The Chicago area office market started the year optimistically, with overall positive net absorption of 1.3 million square feet and vacancy rates down 9 basis points to 19%.
The coming months will show how the large number of mergers across the industries, increasing interest rates and construction costs as well as employment levels will impact the office real estate market. Employers in the Midwest are planning to increase staffing by 27%, lagging behind last year’s prediction of 31% and weaker than the national outlook, according to a survey by Manpower Inc.
Locally the outlook is brightest in the construction, durable and nondurable goods manufacturing and the finance, insurance and real estate industries.
The weakest of all submarkets is still the West I-88 corridor with vast amounts of space left from the technology bust. It also is the only suburban submarket that posted negative absorption in the first quarter.
The Chicago central business district started the year with a strong performance. Several large tenants moved in or signed new leases. But it’s still a vulnerable market.
Downtown
During the past few quarters, the West Loop has been the strongest central business district submarket. With new high-end buildings and proximity to transportation options, this area has become the premier business address in the Loop.
Its vacancy rate at 17.4% is higher than the River North and North Michigan Avenue submarkets but it is clearly leading in absorption with 670,000 square feet in the first quarter alone.
Large leases that were announced in the first quarter were Commonwealth Edison (297,000 square feet), CDW (252,000 square feet), Blue Cross Blue Shield (200,000 square feet), Chapman & Cutler (165,000 square feet), Arnstein & Lehr (94,000 square feet), Duff & Phelps (82,000 square feet) and Grubb & Ellis (64,000 square feet).
A wave of new office construction totaling 2.6 million square feet has started with the site preparations of 108 N. LaSalle. The 400,000-square-foot office part of the mixed-use development will be home to CBS and Morningstar once it’s finished in 2009.
The construction boom is not only driven by tenants with the necessary resources looking for efficient new space but also by large institutions with a hearty appetite for real estate willing to finance these projects.
The downtown investment market still is strong. Seven buildings traded or are currently under contract within the past few months.
While rental rates remain flat, foreign investors have enough faith in Chicago that, in the long-term, the job market will grow healthier and demand for office space will increase as construction slows.
Ten buildings are on the market for sale. The average sale price last year was $226 per square foot. This was an increase by almost 25% over 2004 numbers.
The question of where building prices per square foot will go depends largely on vacancy rates, particularly in older buildings.
The office condominium market, while still in its infancy, has grown to nine buildings amounting to about 2% of the overall central business district office inventory.
Buildings with small floor plates are ideal candidates for conversion. Landlords turning to this option are hoping to capture stable professional, financial and medical companies who want to own their space rather than rent.
As smaller tenants are less likely to receive the favorable rental rates and concessions of larger tenants, this is a viable alternative despite rising interest rates.
Office condominiums also are an attractive target for tenancy in common and 1031 exchanges, especially if stable tenants are in place.
Forecast
Tenants that are expecting the market to recover soon should start renewing earlier to lock in low rates and receive ample concessions.
The last building currently under construction in the central business district will be delivered in the second quarter giving the market some breathing room before the next wave of construction, which is set to deliver product in 2009.
The growing traffic congestion in the Chicago area and the unwillingness of the workforce to accept hour-long commutes will have a direct impact on regional employment growth.
Therefore, closeness to transportation will play an increasing role in the decision-making process for companies planning to relocate.
The Manhattan office market tightened further in the first quarter of 2006.
Vacancy dropped 30 basis points, from 8% at the end of 2005, down to 7.7%. For the eighth consecutive quarter, absorption was positive at 601,131 square feet.
Class A vacancy in Manhattan dropped to 6.9%, and space should continue to decrease throughout the year.
For the first time in more than four years, average class A direct asking rents surpassed $60 per square foot per year, up $2.20 to $60.54 per square foot in the first quarter.
Class B asking rents were up 85 cents to $41.36 per square foot. Expect landlords to continue to raise rents on space, specifically class A space, due to the shrinking of the high-end market.
Leasing activity was strong to start the year with 8.1 million square feet transacted in Manhattan. With the rising demand for office space, expect the leasing transaction volume to remain within the 8 million to 10 million-square-foot range during 2006.
Transaction volume slowed in the first quarter with only $1.9 billion traded. Although the first quarter is historically a slower period for investment transactions, it could be a sign of the investment market cooling due to the rise in the federal funds rate, which now is 5%.
Prior to this quarter where economic growth slowed, the New York City economy grew for nine consecutive quarters. The Gross City Product increased by 2.1%, though this is a slowdown compared to the past eight quarters, when GCP growth averaged 3.45%.
Despite the dip in economic growth, the Manhattan real estate market should continue to maintain its momentum.
Downtown
The overall downtown office market continued its slow recovery during the first quarter, with vacancy remaining steady at 11.7%.
Class A direct asking rents continue to rise, up 81 cents from the fourth quarter to $37.40 per square foot.
However, the lack of available high-end space and rising asking rents in Midtown has helped the class A downtown market recover more quickly.
Since the third quarter of 2005, class A vacancy decreased by 200 basis points to 9.1%.
Tenants searching for quality space have begun to recognize downtown as a viable option, and the 45% difference in pricing between the two market’s high-end spaces assists in tenants’ decision making.
Construction began on the World Trade Center Memorial and Museum in the first quarter, though the disorder surrounding the rebuilding effort of the new World Trade Center has delayed the project.
Talks took place during the quarter between Gov. George Pataki, representing the Port Authority of New York and New Jersey, Mayor Michael Bloomberg, representing New York City, and Larry Silverstein, the owner of the rights to rebuild the office space on the site.
But no conclusions resulted from the discussions. A groundbreaking had been set for April on the Freedom Tower, the first of the five proposed office buildings slated for construction.
But without any decisions reached between the three parties involved, the groundbreaking will be pushed back, as well as all commercial development.
Leasing activity was strong in the first quarter for downtown with 1.6 million square feet of deals.
The deal signed at 55 Water St. for 400,000 square feet by the City Department of Transportation was the largest downtown transaction completed this year.
Construction on 7 World Trade Center is slated for the second quarter and at this time only 19% of the space is preleased,including the Beijing Vantone Real Estate Co. lease of 210,000 square feet for 15 years.
Larry Silverstein reportedly is trying to entice the state of New York to take 500,000 square feet of office space and Verizon Communications has shown interest in leasing 400,000 square feet. But moving tenants from one class A building downtown into another does not ultimately help the recovery in Lower Manhattan.
Forecast
The Manhattan office market is healthy overall. Expect a continuation of similar trends in 2006: falling vacancies and rising asking rents.
As the available supply diminishes, expect landlords to pull back concessions further, increasing the net effective rents on transactions and causing tenants to pay higher rents as the year progresses.
The spread between asking rents and net effective rents has narrowed this year as landlords decreased and, in some instances, eliminated concessions.
The $40 tenant improvement allocations and six months of free rents previously offered in Midtown is no longer the norm. There was a 6.5% spread between class A direct asking rents and net effective rents in the first quarter, compared to a 8.2% spread a year ago.
The blistering pace of growth in the Washington, D.C., metropolitan area slowed in the first quarter.
Net absorption was 860,149 square feet, down from more than 2 million square feet in the fourth quarter and 2.2 million square feet a year ago.
Vacancy continued to decline in all regions and ended the quarter at 13.6%, down 30 basis points from 2005.
Class C buildings showed the most improvement with vacancy declining across the board. Class A and B posted mixed results.
Net absorption was positive in all regions. Although overall absorption was lower than previous quarters, Washington, D.C. shows little sign of slowing down with eight different tenants signing new leases for space bigger than 75,000 square feet in the first quarter.
The government, law firms and government contractors remain dominant in the market, accounting for more than 43% of leases over 20,000 square feet.
Speculative development still remains in the District, and is spilling over into Northern Virginia and Maryland.
Seven speculative buildings are breaking ground in Virginia, totaling more than 500,000 square feet.
Despite no construction starting in Maryland during the first quarter, three speculative buildings are expected to break ground within the next two quarters.
Although total construction in the metro area totals 11.9 million square feet, down from 12.7 million last quarter, the D.C. region remains the national leader in this category.
In the coming year, the Washington, D.C., market is expected to continue growing and lead the nation in terms of real estate.
The region is expected to add 65,500 net new jobs in 2006 and 59,500 in 2007.
Northern Virginia
Northern Virginia continued at a slow place in the first quarter with absorption totaling only 249,227 square feet, down from 1.4 million square feet in the prior quarter.
With a lack of large tenants in the market and slow activity, absorption is expected to be low in the upcoming quarters.
Several issues have combined to create temporary market uncertainty during the past few months: base realignment and closure, government deficit, Metro line to Dulles and major natural disasters.
The effects of these issues are beginning to become clear, which will bring stability back to Northern Virginia.
The Base Realignment and Closure report has spurred activity around the Fort Belvoir area, as forward thinking developers already have positioned themselves for the 21,000 new jobs that will be relocated at the base.
Spurred by criticism, the Federal Emergency Management Agency has been growing by leaps and bounds in Northern Virginia.
The Metro line to Dulles is set to begin construction at the end of 2006 and drilling has begun in Tysons Corner for soil analysis.
At the end of the first quarter the D.C. Airports Authority announced plans to take over the Dulles Toll Road and use the revenue generated to fund the Metro expansion. That eased uncertainty over who would pay for the expansion.
Vacancy remained relatively stable in the first quarter, decreasing by 10 basis point to 12.3% from the past quarter.
There is currently 5.4 million square feet of space under construction in Northern Virginia, with about 3.5 million square feet expected to wrap up in the next two quarters. The space is 57% preleased.
With these new deliveries the vacancy rate (especially in class A buildings) will rise slightly over the next two quarters.
Class B and class C vacancy declined 50 basis points and 80 basis points respectively. Class A buildings saw vacancy rise from 11.3% to 11.7% in the quarter.
Weighted average asking rents across all classes fell slightly to $28.53 per square foot per year from $28.58 in the past quarter.
While supply in Northern Virginia will increase and tenants will have more choices for space, rents are expected to increase as landlords seek to maintain their returns and continue to offer higher tenant improvement packages.
