Detroit market courts more institutional interest

In 1998, we felt the Detroit commercial real estate market deserved recognition with our first annual roundtable discussion of local professionals. At the time, the city's downtown was rejuvenating with talk of new gaming operations. And since our last visit, the city's major automakers have been on a buying/merger spree, fostering the perception, at least, that Detroit is more of a world-class city than ever before.

For this year's return engagement, we bring you our second roundtable of local real estate executives, which was held over breakfast at the Westin Hotel in Southfield, Mich.

NREI: Jeff, your firm recently issued a rather rosy report on the future of the Detroit commercial real estate market. Give us your take on the market dynamic right now.

Jeff Shell: I would agree that it is rosy in terms of an owner's perspective. It's not so rosy in terms of a tenant's perspective. It's really out of equilibrium. We view equilibrium as being more in the 10% to 12% vacancy range. Both office and industrial are well below that and that creates a constriction. In terms of the strength of the market, it's very strong. Very low vacancies, rising rents, and that typically spells health for the real estate community.

Overall for CBD and non-CBD, we're at about 9.5% for office for all classes of space. Class-A across the board is much tighter and we see rents rising pretty quickly there. On the industrial space, there is a lot of product coming on line but it's being absorbed pretty well. I don't know if that absorption will continue to track with supply but it's healthy. The economy is doing very well which supports our belief that the industrial market will continue to be strong.

NREI: Does everyone agree?

Mike Gerard: If you're a tenant looking for 50,000 sq. ft., it's a little out of equilibrium. There are not many places to choose from as an office tenant. You have to go out I-275 and 696.

John Fricke: It's really the first time that a lot of tenants looking for Class-A space had new options to look at. I think there is a lot of pent-up demand to fill the Class-A stuff that's coming on line fairly quickly.

Allan Hayman: The dynamics of the office market are changing because the credit markets recognize that historically office rents were always too low, even prior to the economic debacle of the early-'90s when things were supposedly doing well, the rents that were charged were non-economic rents. Primarily because the amortization of the TIs (tenant improvements) were never a factor in the calculation of the rent. Now when you go out and get a loan on an office building, one of the first things the lender does is set up a reserve for TIs. That can be anywhere from $1 to $2 to $3 a square foot per year, which was never a cost factor in calculating rents before. The reason you have development taking place at a moderate pace now is because rents are escalating to the $23 or $24 range depending on the location and that takes into account the TI. It's difficult right now on leases that are turning over, a lot of these tenants are having difficulty accepting the dynamics of the current market.

NREI: So it's a form of sticker shock?

Hayman: It's sticker shock, but rents are higher than they've ever been in Detroit.

Mike Moran: Rents in Detroit, though they're higher they've ever been before, when you look around the country, they are a lot less than what you find in other major metropolitan areas particularly the East Coast cities like New York and Boston. The tenants that are leasing space today leased space five years ago. Five years ago they could get a deal that was almost turnkey and maybe the rents were $18.50 to $20, and $20 was a stretch number. Today the new buildings are leasing for $22.50 and $23. Some of the higher-end product in Troy is as high as $26 asking price, so the tenants are really in a kind of state of shock from what they were experiencing five years ago, particularly in the tenant improvement area, because developers today are putting in a number rather than doing a turnkey situation. So tenants are asked for the first time to start writing out checks for tenant improvements and that is a wave of shock in the market.

And it depends on the submarket. In Auburn Hills, there basically is no space at all but a lot of demand. Anyone doing anything in Auburn Hills will be leased up tomorrow. Then you get out I-275 where there are competitive forces in play now - you're going to see some things happening.

NREI: Roger, are tenants really experiencing sticker shock now?

Roger Woolstenhulme: Absolutely. We have tenants we represent that are looking at a 20% to 40% increase over what they paid the last time they were in the marketplace. Interestingly enough, it really isn't just the 50,000 sq. ft. tenant that's having the problems. We represent smaller tenants in the 3,000, 5,000 and 10,000 sq. ft. range that are really appalled and astounded that they maybe only have two or three choices, and some of those may not even be to their liking, as opposed to the five to 10 choices they were assuming they were going to see when they entered the market.

NREI: Where are they looking? Is downtown coming back on their radar screens?

Woolstenhulme: It depends on the product type. Obviously if you're looking for C-space, there are limited choices. If you're looking for Class-A space, it really doesn't matter where you are, you've got limited choices, whether you're in the CBD or in the suburbs. Because these new buildings really haven't come on line yet it hasn't helped these tenants now but by next year then a number of these tenants that are out there with pent-up needs will be satisfied. Then I think you'll see some easing, but I don't think what we have on the drawing boards right now is more than the market can absorb and still remain in equilibrium.

NREI: Is there room for much more square feet to come to market?

Gerard: It really depends on what market you are in. For example, who would have thought that Troy, with all of its new buildings coming on line, would lease up as quickly as it did? In a market like 275/696, I don't think right now you will see more product for at least six months.

NREI: On the finance side, what are you lending on right now?

Dan Bober: We're lending on everything. There is no doubt that there is equity money out there, there is debt money for virtually anything in copious quantities and very attractively priced. Relatively speaking, interest rates haven't been this low since the '60s. We've been a tenant and we've gone through the sticker shock. Our company almost quadrupled its size and needed office space very quickly. There were very few options, particularly in a short time frame. And as painful as the sticker shock was, in the grand scheme of things it was a very small number given the cost of moving out someplace, finding space and going through all of the brain damage. A lot of tenants are making do because the financial stars are aligned. The economy is great, interest rates are low, there is lots of demand and the office occupancy costs are a nuisance factor in a certain respect.

Even though there is a lot of money out there, it is still fairly cautious money when it comes to purely spec development. There isn't an equity investor or a debt investor that would plow merrily into the 275 corridor and build another half-million sq. ft. building.

Dennis Bernard: We're lending on everything, all product types are available and it's very much a borrower's market. But building on two things I have heard here, the mentality has changed. Allan's right, when we first got into this business, we used to figure off of NOI. Now we still say NOI, but it's underwriting NOI which really is cashflow which in John's case is replacement reserves and in office/industrial it's tenant improvements and leasing commissions. We're seeing life companies now doing something I've never seen them do that before. They are actually believing thingswe are telling them.

We had a building in Troy where 70% of the leases were rolling in the next two years. One tenant was 20% of the building. They are at $15 plus electric. The lender bought into it because they believed those rents are going to go up 20% to 30% in the next two years because of the Troy submarket. We were surprised how many life companies stepped up and gave it a Class-A rating, gave it the best pricing, and on today's cashflow overlent on the building because of the belief on that.

We are now finding that we can finance for the first time ever shorter leases in some of these submarkets. We are still having trouble doing the five-year, single-tenant office building or high-tech building. Last year, conduits dominated. Then there was the financial meltdown. in the first part of this year, we are seeing the market swing dramatically to the life companies and they are going to, possibly in the first half of this year, set a record for production here. So right now it's a great time to be a borrower. And it's not a bad time to be a mortgage banker, either (laughter).

NREI: Let me touch on the national perception of Detroit as a one-market, automotive-driven town. Is that a true perception?

Hayman: Detroit has never had any other perception nationwide than it is an industrial smokestack city. It doesn't enjoy a very good reputation. Previous to 1990, that tended to work in Detroit's favor because it tended not to get as overbuilt as some of the more glamorous markets. Today, you have the odd national investor that has come in, but generally speaking, it's a family real estate business in Detroit, always has been and probably always will be, and it's moving back toward that now. We always called it the biggest little city in the United States.

Jonathan Holtzman: A lot of things have changed, too. We do a lot of business with pension funds and life insurance companies. One of the things that has helped Michigan a lot, is that Detroit has gotten a lot of publicity nationally for reduction of taxes. Michigan was always known as a state with very expensive taxes. In multifamily, we have proposition A which limits real estate tax increases, something very unique. Politically, Michigan has done a wonderful job with the governor and senator making this state economically competitive which has helped the office and industrial markets, and clearly the single-family and multifamily markets.

What's happened with the automotive industry worldwide has changed Detroit. With Ford starting to buy companies like Jaguar and Volvo, and with Chrysler and Mercedes in their merger, Detroit is starting to be understood as much more a worldwide engineering while other parts of the country are known much more for manufacturing. As we educate the pension funds and life insurance companies who are these residents, they are amazed by their incomes, their college degrees, and it's clearly driven the single-family market to all-time highs because of the amount of people coming from out of state. It's also become much more common to see foreign business people in Detroit.

NREI: Are more institutions coming into the market?

Howard Perlman: When you look back to the early-'80s, not only were we not able to attract any kind of institutional activity from an acquisition standpoint, but actually there was a moratorium against lending in Detroit by those national lenders. We've seen a 180-degree turnaround in that respect. Not only are lenders very open to the Midwest and Detroit, but we've had a great deal of institutional activity from an acquisition standpoint in the last three to five years. A lot of REITs came in acquiring properties when they were in a position to do so. It's only been in the last year or so that they've essentially been out of the market. REIT activity from a disposition standpoint is primarily institutional as well. We're seeing other institutions buying existing REIT product before it actually goes on the market to the public sector.

Detroit really has changed completely in terms of its appeal nationally to institutional buyers. The difference between Detroit and Chicago or Atlanta is the lack of Class-A product that's available from a sales standpoint. Because most of it was developed by local developers who have been in business for many years, those owners have never wanted to sell product. They never looked at liquidating product. Exceptions are being made and I do anticipate we will see more of that over the course of the next couple of years, strictly because we're not seeing new development coming on-line in any major way, with the exception of some major new offices in the 275 corridor. There just aren't infill sites left for development of the kind of product we saw developed in the mid- to late-'80s.

NREI: Do you see downtown Detroit coming back?

Perlman: In the last two months the announcement that Compuware made will have a significant influence on what transpires downtown over the next five years from an office and retail standpoint.

In the next six months we are going to hear about other companies that are going to not necessarily relocate their entire operations to downtown, but certainly open offices downtown. From a timing perspective the downtown comeback is still a ways away, but it's closer than ever.

Hayman: I agree that it's going in the right direction, but Detroit has some basic handicaps that other downtowns don't have. The first and probably biggest handicap is the lack of public transportation. The other problem for downtown is the lack of Class-A space. It's just not there, and short term, there is probably going to be a net loss because there is no space for tenants to move but out to the suburbs. Long term there is a lot happening and we will see the revitalization of downtown Detroit, but we need people living down there and retail. That's going to take time.

Bober: Detroit has had the world's longest pregnancy from a rebirth standpoint. We have loans on major properties downtown but there is a lack of investible real estate. There is still a critical-mass issue there. It's been a long-term gestation and the next wave will probably be after Compuware starts pushing dirt. There's still a show-me mentality there.

Dennis Bernard Bernard Financial Corp.

Dan Bober Bloomfield Acceptance

John Fricke Signature Associates

Mike Gerrard Grubb & Ellis

Allan Hayman The Hayman Co.

Jonathan Holtzman Village Green Companies

Mike Moran Colliers International

Howard Perlman Friedman Companies

Jeff Shell Cushman & Wakefield

Roger Woolstenhulme Trammell Crow Co.


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