Chicago's suburban commercial real estate is turning in another strong performance in 1999. The office sector, however, is one major market that is leveling off as supply is expected to exceed demand for the remainder of the year.

In other property categories, activity is generally on the upswing, fueled by positive economic conditions, according to local industry sources. The large and varied suburban Chicago market continues to be a magnet for relocating businesses as well as local firms seeking to expand primarily because of the area's skilled labor resources. In view of today's tight labor market, businesses are realizing that they have to locate near the labor pools they need.

Office sector takes a dip The consensus view is that supply has met demand in the suburban market and is just starting to taper off. But some sources are looking over their shoulders at the large amount of new speculative space coming on line and asking where all the new tenants are coming from.

Arvid Povilaitis, senior vice president, central region for Chicago-based Equity Office Properties Trust, observes that new construction has peaked and is leveling off. But others point to the large amount of space already in the pipeline, variously estimated at 4 million sq. ft. to 5.7 million sq. ft.

The question, as Greg Van Schaack, vice president of Hines Interests LP, Chicago, puts it is, "When new construction is completed, will it be absorbed?" Van Schaak takes a positiveview, though, and doesn't expect any major imbalance.

Jeffrey Barrett, managing director in the Schaumburg office of Los Angeles-based CB Richard Ellis, agrees with Povilaitis that the number of spec office projects likely to break ground this year has declined, suggesting there may be a slowdown in the cycle as early as 2000. The slowdown in new construction has been accompanied by significantly less space being leased, according to a recent Julien J. Studley report. Leasing activity totaled 1.8 million sq. ft. in the second quarter, far below the 2.9 million sq. ft. in second-quarter 1998. A CB Richard Ellis report puts second-quarter net leasing even lower, at 819,517 sq. ft.

Patrick Gallagher, senior vice president of The Pizzuti Companies, an office and industrial developer based in Oak Brook Terrace, Ill., says equilibrium is the result of the market following its own checks and balances. "People are drawing back a little and capital sources are, too," he notes. "Capital pulls back at the hint of an oversupply."

Marilyn Lissner, senior director in the Chicago office of New York-based Cushman & Wakefield, concurs that there are signs the market is beginning to slow despite strong fundamentals and significant leasing activity. "I would characterize the market as flat compared to the highly energized market we had last year," she says.

Lissner continues, "There are some areas where Class-A space is virtually non-existent, like the O'Hare submarket, and any new supply would be immediately absorbed. But I also sense some hesitancy among large users elsewhere who are waiting to see if the strong economy continues and how that might impact their future space needs."

John Musgjerd, principal at Westchester, Ill.-based Podolsky Northstar Realty Partners, adds, "I'm not sure there's going to be enough absorption to keep developers happy." Musgjerd sees a leveling off of rents, increases in tenant improvement allowances and more tenant choices in 1999.

Joseph Mikes, executive vice president and managing director of Grubb & Ellis' suburban Chicago office in Rosemont, disagrees with Lissner, conceding that leasing activity was slow earlier this year but says there's been a resurgence starting in the past several months which led to an upswing in the market.

"Also, developers are going forward with projects even though they're not leased, showing that they are bullish on the market," he says. Mikes looks for 1999 to be a good year for the office market, but not at the levels of 1998.

The suburban office vacancy rate held at 9% during the second quarter despite a surge in leasing activity, due to the introduction of more than 1 million sq. ft. of newly available space for lease, according to CB Richard Ellis.

The report adds that space coming on the market during the second quarter included eight new speculative buildings totaling 534,000 sq. ft. in addition to the 535,000 sq. ft. former Waste Management headquarters complex in Oak Brook, now being marketed for multi-tenant occupancy under new ownership.

"With the amount of space coming on the market, it's amazing the vacancy rate didn't climb during that period," says CB Richard Ellis' Barrett.

Povilaitis puts the overall suburban vacancy rate between 9% and 10%.

Other vacancy statistics vary widely from 7.4% (Grubb & Ellis) and 10-11% (Opus North) to 12.6% (Cushman & Wakefield) and 14.7% (Julien J. Studley).

On rents, a Studley report says rates have steadied in the suburbs with the overall gross asking rate inching up only slightly in the second quarter to $22.50 from the first quarter's $22.45. Cushman & Wakefield puts the figure a bit lower at $21.62. Randy Tieman, vice president and general manager of Rosemont, Ill.-based Opus North Corp., pegs it at $25 while Povilaitis says the gross rate for well-located Class-A properties is $27 to $30 per sq. ft.

Suburban office absorption was a robust 2.5 million sq. ft. for all of 1998, but 1999 is expected to be considerably lower, tallying only 1.5 million sq. ft., according to Povilaitis.

Most sources agree that office supply has caught up to demand and may actually be ahead in some of Chicagoland's submarkets.

Bucking the overbuilding scare Slower suburban office absorption could have doubly negative ramifications with respect to overbuilding. Douglas Shehan, vice president of The Alter Group in Lincolnwood, Ill., believes all suburban office markets are overbuilt with the exception of O'Hare. Even so, that hasn't resulted in lower rental rates and there's been less panic because ownership structures are stronger, he says.

Tieman observes that there are some overpriced buildings on the market that will have a hard time leasing up, contributing to overbuilt conditions.

Spec space is definitely ahead of absorption in the booming East-West corridor where more than 1 million sq. ft. of Class-B space has been unexpectedly dumped back on the market in the wake of corporate mergers, says Musgjerd. Although it will be in direct competition with new Class-A space, Class-B will be a thorn in the side of Class-A because it offers advantages to tenants looking for cost-effective space.

"To some, it may offer the opportunity to locate in their own building and still pay Class-B rents," says Musgjerd. In any case, the East-West corridor leads the new space parade with an estimated 1.4 million to 1.5 million sq. ft. under construction.

Sources don't look for increases in suburban build-to-suit activity and some, like Shehan, predict a falloff as more spec space enters the market. Mikes agrees that most tenants are choosing spec because there's a lot of space on the market with multiple options. Van Schaack and Shehan agree that the build-to-suit market is driven by specialized needs such as call centers which require expansion capability and heavy parking ratios.

On the investment side, only a few of the larger developers such as Opus and Hamilton Partners are getting lenders to provide spec lending, according to Breck Hanson, executive vice president of the commercial real estate group at LaSalle Bank NA, Chicago. "They're unwilling to lend unless the developer is experienced and successful and this has kept office inventory in check," he says.

"Banks are willing to loan and money is available for new construction," adds Tieman. "However, the rules are tighter and more equity is required from the developers. Investors are more wary of lending and they're looking for smart projects. Many are taking a 'wait-and-see' attitude as to how the new construction on the market fares."

As for changes that may occur affecting next year's suburban office market, Musgjerd pegs it all on the economy. If the economy stays strong, he says, absorption will catch up. If not, spec construction will stop in 2000. Van Schaack observes that there should be a balance between supply and demand, providing the capital markets show restraint, and also cites the impact of new technology such as raised floor systems for power, air conditioning, cable and telecommunications systems.

Shehan foresees a shift in product type to smaller, more cost-effective buildings in the 100,000 sq. ft. to 150,000 sq. ft. range. "The winners will be the developers who have paid attention to the needs of Corporate America," he notes. Tieman and Mikes make the point that developers need to focus on leasing up and getting done what they've started now before thinking about the next wave of new construction.

Industrial jets forward If Chicago's suburban office market is currently experiencing a dark period, the region's industrial performance is the shining light the area needs.

Chicago's large industrial market, covering a property base of 927.6 million sq. ft. according to CB Richard Ellis, has always ranked as a major commercial force because of its centralized location. Most observers characterize the market as strong and stable with an equilibrium between supply and demand.

Jim McShane, CEO of McShane Construction Corp., a major Rosemont, Ill.-based industrial developer and contractor, says spec construction, which slowed down late last summer when the capital markets pulled back, is on the upswing now. Build-to-suit also is very strong because there have been fewer spec choices for customers. Another reason is that more manufacturing building is being done in the build-to-suit market because manufacturers don't fit as well into the spec market, he says.

McShane says bulk warehouse construction has peaked and the new industrial emphasis is on light-manufacturing facilities. "That's build to suit, and the fact that manufacturers are putting up new buildings bodes well for the economy," he notes. He singles out DuPage County and the I-80 corridor southwest as centers of industrial activity. The I-55 Bolingbrook Corridor has flattened out.

New McShane industrial projects include 80,000 sq. ft. of multi-tenant warehouse space in the Glendale Commerce Center, Glendale Heights, and a 72,000 sq. ft. build-to-suit facility for Phonak USA in the Canterra development in Warrenville.

Mikes of Grubb & Ellis points to more emphasis on smaller users in the 50,000 sq. ft. to 100,000 sq. ft. range. "A lot of big boxes were built and those users were taken care of," he says. "Smaller users were not taken care of."

The industrial market has continued strong momentum because of the trend by corporations to outsource and consolidate their distribution facilities, says Pizzuti's Gallagher. "When you pick a few cities nationally, Chicago always pops to the top because of its central location," he says.

Gallagher notes that the market has surged to a new level of geographic consumption as it pushes farther out. "You may need 17 to 20 acres for one large building which means you have to go farther out where land is cheaper," he says.

A CB Richard Ellis report indicates new industrial construction is up 50% over the first half of last year and is beginning to take its toll on vacancy rates. The overall vacancy rate for the second quarter was 8% with an 8.8% figure for properties 100,000 sq. ft. or greater. Initial vacancy increases have been modest, but Douglas Reed, managing director at CB Richard Ellis, says more are in store unless new construction proposed or planned, now standing at some 11.8 million sq. ft., starts to level. During the first half there were 7.9 million sq. ft. of new construction starts.

With a slight fall-off in user demand, CB Richard Ellis says sales and leases totaled 7.5 million sq. ft. in the second quarter, bringing first-half gross absorption to 15.7 million sq. ft.

Gallagher says there isn't too much spec space on the industrial market because "it all gets consumed." Pizzuti is building a 409,000 sq. ft. facility at Southfield Business Center in Joliet, which will be expandable to 700,000 sq. ft.

LaSalle Bank's Hanson says industrial space appears to be in balance now, ahead of the office market, but lenders are cautious about spec lending. An aggressive spec building program could throw the market out of balance but that's not likely to happen, he says.

Grubb & Ellis notes that vacancy rates are favorable and new construction is strong but says activity levels in several market indicators are down compared with 1998. The company says project leasing decreased 40% from last year while building sales dropped 38%. Grubb & Ellis also cites a decline in transactions with approximately 145 completed at mid-year compared with 261 by mid-year 1998. These results may be simply a "hiccup" in the market, the company observes.

Gallagher expects Chicago-area industrial to stay strong with a continued trend toward outsourcing, which leads to larger warehousing and distribution facilities. He says e-commerce is also likely to have an impact on the market. Internet sales don't need as much retail space but do need more storage space, well automated and close to transportation hubs, he concludes.

Retail rings it up The suburban retail market continues to ring up positive results while avoiding any significant downturns, according to Michael George, principal with Oak Brook Terrace-based Mid-America Real Estate Corp. "We've been anticipating softness in the market for many years but it just hasn't happened," he says.

George ascribes the market's success to three factors: Many existing chain stores continue to succeed, so they're expanding; new retail chains continue to move into the Chicago area; and the local success of the Chicago suburban market is prompting successful chains to capture greater market share in this area.

He cites Target and Home Depot as examples of successful existing chains, with Meiers and Galyan's Sporting Goods as two recent additions to the market.

Joseph Mikes of Grubb & Ellis says suburban retail is a good marketplace with most development being led by grocery-anchored shopping centers. Michael Wesley, vice president of retail and a principal at Tanguay-Burke-Stratton in Oak Brook, agrees with Mikes that grocery-anchored centers are the hot commodity right now in retail, although power centers are also doing well. Rents have stabilized, too, he says.

Reflecting increases in new construction, 37 new centers of 50,000 sq. ft. or greater are being built and 21 expanded in metro Chicago in 1999 compared with 30 new and 11 expanded centers in 1998, says George. Around 70% of these are in the suburbs. Prominent openings this year include Bohl Farm Marketplace, a 365,000 sq. ft. center in Crystal Lake anchored by Dominick's, and the Willow Creek Center in Glenview, a 325,000 sq. ft. center anchored by Target and Kohl.

Investment sales have been good in 1999 but not to the level of 1998, George says. Major properties changing hands include the 300,000 sq. ft. Randall Square Center in Batavia, purchased by Inland Real Estate; a six-store portfolio in Chicago and the suburbs purchased by First Washington; and additional Inland purchases of Woodfield Commons East and West in Schaumburg, Spring Hill Fashions in West Dundee and Two Rivers Plaza in Naperville.

According to George, suburban shopping center vacancy rates check in between 8% and 9%. Wesley is in close agreement at 8%. Wesley lists the biggest decreases in vacancies as the centers on Randall Road between Batavia and St. Charles, Crystal Lake on routes 14 and 31 and the route 59 corridor between 75th Street and Caton Farm Road in Dupage County.

George says the largest vacancy increases are occurring in Class-B locations where the better retailers are gaining market share, while the most decreases are in large regional malls. Also experiencing decreases are suburban centers close in to the city or within the city. The highest occupancy levels are in regional centers near enclosed regional malls and the lowest in Class-B locations in the outlying suburbs, George says. He adds that increased competition will be found in every suburban retail class, grocery chains in particular.

"It's the retail playoffs," he observes. "The unsuccessful chains are not making the playoffs." Wesley says Jewel and Osco may be downsizing to the 55,000 sq. ft. level with less backroom space and more merchandise out front. Dominick's is already dropping the fresh store concept under new ownership. There may be stores within Jewel stores providing additional services for customers seeking one-stop shopping, says Wesley.

A CB Richard Ellis report notes mixed demand for space, in a market that has absorbed second-generation space and reconfigured it to better suit retailers' needs. Todd Caruso, managing director with CB Richard Ellis, says, "New centers will continue to come on line nearly fully leased due to tenant pre-commitments. The next major recycling test will be this year when a number of former Builder's Square stores come back on the market."

LaSalle Bank's Hanson observes, "We thought retail would be the next big problem but the economy has kept it from becoming so. However, with the strong economy of the past several years, people have a lot of merchandise. If the economy takes a downturn, retailers could have problems because people won't need more merchandise."

Hotel bumps up supply Hotels are continuing to proliferate in Chicago's suburbs. "There's been a significant increase in suburban room supply," says Ted Mandigo, president of T.R.Mandigo & Co., an Elmhurst-based hotel consultant. These are mostly smaller 60-room to 80-room properties financed locally on smaller sites, many of them on in-fill state highway locations rather than the traditional interstate locations.

Brand names include Super 8, Holiday Inn Express, Comfort Inn and Fairfield. Mandigo says these properties tend to be more oriented toward their communities than toward interstate highway travelers.

Suburban markets are also seeing more chain hotel representation with the result that the older "mom and pop" units are being refurbished or phased out. Twenty percent or more of the newer properties include suites, he says, such as Candlewood, Hawthorn Suites, Homewood Suites, Homestead Village and Extended Stay America.

Mandigo and Steven Marx, president of Chicago-based Hotel Source, both point to extended stay units as a major new development in the marketplace. "They're so popular that supply is still trying to catch up with demand," Marx says. "Extended stay hotels, which include all of the aforementioned brands, have more of a residential feel with kitchens or kitchenettes, separate sitting rooms and bedrooms. They're being used by people who intend to stay one or two weeks such as employees being brought to a corporate site for training or installers of high-tech equipment."

On the financial front, Mandigo says suburban average daily rates (ADRs) range from $55 to $110 with an average of $68 across all markets. The occupancy rate is around 65%, but higher at 72% for properties near O'Hare. For the Chicago Metro area, ADRs rose to $106.14 for the first five months of 1999, an increase of 4.7% year to date through May compared with the year-earlier period. Occupancies, however, were down slightly to 66.1% year-to-date through May.

Major changes ahead could alter the suburban hotel landscape. According to Mandigo, some 8,000 new rooms are proposed over the next two years. That is a potential increase of 20% over the current supply, but Mandigo adds that not all of that new construction will occur, but the net result could still equal a 15% increase.

Multifamily lives well Chicago's suburban multifamily market is on the upswing, fueled by sizable job creation which is bringing an influx of new residents.

"A lot of people are moving into the Chicago area and renting apartments," says Wayne Vandenburg, CEO of Chicago-based TVO Realty Partners, an owner/manager of multifamily properties in five Midwestern states. "The biggest problem is barriers to entry on the part of some suburban communities that don't want apartment housing built in their areas."

Stephen Ross, executive vice president of AMLI Residential Properties Trust, Chicago, which also develops, own and manages multifamily, concurs with Vandenburg about the health of the suburban market. "All AMLI markets including Cook, DuPage and Kane Counties are doing well. Rents have increased and occupancy rates are in the mid- to high-90s," he says.

Neither Vandenburg nor Ross sees any threat of overbuilding, due to the regulatory environment which makes it hard to get zoning for multifamily properties. Those units being built are upscale because land and construction costs won't allow anything less. As a result, the difference between Class-A and Class-B properties is thin.

Metro Chicago's vacancy rates were 4% in 1997, 3.7% in 1998 and 3.7% in 1999, Vandenburg says. "Only five other cities - Minneapolis, San Diego, San Jose, San Francisco and Seattle - rival those figures," he points out. A total of 11,500 units were completed in 1998 and 5,500 units as of mid-1999. Vandenburg expects year-end figures to at least equal 1998's.

Despite a marked dip in its office performance, suburban Chicago is enjoying an incredibly active market with new development and investment on the horizon.