Downtown Chicago continues to bustle with construction activity. This is a good sign and also a scary one. The good news is that some of the construction — new condominium projects and conversions of old office and hotel space and related retail space — points to the growing success of downtown as a 24/7 live-work-play zone. The scary part is those cranes are producing new office towers in a market with a downtown vacancy rate of 14.7% and climbing.

Things may get worse in the office market before they get better. The amount of new office space to be delivered downtown in the fourth quarter is significant, even by late 1990s standards. Rents, too, are suffering. Class-A gross asking rents for the downtown area fell from $32.52 to $30.47, a 6% drop, according to second-quarter statistics from Insignia/ESG.

Meanwhile, three office buildings — one fully leased, two slightly more than half full — are scheduled to come on line in the fourth quarter, even as real estate fundamentals remain soft and the volume of sublease space mushrooms.

On the other hand, when properties change hands, prices are healthy. “The irony of this whole situation is properties are continuing to command high values,” says Rand Diamond, regional president of the Chicago office of New York-based brokerage firm GVA Williams.

Jim Postweiler, managing director with Insignia/ESG's Capital Markets group, concurs. “It's true, we are experiencing a dichotomy where we have a very active investment market, and a very soft leasing market. Properties that have commanded high sale prices have demonstrated reliable revenue streams, coming from good credit tenants,” adds Postweiler.

While rent-roll stability can be found in multiple product types — including industrial facilities and retail projects — investment capital has demonstrated a specific interest in trophy Class-A office buildings, according to Postweiler.

Indeed, several high-rise office towers have sold during the past year, and prices are continuing to rise. Shorenstein Co. purchased the 952,000 sq. ft. 500 West Monroe for $250 million in fall 2001, paying $263 per sq. ft. In comparison, two years ago, Prentiss Properties purchased the 524,000 sq. ft. trophy property 123 Wacker for $87 million, just $166 per sq. ft. Other trophy building sales posted this year included the 1.3 million sq. ft. 311 South Wacker tower, which sold for $275 million, and the 936,366 sq. ft. 181 West Madison, sold for $248 million to a group of German investors. Meanwhile, the 1.3 million sq. ft. One North Wacker is on the market for $400 million.

No V-shaped Recovery

That upbeat view is far from universal. Given the high vacancies and the prospect of new inventory on the market, other observers of the Chicago market are bracing for a sustained slump. “We're hitting a long, flat bottom,” observes Michael Klein, executive vice president of the Midwest region for New York-based Insignia/ESG.

CHICAGO VACANCIES
2nd quarter 2001 2nd quarter 2002
Office (Downtown) 10.2% 14.7%
Source: Cushman & Wakefield
Industrial 7.9% 8.8%
Source: Cushman & Wakefield
Multifamily 3.2% 6.4%
Source: M/PF Research
Retail 9.4% 10.1%
Source: CB Richard Ellis
Unless otherwise noted, statistics provided are for the metro area.


A slow recovery could present a dilemma for the office developments scheduled to come on line later this year. Prime Group's 1.5 million sq. ft. Dearborn Center is 57% leased and Hines' 750,000 sq. ft. 191 North Wacker is 60% leased and could face an uphill battle to fill empty floors, industry sources say. Fifield Cos. will open a 425,000 sq. ft. West Loop headquarters for Quaker Oats Co. in the fourth quarter, to be followed in 2003 by the 1.1 million sq. ft. ABN-AMRO headquarters.

Although companies like The Quaker Oats Co. and ABN-AMRO are committing themselves to the CBD, several factors have combined to harm the overall health of the downtown office market. The Chicago office of New York-based Cushman & Wakefield reports that the downtown Chicago office market was soaked with nearly 5.3 million sq. ft. of sublease space in the second quarter, pushing the overall downtown vacancy rate up slightly to 14.7% from 14.3% in the first quarter.

Reflected in the numbers are the empty offices left by Chicago-based Arthur Andersen LLP, which previously occupied over 1 million sq. ft. Meanwhile, Internet consultant marchFIRST vacated more than 200,000 sq. ft. of leased space and a half-finished headquarters when it went bankrupt.

Topping off the bad news, River North, a submarket that attracted many dot-coms, posted a 24.3% office vacancy rate, up from 22.8% in the previous quarter, according to Insignia/ESG. Class-A gross asking rents decreased across the board during the second quarter. In River North, that decrease resulted in a drop from $35.75 per sq. ft. in the first quarter to $34.79 in the second quarter.

To no one's surprise, landlords are scrambling to keep the tenants they have. “Landlords are starting to restructure leases up to four years in advance in order to keep major tenants, even if it means cutting rents today,” says John Goodman, executive vice president and regional manager in the Chicago office of New York-based Julien J. Studley. As a result, law firms such as McDermott Will & Emory and Altheimer & Gray made decisions not to relocate this year, although each had been looking for new space.

But new construction has its advantages. That's because new buildings can cut occupancy costs by 5% to 7%, due largely to their large floor plates and state-of-the-art infrastructure, says Steve Stratton, managing principal with the Chicago office of Dallas-based The Staubach Co. Such benefits are being touted by the developers of new office towers proposed for the West Loop, some of which could be completed as early as 2004.

John Buck Co., Higgins Development Partners, the Fifield Cos., Tishman Speyer, Development Resources and Hines are aggressively competing — with each other and with potential tenants' current landlords — for the handful of tenants in the market that could anchor a speculative building. These tenants include Deloitte & Touche, currently negotiating a letter of intent with John Buck Co. to lease between 310,000 and 350,000 sq. ft. at 111 S. Wacker, as well as Goldman Sachs and law firms Mayor Brown Platt & Rowe and Foley & Wardner.

No matter what the incentives, however, demand will only support a small percentage of the would-be players, according to market insiders. “Only one or two of these towers will go forward,” predicts Drew Neiman, principal of the John Buck Co. “It will never again be like it was in the early 1990s when there were no financial restraints.”

Even two buildings might be one too many, says Goodman. “If one new building gets built that is half leased, it's a small factor,” he says. “But if more go forward, it could prolong the downturn by up to 24 months.”

Postweiler adds that the new buildings don't exist in a vacuum. “If absorption in the new buildings comes at the expense of older buildings downtown,” he cautions, “it will continue to depress the market.”

Suburban Office Sector Is in the Doldrums

But downtown landlords and developers have one thing to be thankful for — they're not in the suburban market. “The difference between downtown and the suburbs is that there's actually some demand downtown,” Goodman says.

Of nearly 5.8 million sq. ft. of space added to the suburban inventory in the past year, 57% is still available, reports Studley. And while net absorption was a positive 145,000 sq. ft. in the second quarter of this year — the first time since the fourth quarter of 2000 — more than 7.4 million sq. ft. of sublease space continued to drag down the market, according to Insignia/ESG. The overall availability rate was 23.3%, up from 23.2% in the first quarter.

“What's going on in Chicago is similar to what's going on in the rest of the country,” says Scott Pfisterer, marketing director for the suburban Chicago portfolio of Dallas-based Prentiss Properties. “It's traditional supply and demand, and the supply side has been hit hard with sublease space.” Massive employee layoffs at Lucent Technologies, Motorola and other Fortune 500 companies caused much of the current suburban vacancy.

A scattering of leases offers some hope, however. These include a lease of 270,000 sq. ft. by Sirva (formerly Allied Van Lines) in Westmont and Boise Cascade Corp.'s lease of 183,000 sq. ft. in Itasca.

Industrial: Chicago's Bread and Butter

The one bright spot in Chicago's suburban market is the industrial sector, says Thomas O'Donohoe, senior vice president of Skokie-based The Alter Group. While the overall Chicago industrial market vacancy rate for the second quarter hovered at 8.8%, according to Cushman & Wakefield, an increase in leasing activity is driving a resurgence of speculative development.

“It wasn't as bleak as some people seemed to think. Some companies were in a waiting mode in late 2001, but that created pent-up demand after the first of the year,” observes Sally Macoiz, a senior director with Cushman & Wakefield.

Macoiz recently closed two transactions totalling more than 1.3 million sq. ft. for Central American Group, a Chicago-based food distributor, both for space in speculative buildings along I-55. Other recently signed leases in that submarket include a 258,684 sq. ft. expansion for Gart Sports and a 574,000 sq. ft. facility for Georgia Pacific.

The McShane Cos., a Rosemont, Ill.-based real estate and construction firm, secured a contract to buy a key piece of land along I-55 following a five-way bidding war. “We haven't seen this type of competition for a while, but it's going to be awfully hard to compete if you buy land later on,” says Insignia/ESG senior director Kirk Armour.

I-55, however, isn't the Chicago area's only industrial boomtown. “We're very bullish on the infill sites inside I-294,” says Randy Tieman, senior vice president of Rosemont, Ill.-based Opus North, which just broke ground on a new 450,000 sq. ft. speculative warehouse/distribution facility in Melrose Park.

Meanwhile on the I-88 corridor, two build-to-suit facilities and a few speculative properties are under way, including an 850,000 sq. ft. facility for Kraft Foods and a 350,000 sq. ft. distribution center for Hyundai.

Retail Remains a Driving Force

The increased industrial activity is being driven largely by the strength of the consumer goods sector — and the retailers who sell them. “There have been quite a few retailers in the market for industrial space. Demand for distribution centers is being driven by retail expansion,” emphasizes Jeff Fischer, an Insignia/ESG director and industrial specialist.

While much media attention has focused on Kmart's bankruptcy filing and the struggles of some tired regional malls, suburban retailers who planned expansions prior to the recession are generally following through, says Marc Blum, principal of Northfield-based NextRealty.

“Retailers which had planned 10 to 15 new stores are now opening between two and five stores, but they are still expanding,” Blum explains, adding that few new retailers are entering the market, resulting in a smaller playing field from which landlords can recruit new tenants.

A similar dynamic is playing out downtown. New stores are opening along Michigan Avenue and State Street, but at a slower pace than in recent years. Many of the stores are opening as part of mixed-use developments.

“Retail is a function of residential,” notes Jim Klutznik, a principal with Klutznik Fisher Development. “Retailers are essentially camp followers, and they are taking advantage of the influx of new residents to downtown areas.”

Thriving Apartment Sector

If retail follows residential, where are the shoppers living? In addition to high-rise developments in River North and the Loop, multifamily development is thriving in neighborhoods on the near south, west and northwest edges of downtown. Condominium and office buildings alike in the West Loop are including significant ground-level retail plans.

For example, in the new Kingsbury Park development just northwest of the River North area, home to several new condominium towers, the redevelopment of 600 West Chicago will include offices, as well as a Bockwinkel's grocery store, restaurants and retail shops.

State Street also is betting on these new residents. While the historic Loop shopping district is undergoing a city-backed renaissance, the results so far have been mixed. A Toys-R-Us has been shuttered while other businesses are thriving. Jerry Sider, executive director of the Greater State Street Council, cites flagship Sears and Old Navy stores, a new Borders bookstore, the Hotel Burnham, and other smaller retailers like Nuts on Clark and Zoom Kitchen as businesses “holding their own,” despite the tough economic climate.

Mesa Development's The Heritage, a 59-story residential development just off Michigan Avenue and only a block from the State Street shopping district, will include 100,000 sq. ft. of retail space, as will Dearborn Center, an office tower whose retail component fronts State Street. Additionally, the street's retailers could get a jump-start if Harrods decides to launch its first expansion outside the London flagship store. If current negotiations prove fruitful, the Mills Corp.'s development at 108 North State, the State Street site formerly known as Block 37, will be anchored by the British retailer.

Condominiums Continue to Rise

New residents are continuing to pour into the city's center. Developers are adding new units by the thousands to keep up with demand. While economists debate whether the “housing bubble” will eventually burst, prices continue to rise. Developer Chris Carley reports that more than 1,000 new condominiums priced over $1 million will be added to the River North market in the next five years.

The Pinnacle, one of Carley's two buildings under construction just west of Michigan Avenue, will include condominiums that are selling for an average of $900,000, or $500 per sq. ft. These prices could mean good news for New York real estate mogul Donald Trump, for whom the success of the planned 86-story Trump Tower Chicago will depend on his ability to command high condominium sale prices, in addition to competitive office and retail rents.

Emergence of Adaptive Reuse

Some of Chicago's older commercial real estate properties, which don't have the technology infrastructure needed to compete in the office and hotel markets, are being given new life through conversion. Both the Blackstone and Ambassador West hotels will become condominiums, as will the landmark Palmolive building (also known as the Playboy Building) on North Michigan, which will include high-end shops.

Condominiums aren't the only new use for older buildings. The landmark Carbide & Carbon building on Michigan Avenue will open in 2003 as the Hard Rock Hotel Chicago. Around the corner, significant renovations at the Westin Michigan Avenue and Whitehall hotels are under way. These investments represent faith in the cyclical nature of business. Downtown Chicago's revenue per available room (RevPAR) — a measurement that tracks both occupancy and room rates — sunk 13% from May 2001 to May 2002, to $58.55.

While occupancy is back to 2000 levels in some properties, most Chicago hotels are still struggling to return to the profit levels of the late 1990s.

In fact, Chicago real estate investor Barry Mansur points out that despite the good standing of his current hotel investments like the Hotel Burnham, his firm remains cautious on hospitality projects, and is directing its investment interest toward the retail and multifamily sectors.

Judging by the significant number of projects on the drawing board across the property types, the self-proclaimed “Capital of the Midwest” is betting on future demand. The city's downtown continues to thrive as the cultural capital of the Midwest, a boon to both commercial and residential development.

Facing up to the challenges ahead, Howard Meyer, senior vice president and director of property leasing for Chicago-based U.S. Equities, is optimistic. “Chicago is attractive to our tenants and to the investment dollar because it has become a true 24/7 city.”

Margy Sweeney is a Chicago-based writer.