Warrenville to nearby Lisle, where it will occupy the former Alcatel-Lucent office complex. Navistar acquired the 85-acre campus, which includes 1.2 million sq. ft. of offices, for just $34 million, but is spending another $75 million to update and expand the facilities. The move involves the retention and creation of about 3,000 jobs.

All this activity has suddenly awakened the once moribund market. “There are a lot of investment funds looking at Chicago right now,” declares John Przybyla, a vice president and regional manager of the local Marcus & Millichap Real Estate Investment Services office. “If we can get some job growth here again soon and rents started to stabilize, both of which are being predicted for 2011, then office transactions will really start to increase around Chicago.”

New deals and projects are badly needed in the Windy City. “Chicago is in a flatline condition, and there don't appear to be many growth industries and confident employers to pull us up,” says Jeff Liljeberg, a Jones Lang LaSalle managing director. He believes that no new construction is likely downtown for at least three years, and perhaps five years or longer. However, that dearth has an upside, in that it should promise a firming in rents and operating performance for big office towers. And that, in turn, should help boost interest in each of the properties coming up for sale. Even so, Liljeberg wonders how the glut of vacancies will get fixed.

Eyes on Chicago prize

William Rogalia, a senior vice president at KBS who is the director of acquisitions for the central region, is well aware that his deal for 300 North LaSalle could set a precedent. “I'm sure owners of quality assets around the entire U.S. were watching our transaction here in Chicago closely,” he says. “It may affect people's decision to invest not just here, but in other big cities around the U.S. in coming months. There is a good appetite developing right now for strong assets.”

Todd Lippman, a vice chairman of CB Richard Ellis, believes that investors in the current cycle are looking first and foremost for the biggest and best trophy assets in downtown Chicago. “The sale of 300 North LaSalle got other folks thinking,” says Lippman. “It put into play buildings like Hyatt Center that had been waiting for a signal from the market. Hines is a very smart owner. It saw an opportunity and got ahead of the curve. Other top Class-A buildings will be for sale soon, though there are only a handful of them.”

Don't look, however, for a return to the turbo-charged barrage of activity that dominated the middle part of the last decade anytime soon. In 2007, according to Marcus & Millichap, there were 120 office transactions valued at $45 billion in the overheated downtown office market. Those totals fell to just 20 sales valued at $304 million for all of 2009. Through the end of August this year, there have been 16 transactions valued at $764 million.

“We're not going to get back to the kinds of numbers we posted in 2007 for at least another three or four years,” says Przybyla of Marcus & Millichap. “We'll get past $1 billion this year downtown, and maybe even $1.5 billion. That represents a modest recovery in the capital markets — enough to celebrate considering what we've been through.”

Trouble in the burbs

The capital markets have been constrained by dismal fundamentals in leasing. A survey by Jones Lang LaSalle put downtown office vacancy at 16.1% at the end of the second quarter, up from 15.8% at the end of last year. Suburban vacancies are running a fearsome 25.4%, up from 24.8% at the end of 2009. These numbers are the highest since the early 1990s when the office market crashed, according to veteran observers.

The construction pipeline this year in the city has fallen to zero, after three big 1 million sq. ft.-plus buildings were added to the market last year. The city seems to be still digesting a decade-long building binge. Since 1998, developers have put up 160 buildings of 12 stories or more (including condominium towers) in the greater downtown Chicago area, according to Appraisal Research Counselors in Chicago.

That's more high-rises than other Midwestern cities such as Detroit (126) and St. Louis (105) have in total, a Chicago Tribune report noted.

It hasn't helped that the city has been shaken by recent events, including the failure to attract the 2016 Summer Olympics, even with native son Barack Obama serving as advocate-in-chief. Mayor Richard M. Daley announced that he won't run for re-election after serving for more than 20 years as a pro-business leader whom real estate executives had come to trust. His successor — there are likely to be a dozen or more candidates — will almost certainly be less friendly to big business. Meantime, traffic at O'Hare International Airport, once the world's busiest, has been sliding downhill while city officials and the major airlines argue over who will fund a multi-billion-dollar expansion plan.

However, deal-making is percolating in the suburbs beyond Navistar's new headquarters. Earlier this year Astellas Pharma, a Japanese pharmaceutical company, broke ground on a $150 million, two-building campus in north suburban Glenview to serve as its new North American headquarters. The buildings, encompassing 425,000 sq. ft. in all, are being developed by GlenStar Properties of Chicago.

Astellas acted after labor unions and vendors agreed to cut the building's costs from an earlier estimate of $180 million. Prices are falling elsewhere in the market. White Oak Realty Partners LLC, based in Skokie, Ill., led a partnership that acquired the Central Park of Lisle office complex, in the western suburbs, for $77 million, or $130 per sq. ft. from a partnership headed by New York's Tishman Speyer Properties. Tishman had paid $101 million, or $170 per sq. ft., for the 596,000 sq. ft. asset four years ago. Thus the property traded for 23% less than Tishman had paid for it. White Oak's partner in the deal was Angelo, Gordon & Co., based in New York City.

Kevin McLennan, a senior managing director for Studley in the suburbs, warns that the suburban vacancy problems could spike higher with the expected announcement soon that Alcatel-Lucent, beyond its building sale, is getting ready to put another 225,000 sq. ft. of offices up for lease in the western suburbs.

Yet he's encouraged that several large employers are hunting for office space in the suburbs. The roster includes Follett Corp., the producer of school textbooks based in River Grove, and Harris Bank, the Chicago money center institution, hunting for a call center operation outside of downtown. Both want more than 200,000 sq. ft.

Vacancy rates are as high as 26% in the far western suburbs right now, says McLennan. “But there is a prospect for some very large leases to be executed in the next 12 months. That is likely to shift the vacancy numbers more positive, though maybe not by much. Everything depends on when employers will start hiring in substantial numbers again.”

The hardest-hit suburban submarket has been far north of Chicago, where vacancies are running around 28%, notes Dan Fernitz, a senior vice president with Jones Lang LaSalle. “The suburbs overall continue to be under stress,” he says. “If we could get suburb-wide vacancies down even to 15% to 18% within the next three years, we'd be doing very well.”

Brighter lights downtown

Leasing activity in downtown Chicago is being pushed by the growing belief that rents have hit bottom and that the deals from landlords can't get much better. Rents on high-quality, Class-A buildings haven't moved much in the past year, with quoted prices running between $35 and $52 per sq. ft. on a gross basis, or $18 to $34 per sq. ft. on a net basis. What's changed are the extras that landlords are willing to toss into a deal now. Brokers say that 10-year leases that routinely included eight to 10 months of free rent and tenant improvement allowances of $60 per sq. ft. three years ago now offer upwards of 15 months of free rent and as much as $80 per sq. ft. in tenant improvements.

“There are some really good deals in the downtown to be had for tenants now,” confirms Robert Sevim, a tenant rep and executive managing director with Studley's Chicago office. Building owners have been alarmed by a rash of space being given back by companies both big and small. Sevim reports that “between 30% and 40% of my tenant clients are downsizing this year. That's the most downsizing I've seen in my 10 years in Chicago.”

Indeed, companies continue to pare back their space needs. Blue Cross & Blue Shield of Illinois was growing in its 263,000 sq. ft. space at 111 E. Wacker Drive as recently as 2007. In September the company exercised a termination option to leave the building altogether and consolidate operations in a smaller complex nearby.

Stock brokerage William Blair & Co. had planned to move to a new 1.1 million sq. ft. tower developed by Hines at 444 W. Lake St., taking 340,000 sq. ft. in the structure as an anchor tenant. But a year ago Blair cancelled the deal, then began peeling away employees and space in its present headquarters at 222 W. Adams St. Hines was forced to drop its project.

Dire losses at the mart

There are plenty of troubling signs in the downtown business district. The Merchandise Mart, which is going up for sale, has reportedly sustained a two-year operating loss exceeding $12 million.

A 46-story tower at 500 W. Monroe St. owned by Broadway Partners Fund Manager is close to foreclosure as its lenders, headed by Chicago's Transwestern Investment Co., complain that loans have gone unpaid. It would be the first foreclosure of a Loop office tower in 11 years.

Broadway paid $336.7 million to buy the building in mid-2007, but most observers peg its value now at $240 million, or 30% less, based on current operating income.

Elsewhere, other assets are suddenly, albeit without fanfare, coming onto the market for sale. The former Montgomery Ward building at 600 W. Chicago Ave., owned by a local investment group, is said to be available at a price of $425 million. Its office space encompasses 1.6 million sq. ft. and is just 4% vacant.

Buildings at 550 W. Washington Blvd., 353 N. Clark St. and 550 W. Jackson Blvd. are all up for sale, too, at asking prices exceeding $100 million.

As the buildings await new owners, Liljeberg of Jones Lang LaSalle wonders how metro Chicago's vacancy woes will get fixed.

“Unless the economy starts to come to life, conditions could continue flat here for quite a while yet.”

H. Lee Murphy is a Chicago-based writer.

CHICAGO: BY THE NUMBERS

METRO POPULATION

9.57 million

Source: U.S. Census Bureau

UNEMPLOYMENT RATE:
10.5%

Source: Illinois Department of Employment Security

METRO AREA VITAL SIGNS

Office:

19.9% vacancy 2Q 2010

18.1% vacancy 2Q 2009

$21.71* asking rent per sq. ft. 2Q 2010

$26.98* asking rent per sq. ft. 2Q 2009

Source: Jones Lang LaSalle
(*gross)

Industrial:

10.2% vacancy 2Q 2010

9.6% vacancy 2Q 2009

$4.53 rent per sq. ft. 2Q 2010

$4.71 rent per sq. ft. 2Q 2009

Source: Grubb & Ellis

New Airline and Multi-use Projects Provide Hopeful Signs for Chicago

Despite the slow pace of development over the past few years, the Chicago office market is buoyed by several new deals that are expected to spur construction of new, long-term projects. There are also signs of a turnaround in leasing, which would mark an improvement in the double-digit vacancy rate.

The mega-merger of United Airlines and Continental Airlines was approved on Sept. 17, and the new, consolidated company headquarters will be near United's existing base in Chicago's downtown, promising more jobs and office demand.

A Chicago development firm, Fogelson Properties, planned to erect a multi-use project south of downtown on 23 acres formerly promised to the Olympics. However, Chicago lost its bid for the 2016 Summer Olympics. The development would include 3,000 hotel rooms plus residential units and retail space, but would be anchored by an office tower of 70 stories with 1.5 million sq. ft. The Fogelson project is expected to take a decade or more to come to fruition.

There are hints of improving office fundamentals in downtown Chicago, known to locals as the Loop. It houses 137 million sq. ft. of offices, compared with more than 96 million sq. ft. in the suburbs. Positive space absorption occurred downtown in the second quarter for the first time in two years.

Sublease space has dropped by 20% since the end of last year to just 3.4 million sq. ft. That is the lowest sublease total since the end of 2008. The direct vacancy rate in the 30 newest downtown towers — those considered most likely to be coveted by buyers — stands at 11.5%, down from 12.2% earlier this year, according to MB Real Estate Index. Older buildings may take longer to recover occupancy.

Although there is currently no new construction under way downtown, the market could soon be ready to support another high-rise. “The trophy buildings are all pretty well leased in Chicago, and it won't be long before another new building gets launched,” says Todd Lippman, vice chairman of CB Richard Ellis Group.

A new high-rise could be built by late 2013, when a number of leases will expire in the Loop, says Lippman. He estimates the market would support up to an 800,000 sq. ft., 40-story high-rise. “Anything bigger than that you couldn't get financed. Any new building would have to be at least 50% pre-leased, which is going to be the biggest challenge.”