The good news for Higgins Development Partners and Pritzker Realty Group is that their new 47-story Hyatt Center in downtown Chicago is nearly two-thirds leased as construction gets under way. The bad news for the rest of the Chicago office market is that the 1.5 million sq. ft. tower at 71 South Wacker will join a handful of other major office projects that could dump 4 million sq. ft. of office space onto a market that already has more than enough empty space.
And the tenants who have signed up for the building are vacating other Class-A spaces in the area. Chief among them are parts of the Pritzker family empire, Goldman Sachs and the law firm Mayer, Brown, Rowe & Maw, Hyatt Corp.
“The downtown market is very soft, as soft as it has been at any time since the real estate depression of the early '90s,” says Joe Learner, executive vice president with Julien J. Studley Inc. “At no time in history have there been more options for tenants seeking 50,000 sq. ft. or more. Practically every building in the Loop can accommodate them.”
That softness is clearly reflected in the statistics. The vacancy rate for the first quarter of 2003 was 18.2% — slightly below its peak of 18.6% recorded during the first half of 2002 — but still higher than the national average, according to Insignia/ESG.
Learner questions the prudence of adding millions of square feet of office space at a time of negative net absorption, ample sublease availabilities and even shadow space — the hard-to-quantify inventory that is rented but not currently utilized by tenants. There also are other trends that could impede recovery, such as penny-pinching tenants seeking more efficient configurations and fewer square feet per employee.
Joining the Hyatt Center space, which will be available in early 2005, are the 1.2 million sq. ft. corporate headquarters Hines is building for ABN AMRO in the West Loop and John Buck Co.'s 950,000 sq. ft. tower at 111 South Wacker Drive, which Deloitte & Touche will anchor with more than 400,000 sq. ft. Hines also is ready to begin construction on a tower at 7 South Dearborn, where the law firm of Sidley Austin Brown & Wood is considering taking two-thirds of the building.
According to David Tropp, senior managing director with Insignia/ESG, the new construction is being driven by the limited space options for large tenants. “Maybe there is a block available today, but it won't be there when their lease expires,” Tropp says. “Those tenants need to decide three to four years ahead of expiration whether their current facility will accommodate their needs.”
But even if the new buildings fill up, vacancies will continue to rise in the buildings the tenants vacate. Learner points out the potential fallout from Hyatt Center alone: Goldman Sachs will leave its space in the Sears Tower and at 311 South Wacker Drive, while the Hyatt Corp. and the Pritzker family interests will consolidate from a variety of locations, and Mayer, Brown, Rowe & Maw relocates from 190 South LaSalle Street. “The Hyatt Center could create one winner and bunch of losers,” Learner says. “The recovery could be pushed back until 2007.”
On the other hand, a lot can happen in the interim. “If we see a surge in employment, that space could hit the market at a perfect time,” Tropp says.
Investment Risk Rises
It's not just that new construction may delay recovery. Given the recent buying frenzy, some question whether the development activity will exacerbate the market's lofty asset values. Taking advantage of recent changes in their own securities laws, strongly capitalized German investors have been aggressive in acquiring downtown properties, including 181 West Madison, 1 North Wacker, 150 North Wacker and 55 East Monroe.
Joe Havsy, senior vice president with LaSalle Investment Management, estimates that Germans accounted for roughly $1 billion of the $2.5 billion in sales last year, including a sky-high $400 million for 1 North Wacker Drive. Havsy explains that these buyers are not necessarily looking for the big appreciation kicker. Instead, they want a steady yield and they're willing to pay for it.
But are these prudent acquisitions, given the underlying fundamentals and new supply in the pipeline? Rents are falling and there is a big disparity between what investors are paying and what tenants will pay. At a certain point, prices and rental rates must move in conjunction with each other, according to Learner. “Asset allocations and low interest rates explain some of this, but it's difficult to strike an argument supportive of paying these types of prices,” he says.
The industrial market has not been immune to the downturn in the economy. The vacancy rate for the Chicago-area industrial property market increased from 9.1% in the first quarter of 2002 to 11% in the first quarter of 2003, according to Insignia.
Jeffrey Barrett, managing director with CB Richard Ellis, explains that economic uncertainty has led to an increase in the vacancy rate, but Chicago's position as a regional distribution hub reinforces its strength. “Companies, particularly retailers, continue to look for ways to enhance efficiencies in operations,” he explains. “Streamlining the distribution of product and developing a regional distribution strategy are benefiting the Chicago market.”
That development strength is apparent in the recent announcements by retailers Michael Stores and Dollar Tree, which will be building distribution facilities of 700,000 sq. ft. and 1.2 million sq. ft. in New Lennox and Joliet, respectively. The success of CenterPoint Property Trust's Intermodal Center in Elwood also buoyed plans for another intermodal hub in Rochelle, 75 miles west of Chicago.
Another driver for this development activity has been continued institutional interest in this sector. “Industrial continues to be a darling among institutional investors,” explains Barrett, “so we are seeing major capital sources to team up with developers.”
For example, McShane Corp. and Metropolitan Life late last year announced a $50 million alliance, which will fund a new 800,000 sq. ft. industrial business park in Bolingbrook.
Room at the Inns
As an international business destination, Chicago has been hit hard. Steep declines in convention and business travel have been compounded by the addition of new hotel rooms, particularly in the high-end arena. The 415-room Hotel Sofitel, which opened in the third quarter of 2002, is the most recent addition. In addition, the W Chicago Lakeshore, the Peninsula and the W Chicago City Center have added almost 1,300 rooms.
“Chicago started to see improvement during the first part of the year, but in March the industry was hit fairly hard with events leading up to the war,” explains Melinda Mckay, senior vice president with Jones Lang LaSalle Hotels.
But average occupancy held steady at 51% from the first quarter of 2002 to the first quarter of 2003, according to Jones Lang LaSalle. However, the average room rate fell by 5% to $94. As a result, revenue per available room (RevPAR) declined by a corresponding 5% to $48.
Fortunately for the market, the only development under way is Hard Rock Hotel on North Michigan Avenue. This renovation of the Carbide and Carbon building will add 385 rooms and is slated to open in December 2003.
Despite the weak first-quarter numbers, McKay remains optimistic about the overall market, particularly on the investment side. “Now is a great time to buy,” she says. “When the economy recovers, Chicago's economy should outpace it due to its international importance.
The Chicago-area apartment sector has been in freefall. Low interest rates have spurred renters toward home ownership. Job losses in Chicago have been severe. Some renters have doubled up and others have left the city. Meanwhile, supply has ballooned, particularly downtown. New projects such as North Town Village, 400 North LaSalle Street, and Grand Plaza Apartments East Tower will add more than 1,000 new units to the market this year alone, according to LaSalle Investment Management and Reis Inc.
In addition, the 5,000-unit behemoth Lakeshore East is being erected just east of State Street on a 26-acre site that had been a nine-hole golf course. Sources say the price was about $81 million, or almost $74 per sq. ft.
All this new supply leaves landlords throwing money at prospective tenants. “It's astounding how widespread the concessions have become,” says Greg Willett, vice president of research products with Dallas-based M/PF Research. We've gone from about one-third of the available product offering concessions a year ago to almost 60%.” Among projects sporting concessions, rents are being discounted by an average of 9%, or a little more than a month of free rent, according to Willett.
The good news, however, is that the preliminary first-quarter numbers show some stability is finally returning to the market. The apartment occupancy rate in Chicago registered 91.4% during the first quarter of 2003, down 1.6 points from a year ago, but only nominally lower than year-end 2002.
Retail's Quiet Strength
According to CB Richard Ellis' survey of large retail properties (excluding regional malls), the Chicago area shopping center vacancy rate declined to 10.2% during the first quarter of 2003 from its peak of 11.1% at year-end 2002. Nevertheless, the retail sector is not immune to the weak economic climate. According to Todd Caruso, managing director with CB Richard Ellis, one-quarter of retailers canvassing Chicago have deferred expansion plans.
Where there appears to be an imbalance between demand and supply is among investors, says Bob Mahoney, first vice president with CB Richard Ellis. The sector is perceived as being more stable than other property types, with institutions showing a strong preference for both urban and suburban infill locations with trade areas of strong demographic profiles and where there are limitations on new developments.
For example, the 427,000 sq. ft. Village Crossing center in Skokie is under agreement to be purchased by an undisclosed buyer, Mahoney says. The center recently overcame the closing of two anchors and was quickly re-tenanted. In addition to its infill location and bevy of national retailers, the center became a hot commodity among institutional investors, he claims. Says Mahoney, “Retail has moved up the ladder, relative to other categories.”
Alexis Petrakis is a Chicago-based writer.
CHICAGO-BY THE NUMBERS
City: 2.9 million
Metro area: 9.2 million
UNEMPLOYMENT RATE: 7.2%
University of Chicago
U.S. Post Office
Source: Career InfoNet
METRO AREA STATS:
18.2% vacancy, 1Q 2003
18.6% vacancy, 1Q 2002
Rent per sq. ft.: $28.56 1Q 2003
8.3% vacancy, 1Q 2003
7.0% vacancy, 1Q 2002
Rent per unit: $962 1Q 2003
Source: M/PF Research
10.2% vacancy, 1Q 2003
10.3% vacancy, 1Q 2002
Rent per sq. ft: $19.73 1Q 2003
Source: CB Richard Ellis
11.0% vacancy, 1Q 2003
9.1% vacancy, 1Q 2002
Rent per sq. ft.: $6.10 1Q 2003
51% occupancy, 1Q 2003
51% occupancy, 1Q 2002
Source: Jones Lang LaSalle Hotels
MAJOR PROJECTS UNDER CONSTRUCTION:
Hyatt Center, a 1.5 million sq. ft. office tower at 71 South Wacker
Developer: Higgins Development Partners and Pritzker Realty Group
Completion: Early 2005
Lakeshore East, a 5,000-unit multifamily development just east of State Street
Cost: $81 million
Developer: Magellan Development Group
Completion: Second quarter of 2004
ABN AMRO Headquarters
a 1.2 million sq. ft. corporate headquarters in the West Loop