A new round of development is under way in the Twin Cities even as the commercial real estate market struggles to regain its footing. The volume of construction activity is modest by historical standards with roughly 1.8 million sq. ft. of retail, office and industrial properties under way at year-end 2003. But the development pipeline is filling up rapidly with more than 17 million sq. ft. of projects proposed or in preliminary planning stages.

Granted, it may be years before many of these projects make it off the drawing board, but the spike in activity is one indication that developers are gaining confidence in a market recovery. Chief among the proposed projects are a $600 million mixed-use development in Bloomington and a $157 million rehab of the vacant Sears complex in South Minneapolis. Construction on both projects is expected to begin later this summer.

Minneapolis-based Ryan Cos. US Inc. is moving forward with Midtown Exchange, a redevelopment of the former Sears retail and warehouse complex. “The fact that they are putting the Sears property back into use is probably the biggest story in the Twin Cities,” says Whit Peyton, a senior managing director at CB Richard Ellis in Minneapolis. The property has sat empty since 1994, and past efforts to revitalize the property have fallen flat.

Ryan plans to remodel the original 1 million sq. ft. existing structure to accommodate its mixed-use project that includes a new 250,000 sq. ft. headquarters for Minneapolis-based Allina Hospitals and Clinics, a three-star hotel, 120 apartments, 90 senior apartments, 82 condos, 52 townhomes and 1,400 parking spaces. A second phase will include an additional 170,000 sq. ft. of office and laboratory space and 100,000 sq. ft. of retail space.

St. Paul-based McGough Cos. is the lead developer on Bloomington Central Station, a mixed-use development slated for a 45-acre site located two blocks east of the Mall of America. The master plan includes more than 1 million sq. ft. of office space, 1,000 housing units and a 500- to 700-room hotel and resort that will feature a 60,000 sq. ft. water park.

Both projects are highly ambitious in a market where — with the exception of retail — occupancy rates and rents have taken a dramatic plunge. The weak employment picture continues to be a drag on the market. Between 2000 and 2002, the Twin Cities metropolitan area lost 2% of its employment base. And as of December 2003, non-farm employment totaled 1,722,400 — down 9,600 from year-end 2002.

Office vacancies have hit a 10-year high, topping out near 20%, according to Bloomington, Minn.-based United Properties. The industrial sector also is struggling: vacancy registered 15.2% at the end of the fourth quarter of 2003.

That's not to say there aren't signs of life in the office market. Boston Scientific Corp., for example, recently announced plans to add 600 jobs and build a new 120,000 sq. ft. facility at its corporate campus in Maple Grove. The Natick, Mass.-based firm is a medical device manufacturer.

“Big picture, what we're seeing among corporate users in the marketplace is a desire to have enough space to grow,” says Peyton of CB Richard Ellis. “So, we're starting to see some light at the end of the tunnel after a 24- to 36-month recession.”

Indeed, office space absorption in the Minneapolis CBD during the second half of the year was a positive 122,515 sq. ft. compared with negative absorption during the first half of 494,392, according to United Properties.

Resiliency of Retail

Twin Cities retail has survived the recession with barely a scratch. The year-end vacancy rate held steady at 5%, according to United Properties. The sector has welcomed roughly 2 million sq. ft. of new retail space each year for the last few years, and 2003 was no exception with 2.2 million sq. ft. hitting the market, according to United Properties.

“I think that pace will be sustained as long as we can keep interest rates relatively low, which in turn will fuel residential and retail development,” says Michael Sims, a vice president in retail brokerage at United Properties. As of mid-March, the 10-year Treasury yield registered 3.75%.

The bulk of new construction is focused on community and neighborhood centers — including three SuperTarget stores in Champlin, Blaine and Savage. “The engine that drives our market is clearly the grocery-anchored, general merchandise neighborhood center,” Sims says. SuperTarget, for example, has been aggressively expanding in the metro with a total of 11 stores expected to be open by the end of 2004.

Several national retailers also are planning to open their first stores in the Twin Cities this year. CVS Corp. is scouting for more than 20 metro locations. Lowe's Home Improvement has acquired a site in Coon Rapids for its first store, and Swedish furniture retailer Ikea is building a new 330,000 sq. ft. store across from the Mall of America that will open in the third quarter.

Lifestyle centers continue to attract retailer interest. Minnetonka-based Opus Northwest and Kansas City-based RED Development co-developed the 411,000 sq. ft. Shoppes at Arbor Lakes in Maple Grove. The lifestyle center, which opened last fall, was purchased by Newark N.J.-based Prudential Insurance Co. in December for $86.9 million.

Opus and RED are planning a 400,000 sq. ft. lifestyle center in Woodbury. “Woodbury represents a terrific opportunity, and it will hopefully look a lot like Arbor Lakes,” says Dave Menke, vice president of real estate at Minnetonka-based Opus Northwest. The project is currently in the city approval process, but Opus expects to break ground later this summer.

Industrial Recovery

The Twin Cities industrial market appears to have stemmed its backward slide. The 15.2% industrial vacancy rate at year-end 2003 is actually a slight improvement from the 15.9% figure recorded at mid-year, according to United Properties. “We really started to book deals in earnest late last year and earlier this year,” says Scott Frederiksen, a senior vice president at Bloomington-based Welsh Cos.

Although the Twin Cities industrial market recorded negative absorption of 1 million sq. ft. during the first half of the year, demand rose during the latter half of the year with a total of 1.1 million sq. ft. of positive absorption, according to United Properties.

The industrial market also has been successful in absorbing much of the sublease space that has plagued the market. Certainly one of the biggest sublease headaches in the market has disappeared. The nearly 1 million sq. ft. of office and industrial space dumped back on the market by Eden Prairie-based ADC Telecommunications Inc. has either been leased or sold.

“During the year, concessions will continue to evaporate, which will allow rents to rise — hopefully by year-end,” Frederiksen says. Industrial development will likely follow in the wake of rising rents, with the next wave of construction beginning in spring 2005, he notes.

Quoted net rental rates for warehouse space averaged $4.29 per sq. ft. at the end of 2003 compared with $4.23 a year earlier. During the same period, quoted net rental rates for office space in the industrial buildings averaged $7.88 per sq. ft., slightly lower than the $8.04 quoted at year-end 2002, according to United Properties.

Office Sector Wallows in Vacancy

Owners of office properties are facing a long road to recovery. The average office vacancy rate for all classes of space rose from 18.4% at mid-year to 18.9% at year's end. Rental rates declined to an average of $11.68 per sq. ft. from the mid-year mark of $11.91, with concessions widely in use, according to United Properties.

Yet industry experts are optimistic that the office sector has finally turned the corner. Why? “Much of the sublease space that had plagued the market since early 2000 has been absorbed or leases have expired,” says Rick Collins, vice president of development at Ryan Cos.

Although total absorption during the second half of the year was negative 204,980 sq. ft., five of the seven submarkets reported positive absorption — including the Minneapolis CBD. Deals such as U.S. Bancorp's lease of 270,000 sq. ft. at 200 S. Sixth Street helped to propel downtown absorption to a positive 122,515 sq. ft., according to United Properties.

Speculative development of new office buildings is not expected to return until 2005 at the earliest. “I think it will be another slow year of recovery,” Collins predicts.

Multifamily Headaches

Low interest rates and continued construction have taken their toll on the multifamily sector. Vacancies — which have been on the rise since reaching a low of 1.1% in the third quarter of 2000 — hit 7.6% at year-end for the Twin Cities metro, according to a fourth-quarter report by GVA Marquette Advisors in Minneapolis. Vacancies are likely to edge up further during the first half of 2004, with several projects set to open in the next few months.

The good news is that the pace of new development appears to be slowing. Across the metro area, 3,031 units were under construction at year's end compared with 4,051 units at the end of 2002, according to United Properties.

Although rental rates remain flat, averaging $845 in the second half of 2003, they do not reflect the concessions, including free rent, that landlords are offering tenants, according to GVA Marquette. Landlords will face even more competition in the coming months with several new projects set to open during the first half of 2004.

In addition, stagnant office and industrial construction has prompted some commercial developers to pursue a burgeoning demand in the residential condo market. Opus, for example, has three condo projects under way or proposed in Minneapolis that could add more than 850 for-sale condo units to the downtown market. Although apartment landlords don't relish the added competition, the expanding downtown residential base is good news for retailers and service businesses.

“Interest rates have allowed many people to move to ownership. That has been a big boost to CBD housing development,” Menke says. The growing housing base, coupled with downtown additions such as the Block E retail and entertainment complex, have made downtown Minneapolis a vibrant place to live, he adds.

Block E is anchored by Gameworks, Hard Rock Café and Crown Theatres. Opus' first condo project, the 327-unit Grant Park, will be fully completed in July. Opus is co-developing all three projects with St. Louis Park-based Apex Asset Management Inc.

Hotel Comeback

The beleaguered hotel sector is beginning to show signs of improvement. “The business traveler is starting to come back,” says Stephen Sherf, a senior vice president at GVA Marquette. The year-end occupancy rate climbed to 65% compared with 58.4% at the end of 2002, according to GVA Marquette.

Owners are still discounting rates to fill rooms. Average daily rates fell from $91.58 in the fourth quarter of 2002 to $89.91 at the end of 2003, according to GVA Marquette. Sherf expects the occupancy rate to rise another two to three points in 2004, which will likely spur rate increases in the third or fourth quarter. “I think we will see a quarter or two of occupancy increases before hotel managers start to increase rates,” Sherf says.

Hotel development may return as early as the fourth quarter of 2004. That's because there is pent-up demand for new hotel properties, particularly for limited-service hotels in growing communities on the fringe of the metro, Sherf notes. Demand also exists in closer-in markets where the older, economy motels built in the 1970s and early 1980s are beginning to approach obsolescence, he adds.

Ultimately, the development activity coupled with some positive absorption in the office and industrial sectors indicate that the Twin Cities commercial real estate market is on track for continued improvement in 2004. “In the next year there are going to be stops and starts in the market recovery,” Peyton says, “but it will be better from the perspective that there will be more activity, and user activity helps to drive a healthy market.”

Beth Mattson-Teig is a Minneapolis-based writer.

TWIN CITIES - BY THE NUMBERS

POPULATION OF METRO AREA:

7-county metro area: 2.64 million

UNEMPLOYMENT RATE: 4.1%

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:

18.9% vacancy, 4Q 2003
15.9% vacancy, 4Q 2002
Rent per sq. ft.: $13.69 4Q 2003
Source: United Properties

Multifamily:

7.6% vacancy, 4Q 2003
6.6% vacancy, 4Q 2002
Rent per unit: $845
Source: GVA Marquette Advisors

Retail:

5.0% vacancy, 4Q 2003
4.5% vacancy, 4Q 2002
Rent per sq. ft: $29.45 4Q 2003
Source: United Properties

Industrial:

15.2% vacancy, 4Q 2003
14.0% vacancy, 4Q 2002
Rent per sq. ft.: $4.29 4Q 2003
Source: United Properties

Hotel:

65.0% occupancy, 4Q 2003
58.4% occupancy, 4Q 2002
Average Daily Rate: $89.91 4Q 2003
Source: GVA Marquette Advisors

MAJOR PROJECTS UNDER CONSTRUCTION:

Bloomington Central Station, a mixed-use development with 1 million sq. ft. of office space, 1,000 housing units and a 500- to 700-room hotel
Cost: $600 million
Developer: McGough Cos. is the lead developer
Completion: 2006

Midtown Exchange, a mixed-use redevelopment with a 250,000 sq. ft. headquarters for Allina Hospitals and Clinics, a hotel and approximately 300 housing units
Cost: $157 million
Developer: Ryan Cos. US Inc.
Completion: 2005

Grant Park, a 327-unit condo project in downtown Minneapolis
Cost: $100 million
Owner: Opus Northwest and Apex Asset Management Inc.
Completion: July 2004

Westgate Business Center V, a 98,250 sq. ft. office/showroom
Cost: $5.5 million
Owner: CSM Corp.
Completion: Spring 2004