Minneapolis-St. Paul is witnessing the resurgence of new development for all property types in 1997.

The resurgence of a healthy market is in full swing throughout the Twin Cities, and it spans every product type from office and industrial to retail, hospitality and multifamily. The metro area is still shaking off the last of the symptoms from the down market that hit in the early 1990s. Depressed rents are once again on the rise, and developers have ended the construction drought with a flurry of new activity.

"Overall the market is pretty fabulous. Without question it's a landlord's market again," says Stuart Ackerberg, president of the Ackerberg Group. "Every market sector has minimal vacancies and increasing net rents, and the strong market is expected to continue. I think we definitely have some years left in this healthy cycle."

Healthy office market Office vacancies are tight across the board. Vacancy rates have dropped to a 13-year low of about 7.1%, and submarkets such as the southwest metro are reporting vacancies as low as 3%. Class-A vacancies are the tightest, and big blocks of space of any type are scarce. "I think the office market is very healthy. It's been very strong for the last 18 months or so," says Boyd Stofer, president and CEO of United Properties.

The big story in the Twin Cities office market is new development. Three new multitenant properties became available and target the southwest market. In addition, more than 9 million sq. ft. of new office space is proposed or under construction. In 1997, the pent-up demand was so strong that when new space came on line, it barely created a blip on vacancy charts.

Although not all of the projects will make it off the drawing board, the million dollar question focuses on how many will actually break ground. "There are some who believe that we may already be seeing warning signs of overbuilding. I don't think we are at that point yet," says Rick Collins, president of Welsh Cos. "It is difficult to predict what projects will not make it off the drawing board. I believe that the majority of those proposed will end up being built, although at a slightly longer schedule than anticipated by the developers."

The new development is concentrated in the southwest and west suburban markets. Developers also are maneuvering for position in downtown Minneapolis to build the first multitenant office market in six years. Minneapolis-based Ryan Cos. has already started construction on a new corporate headquarters for Target, while Opus Northwest LLC is developing a new building for American Express Financial Advisors. Downtown St. Paul has made its own impressive recovery during the last year, and Frauenshuh Cos. is expected to start a new multi-tenant office building anchored by Lawson Software next year.

The investment market is extremely competitive, and sale prices are approaching that of replacement cost. "There's an enormous amount of money out there interested in commercial real estate from pension funds, REITs and other private interest groups," says Stofer. "Sale prices are the highest seen in more than a decade. A competitive investment market has buyers putting their money into new developments. Certain investors are going to place acquisition funds in new spec office product, in lieu of trying to compete for a yield that is not acceptable."

Industrial starts climbing The industrial market started climbing out of the recession nearly three years ago and is still going strong. Industrial vacancies average about 7.9%. Overall, rents saw mild increases about 12 to 18 months ago but have remained relatively stable. Landlords also have been finding ways to boost their yield in other areas, such as reduced tenant improvement dollars, or attractive amortization schedules. "Landlords may not be able to drive the face rate up higher, but they can certainly do things in the lease to increase yield and transfer expenses," says Raymond J. Reese, a senior sales associate and industrial specialist for Towle Real Estate Co.

"What we've seen over the last couple of years is pent-up demand in the industrial market, which has served to fuel a great deal of industrial development," says Michele Foster, a director of real estate development at Opus Northwest LLC. "And the boom in industrial development continues with more than 6 million sq. ft of space expected to come into focus during the next year." According to statistics compiled by United Properties, absorption for 1996 was about 1.9 million sq. ft., and absorption during the first half of 1997 was nearly 900,000 sq. ft.

"People have very much responded to the demand for new space, the question is whether that demand will keep up with the new construction," says Foster. "The sense of caution is fueled by an increasingly crowded field of developers. We've seen a lot of new entities become developers. New REITs, individuals and other investors have entered the development arena in the last two years."

One of the factors that will serve to rein in overbuilding is a shortage of building materials. Developers that have not yet booked their steel and precast concrete will probably have to wait until next spring. "Clearly that will slow down the overbuilding," says Reese. "In addition, more companies are putting expansion efforts on hold because of concerns over labor availability. The Twin Cities unemployment rate of 2.5% ranks as one of the lowest rates for a metropolitan area in the country."

Investment transactions for larger industrial properties and portfolios has slowed in recent months. A wave of institutional buyers have gobbled up Twin Cities inventory. "Those buyers' appetites have been very large. There's not a lot of available, investment-grade property on the market available at values that would interest those types of investors," says Reese. "Properties are getting priced to the point where they are no longer attractive acquisition opportunities."

Low retail vacancy rates Despite heavy construction activity that included the addition of 5 million sq. ft. of new space in the last two years, retail vacancies are still averaging a low 8.6%. "I think the market is in balance by and large," says Bill McHale, vice president of retail development for Ryan Cos. "Although a shake out among category killers was widely anticipated after a surge of new development, the closings were fairly minimal. Retailers such as F&M Distributors, Media Play, Builders Square and Filene's Basement are the major retailers that ended up closing some Twin Cities locations."

"I think like any business, you will continue to see consolidations. What you're not seeing is a lot of failing concepts that people were expecting," says McHale. "Those stores that have closed have been able to be recycled by other retailers. New retailers also have continued to enter the market such as Galyan's, Home Depot and Bed Bath & Beyond."

One of the biggest new retail projects is the Mall of America Phase Two, which is expected to be parallel in size to the 2.6 million sq. ft. megamall, but will also include complementary uses such as hotel and entertainment. St. Paul-based CSM Corp. has been extremely successful with its Shops at Lyndale, a two-phase retail project in Richfield. Ryan recently opened The Quarry, a 405,000 sq. ft. retail center, which is the largest inner-city neighborhood retail center development in Minneapolis' history.

The multiplex craze also has landed in the Twin Cities. "That's the portion of the industry that is going through the biggest power shift right now," says McHale. "The new wave features multiplexes with up to 20 screens, and new features such as stadium seating and state-of-the art audio and visual. Six theater projects have already started construction, and another six will likely break ground within the next year."

Grocery-anchored retail centers continue to be the most popular retail investment. AMB Institutional Realty Advisors paid $99.66 per sq. ft. for Rockford Road Plaza, a Plymouth community shopping center, while Southdale Shopping Center, a premier regional center in Edina, sold last spring for $72.30 per sq. ft.

Hospitality development increases The hospitality industry has seen heavy development activity this year. In 1997, 11 hotels have opened and another eight are currently under construction, and conservative estimates show more than a dozen projects in various planning stages. "The market is very healthy, but it is starting to soften," says Kirby Payne, president of American Hospitality Management Co. "On a broad-basis, there is certainly a danger of overbuilding. However, supply appears to be meeting the growing demand."

Twin Cities occupancy rates averaged 67.5% through June, up from 66.5% from the same period in 1996. Average daily room rates for the same time period were $80.25, up from on average of $76.25 the previous year, according to statistics provided by Minneapolis-based Marquette Advisors.

Development has been occurring predominately in the limited-service sector. "Limited service has been popular because it's easier to build, less capital is required, it's easier to run, and certainly easier to finance, although that is gradually beginning to change," says Payne. "Extended-stay properties have been another popular choice. The availability of franchises has created a lot of activity."

Development is expected to start shifting to the full-service arena. "There is clearly a trend to want to build full-service as opposed to limited-service, because developers feel limited-service is becoming overbuilt," says Payne. "I think we will start to see some full-service development return."

Active multifamily environment The multifamily market is extremely tight in the Twin Cities. Vacancies for second quarter 1997 average 4.7%, which is down from 5.8% for the first quarter, according to Edina, Minn.-based Apartment Search Profiles. "It is very, very healthy from the landlord's standpoint, because we haven't seen vacancies this low in some time," says Sue Schnarr, vice president of Mid Continent Management Corp. and 1997 chairwoman of the Minnesota Multi Housing Association. "The high occupancies have prompted moderate rent increases. Second quarter rents averaged $528.32 per month. However, in many cases apartment rents have been at 1987 rents for the last 10 years."

The tight housing market has sparked the return of new multifamily development, along with more activity occurring in the rental townhome market. Prohibitive costs of construction and operation have developers building properties that command higher rents. The first major Class-A apartment property to be developed in seven years opened earlier this year in Eagan. Minneapolis-based Healey Ramme Co. developed the 282-unit Promenade Oaks.

The good news for owners is that the multifamily industry finally got a long-awaited tax reform measure that reduces tax rates for apartments by nearly 15%. Minnesota multifamily properties are taxed at one of the highest rates in the country. The Twin Cities is an ideal seller's market, with buyers outnumbering available properties. Most Class-A properties are selling for $60,000-plus per unit and achieving cap rates of about 8%. Class-B cap rates are at 9%, and Class-C cap rates are at about 10%.

Beth Mattson is a writer specializing in commercial real estate based in the Twin Cities.