Expansive Beginning to 2007 for Twin Cities Commercial Real Estate Markets

• Investment sales activity remains strong, particularly for office and industrial properties
• Demand for Class A space spurs the beginning of a new office development cycle
• Rising rental rates and continued strong absorption have spurred speculative industrial development
• A note of caution is being seen in the retail market as higher energy costs, consumer spending concerns and the slowing housing market take their toll

Twin Cities commercial real estate markets are riding higher at mid-year, buoyed by ongoing demand in the office and industrial markets and a rising tide of rental rate increases across a majority of the multi-tenant property categories.

Overall vacancy in the Twin Cities commercial real estate markets stands at 10.9% at mid-year (12% including sublease space), down from the 11.7% vacancy rate at year-end 2006.

The market saw total positive absorption of 2.87 million square feet of space during the first half, led by 1.67 million square feet of positive absorption among industrial properties.

New construction brought 1.42 million square feet of new product on line, a majority of it in the office and industrial markets. Retail construction will heat up in the second half of the year, with 2.12 million square feet of new product planned to come on line in time for the busy autumn and holiday shopping seasons—virtually all of it community center space.

Investment sales activity is also strong. The Twin Cities office, industrial and multi-family markets are in high demand among investors, while the retail market is showing signs of cooling interest. Investors are also becoming more willing today to purchase older or Class B properties—typically with vacancy rates that are higher than market average and in need of substantial renovation—in anticipation of continued recovery in demand and rental rates over the next few years.

Developers are breaking with Twin Cities tradition and stepping up the pace of new construction in the office and industrial markets at a time when vacancy rates in both markets are above the 10% level.

Previous development cycles typically started with vacancy rates below 10%. The overall office vacancy rate is currently 14.7%. However, most new office development is concentrated in the large West and Southwest submarkets, where Class A vacancy rates are well below 10%. New development is also being spurred by the increased willingness of investors to joint venture with developers on new projects as a way to expand their capital investment in commercial real estate.

Capital Keeps Flowing to Commercial Real Estate

Commercial real estate continues to maintain its hold as a favored asset class among the investment community, despite some recent volatility in interest rates.

The Twin Cities is drawing increased interest from larger national investors, who like the region’s diverse economy and the potential for a higher return on investment here versus more pricey commercial real estate markets on the coasts.

Improving Fundamentals Bolster Investor Optimism

Investment sales activity is strongest in the industrial and office markets, with multi-family also moving back into favor with investors. The level of retail volume is subsiding from the blistering pace of recent years, although high-quality, grocery-anchored property remains in high demand.

Office-showroom has emerged as an investor favorite in the industrial market, bolstered by the upturn in demand for office space. Rising rental rates are also bolstering the case for more investor interest in industrial buildings.

Office sales volume is keyed to the improving fundamentals in the suburban office markets, especially the West and Southwest. Transaction activity in the Minneapolis Central Business District (CBD) remains vibrant this year, following several years of unprecedented sales activity. Several properties acquired within the past three years are slated to be brought to market this year. Also active is the St. Paul CBD, with several significant office properties currently on the market.

Existing office and industrial properties are gaining value as second-generation space is leased up at rising rental rates, supported by the cost of new construction.

Sales volume in the office market is on pace to reach another strong year in terms of the number of transactions, although dollar volume may be slightly lower this year depending on the number of Minneapolis CBD office buildings going to market.

Twin Cities multi-family properties have regained investor interest as market fundamentals continue to improve dramatically. Several new national investors have entered the market in recent months. The overall vacancy rate in the market is now in the 4% range. The slowdown in the housing market has noticeably benefited the demand for rental units, as has the steady Twin Cities employment market. New development is on the horizon for the first time in several years.

Rising Expectations Lift Office Market

Twin Cities office space users continue to fill up on premium office space, judging from the variances in vacancy rates between premium-grade Class A space and the lesser-grade Class B and, in particular, Class C properties.

Vacancy in the Class A market is 11.3% at mid-year, versus 17.6% for Class B space and 18.8% for Class C space.

More remarkably, the Class A vacancy rate in the Southwest is 7.4%, against 28.2% vacancy among Class C properties. Vacancy in the West submarket’s Class A properties is 7.8%, while the vacancy rate for Class B space is 17%. A similar story exists in the Northeast submarket, where vacancy among Class C properties is 19.2%, while the Class A rate is 10.6%. In the Minneapolis CBD, the vacancy rate for Class A upper floor office tower space is less than 6%—while the vacancy rate in Class B properties is 19.7%.

Numbers like these help clarify why developers are moving forward with new speculative office projects in the West, Southwest and Northeast submarkets while the overall vacancy rate in the metropolitan area is at 14.7%. There’s also an expectation that the Minneapolis CBD will see the announcement of plans for a major new office tower by year’s end, and that a significant portion of that project could be for speculative office space.

Overall, the Twin Cities office market is experiencing steadily rising rental rates at mid-year, especially for Class A space. The average quoted rental rate for Class A space is $14.94 per square foot today versus $14.41 at year-end 2006. Absorption was positive at 286,403 sq. ft., led by 232,000 sq. ft. of positive absorption in the Minneapolis CBD. Another 1 million square feet of overall absorption is anticipated during the second half, fueled by significant new leasing activity in the West, Southwest and Minneapolis CBD submarkets.

Industrial Market Ramping Up

Rental rates are trending higher across the board in the four Twin Cities industrial submarkets while concessions are waning. The market experienced total absorption of 1.67 million square feet. This activity helped decrease the overall vacancy to 11.5%—the lowest since 2000. Another 1.6 million square feet of absorption is expected by year end, which will further reduce the vacancy.

Demand for bulk warehouse space increased substantially, resulting in 857,000 sq. ft. of positive absorption for that type of property. The vacancy rate among bulk warehouse properties is 13.4%, the lowest level since 1999.

Pressure for new development is building, giving rise to new construction activity in every submarket. Developers are optimistic about the potential for new projects, despite continuing concerns about high construction costs.

Medical Office Market Binging on New Construction

A surge in new construction of medical office product is cresting this year, with an additional 385,000 sq. ft. of space due to come on line by year’s end. That will bring the total amount of new medical office product added to the market during the past year to 600,000 sq. ft.—an approximate 12% increase in the overall size of the market. Much of the new development is occurring in the Maple Grove area in conjunction with the construction of a new hospital there. The forecast for next year is for little in the way of new construction as the market adjusts to the current sharp increase in supply.

The overall vacancy rate in the medical office market is 10.2%. Vacancy in the on-campus market is 7% and 13.7% among off-campus properties. The market recorded positive absorption of 175,000 sq. ft. during the first half. The Southdale trade area in Edina remains the strongest submarket overall for medical office space demand due to its exceptional demographics.

Retailers in a More Cautious Mood

Vacancy among retail properties is holding steady at 5.8% overall, anchored by a 3.6% vacancy rate in community centers. First-half absorption totaled positive 741,000 sq. ft. overall, while the average rental rate increased to $28.60 per square foot from the year-end rate of $28.15 per square foot.

Big box retailers are still fueling the growth in community center development—estimated at 2.14 million square feet this year—but they are becoming more selective in their approach amid concerns of a slowdown in consumer spending. Higher energy costs and the housing slowdown are taking a toll on some of the region’s smaller retailers, and landlords in some of the affected centers may have to get creative to fill existing in-line space.

Regional malls are returning to form, evidenced by a significant decline in overall vacancy over the past six months. Discussions are surfacing about the possibility of a new regional mall in one of the newer zones of consumer affluence such as the Maple Grove or Chanhassen/Chaska trade areas.

Developers are beginning to step up to the plate with plans for new development in the area surrounding the new Minnesota Twins baseball stadium in the Minneapolis CBD. Construction started on the new stadium this Spring, with the completion scheduled for 2010. The new stadium is expected to trigger a wave of new retail, residential, entertainment and hospitality development in the area surrounding the ballpark.

The slowdown in the housing market has delivered some good news to retail developers in the form of lower land costs (residential developers aren’t competing as much for land positions, which drives up the cost).

Land Prices Drive Developers into New Territory

Land prices in some market segments are declining in the wake of the slowdown in the housing market. Industrial developers are picking up some of the development slack, with office developers coming up behind them. New residential development is at a virtual standstill, while foreclosures are increasing dramatically. There is an estimated 18- to 36-month supply, depending on product type and municipality, of lots and new housing stock in the Twin Cities.

Some of the new industrial development in the planning stages is set for areas such as Inver Grove Heights, Rosemount, Chaska, Otsego, Blaine and Afton—areas previously considered beyond the range of the Twin Cities industrial mainstream.