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Will the CBD bubble burst?

In March, newly released U.S. Census figures revealed what many Chicagoans already knew — the city's population has grown modestly over the past decade. According to the Census, the city's population jumped by 4%, or 112,000 people, between 1990 and 2000, raising the total to 2.9 million. Such growth for the City of Big Shoulders is significant because it marks the first population increase since 1950.

As a reflection of that budding growth, the commercial real estate sector was busy as a bee in 2000. Seven office projects totaling more than 4.7 million sq. ft. of space were in varying stages of development at the close of last year, according to Northbrook, Ill.-based Grubb & Ellis. Three Class-A buildings were either completed or substantially complete by year-end: One North Wacker, Dearborn Center and 191 North Wacker Drive. Meanwhile, MCL Cos.' ambitious $1.5 billion River East development began taking shape.

The good times were tempered, if only for a few weeks last summer, by a sharp rise in local gas prices as they soared to $2 per gallon. A more lasting concern has been the precipitous drop in the stock market and the corresponding dot-com fallout, which has only worsened since we visited Chicago in late February.

To better gauge the Chicago CBD's near-term prospects, NREI invited 10 of the brightest minds in the commercial real estate business to share their views as part of roundtable breakfast at the Ritz-Carlton, Chicago. An edited transcript follows.

NREI: Ty, we'll start with you. You spearhead the “Get in the Loop” program, the city's downtown retail recruitment effort. What project tops the agenda at the moment and why?

Ty Tabing: Definitely Block 37. It's a $260 million project that has been in the works for about 30 years now, so the anticipation is definitely there. It's a complex project that involves relocating the pedway and a lot of very complicated planning issues. It's about 500,000 sq. ft. of retail, a Marriott Suites Hotel with 350 rooms and about 300 condominiums on top of that. It's going to be a great addition to everything this city is doing to add retail on State Street and enhance the theater district. It's really the home-run project for downtown right now.

NREI: There have been a number of proposals for that site, and they all seem to have died on the vine. What's been the biggest obstacle?

Tabing: I'd say Mayor [Richard] Daley. He has very specific ideals about what he wants on site, and there have been a lot of less dense proposals that have come forward. A Target on a big block in downtown Chicago might be good for some people, but in terms of what it brings to downtown, it's not what the city and mayor have in mind.

Of course, the economy in the early ’90s was problematic and killed one of the previous proposals.

NREI: Mable, can you tell us what's new in retail on both State Street and Michigan Avenue?

Mable Gin: Well, there's been an enormous amount of activity in the city, and that's due to several factors — certainly the commitment from the city of Chicago and Mayor Daley.

Last year in the State Street/Wabash area, the retail vacancy was down to about 1.5%, which is down almost 50% from the previous year, and that's out of a universe of 2.6 million sq. ft. And then if you compare that with North Michigan Avenue's addition of Nordstrom and the Shops at North Bridge, that added another 386,000 sq. ft. The vacancy rate for that area is roughly about 3.7%, which is down from about 5.5% the previous year.

So what does this all mean? Certainly more tax dollars and revenue. Chicago annually receives more than 30 million visitors, and that's tied to business functions and also to what the city does to promote business. You see that with what U.S. Equities is doing with Grand Plaza and what River East is doing. I think they're all feeding upon each other.

I have received a few calls recently about whether or not I'm seeing a slowdown in the retail sector. Perhaps people need to be careful because it can become a self-fulfilling prophecy. Yes, it's always good to take a look and assess how you did last year, your expansion program, and perhaps not get too carried away. So far it has been relatively healthy, and I don't hear that loud thud yet.

NREI: So Michigan Avenue is more insulated from some of the negative retail market trends?

Gin: Depending on the price points, Michigan Avenue is certainly [more insulated]. You're seeing more of the national retailers lease space because the majority of the available space has just been in a larger-size range.

NREI: Kevin, Mable mentioned the River East project. Could you give us an update and overview of it?

Kevin Augustyn: The River East project is the redevelopment of the Chicago Dock and Canal Trust land. The Chicago Dock and Canal is an old Chicago company founded in the 1850s by Chicago's first mayor. Abraham Lincoln incorporated the company. We purchased the company, which was a REIT, in a reformat in 1997.

Although there is an office component — River East Plaza — the development is really residential and retail. It's on the lake, so it's an attractive residential site. Because it is almost halfway between Navy Pier and the North Bridge development that John Buck did along Illinois Street, it's a natural for some entertainment-type retail and retail that, as I see it, does not compete with Michigan Avenue. Nor does it try to replicate the tourist-type of impulse shopping of Navy Pier, but it creates more of a retail base that will serve the neighborhood.

We have three projects that are in various stages. The first is the River View Condominium development. We've completed the first phase: 100 units with 12 townhouses on the Chicago River. To give people a sense of timing, that project sold out within a year, and we are delivering the last 10 of those units over the next month. We initially priced those at $295 a sq. ft., and pretty quickly they reached $350.

The second project is River East Center. That's a big urban, mixed-used project with four components — a 457-room Embassy Suites hotel, 620 condominiums, a 21-screen AMC Theater and some additional retail, and a 1,100-car garage. We designed that project to take advantage of the location on Illinois Street between Navy Pier and Michigan Avenue, and it's our plan that the 21-screen AMC Theater will solidify the area east of Michigan Avenue as a retail destination.

The other development that we have planned there is primarily for-sale residential. There will be an additional phase of River View that will be breaking ground in the next month. That project is a little bit bigger — 140 units — and that project is 75% pre-sold.

Steven Fifield: Ty, besides Lord & Taylor what other retailers have signed at Block 37?

Tabing: They haven't signed other people at this point. They are talking to a lot of top-notch retailers — Williams & Sonoma; they are talking to Talbot's; and they are looking at the [development's] four corners. Each corner of the block will have a two-story retail presence with showcase windows.

JMB [Realty Corp.] has quite a history in terms of developing shopping malls, so it has relationships with all the appropriate retailers. That provides a sense of comfort for the city.

NREI: Kevin, we hear a lot today about live/work/play communities. Is this a fad or a true paradigm shift?

Augustyn: Chicago is going to be successful because of a lot of the attributes that make it unique. It's a beautiful city, and few other major cities have the arts, the amenities, the entertainment, the physical beauty. Go to any other Great Lake city and look at the lakefront and see how dramatically different that is from Chicago's. People want to live here and work here. They have access to a whole range of cultural activities and a whole range of retail activities and some very good housing stock that's being developed. I don't really see it as a fad.

People talk about softening of the economy, but if you look at the raw demographics of the people reaching a certain age that want to be back in the city, and you look at the demand for retail and financial services, it far outstrips any kind of economic trend. People are tired of long commutes, and they are tired of the lifestyle they may have led for the past 15 or 20 years. Now they want something different.

NREI: Charles, can you discuss the office market, specifically what you are doing with UBS Tower [also known as One North Wacker]?

Charles Beaver: We did One North Wacker, and we were the first out of the ground. It's 1.3 million sq. ft. over at Madison and Wacker, and we did it on a spec basis. In general, leasing has gone very well.

One North Wacker opens up in nine months, and it's 87% preleased. We are looking at a second site at Monroe and Wacker, which we are committed to acquire. We have a discretionary fund that will allow us to purchase that without a partner. But the idea of building spec office buildings downtown is a thing of the past. The challenge for all of us is achieving preleasing.

The other issues are capital and the creditworthiness of projects. The banks, which already have been tight throughout the cycle, are likely to tighten further. The challenge is going to be getting the capital, which probably is going to require preleasing of at least 30% to 40%. Given the tightness of credit and with the availability of space and projects that are under construction, it's going to be extremely difficult to bring either the equity capital or the debt capital to any projects other than the next one or two.

NREI: Christy, do you want to expound on that a little bit?

Christy Lockridge: Actually at Heller, we are a middle-market lender, so for us to provide the equity for a project like One North Wacker is really out of our ballpark. We've done a couple of spec office projects, but they have been 150,000 sq. ft. to 300,000 sq. ft. suburban developments.

We've seen a shift in the construction lenders. Four years ago, they would have easily done 75% to 80% on spec, and we would come in with anywhere from 50% to 90% of the equity. There has been a real tightening in that construction lenders are saying, “We are not going above 70% unless you are backed by substantial financial statements.” Last year, we did a deal with LaSalle, and it went up to 75% because there was an extra principal added to the deal.

At Heller, we still are doing some spec developments, but we've lowered the amount that we'll bring in to 70% of the capital structure. We want some real equity, and in every market you're going to look at the supply and demand dynamics. In Chicago, with the last count I had, there was about 10 million sq. ft., if you include the ABN Amro site. In the next few years, there is going to be a softening.

Mark Goodman: How much are we building these buildings to steal tenants out of a Quaker Oaks Tower? We're taking tenants from one property off to another. Where is our sensitivity of real job growth, real demand, of real growth rather than shifting chairs? I try to analyze that all the time in the context of what's the real need? Are we just in a competition amongst ourselves to try and get the tenant before the other guy does, and then we leave the other guy with the vacant space?

We have to ask ourselves what our responsibility is and what's the reality?

Fifield: I don't think we have a musical chairs market. We've analyzed the market very carefully. [Chicago] has 110 million sq. ft. downtown, and, like the retail industry, we have an evolution of companies within the market.

In the office market we're generally growing. You look back at the statistics. We had a phenomenal 2000 and people forget in 1999 we had a pretty poor year. But if you look back five or six years, we've absorbed between 1.9 and 2.1 million sq. ft. per year on average. If you look all the way back to World War II, we've absorbed 1.5 million sq. ft. per year, including all the bottoms of the cycle, and that's on a base that was less than half the size that we now have.

There is net new growth in employment in the Chicago area that demands office space. And if we are only absorbing 1.5 to 1.9 million sq. ft. a year, overall, the current vacancy is 8%. If you look at the lower or higher end of those two absorption numbers, the vacancy in this market for the next four years will fluctuate between 8% and 9%. It's not going to go to 12% to 15% like we had in the early ’90s when we were way overbuilt. The fact is, we haven't overbuilt the market at all.

There are six buildings under construction today, and they comprise about 4 million sq. ft. That includes [One North Wacker]. That includes [Paul] Beitler's building. It includes the four peripheral buildings that Mark, myself, Development Resources and The Alter Group have built, which were smaller buildings, about 400,000 sq. ft. That 4 million sq. ft. also represents the ability for tenants to move in over a three-year period. Those buildings actually didn't quite take up the demand, which is why next year Chicago's downtown vacancy is expected to fall to about 7.5%. And that's not accounting for Class-C buildings converted with TIF [Tax Increment Financing] dollars to residential rental or, without TIF, to condos.

We plugged in the proposed buildings the other day, and the statistics showed that in 2003 the vacancy ticked up to about 9%, and in 2004 it's back down in the 8% range. Historically, 8% is a pretty tight figure when you start to break it down into Class-A, B and C buildings. Right now Class-A buildings are under 5%, which is a real problem for major corporations that want contemporary space.

This is supposed to be a bad market? I hope we have more bad markets like this because our fundamentals are just damn strong.

In the suburbs we pulled in our horns. Our last [suburban] building is under construction. It happens to be 100% leased, but I would not do another spec suburban building.

Even if 2001 has a little dip like 1999, if you look at two- and three-year rolling averages, all the space, everything that has been announced for downtown will be leased in an orderly manner without the fundamental disruption that we had in the early 1990s.

NREI: What happens to the space that's being vacated as tenants go?

Goodman: You have to look at the natural aging of your housing stock, so to speak, because a lot of these buildings don't have the infrastructure for what businesses require today; 550 Washington probably will see progression from 20-year-old buildings.

Fifield: A lot of buildings that were built to be competitive cost structures in the 1970s and 1980s were under-elevatored. That's probably one of the single biggest problems. It's okay in buildings that have gone to a lot of small- to medium-sized tenants because elevator demand is not as high there. But the majority of downtown Chicago is large tenants, and large tenants are going to higher densities. They need the elevator capacity and the electrical, HVAC and riser capacity.

There are some buildings where the elevator ratios are 55,000 or 60,000 sq. ft. per car, and those buildings can not handle large tenants. Also, we were building smaller floorplate buildings back in the ’70s when I started in the business. We thought a 15,000 sq. ft. to 20,000 sq. ft. floor was perfectly appropriate. If you talk to the major users today, 25,000 sq. ft. is probably as small as most large users want. They would probably prefer 30,000 sq. ft. and 35,000 sq. ft.

People say, “What are you going to do with the vacancy at 123 North Wacker?” My answer is, well, we really are not going be competing for tenants there because that building has 18,000 sq. ft. floors.

NREI: Aon Corp. recently vacated 123 N. Wacker.

Dan Nikitas: You talked about the floorplate factor. Aon could have stayed there size-wise and had lower rents. The problem was that the floorplates for a multi-floor user don't work well at that size.

The highest number we've ever had in downtown inventory was about 125 million sq. ft. So if it's 110 million today, and development has added some new inventory, that means there has been an attrition of some 15 million sq. ft. You had a pretty major attrition of functionally obsolete real estate. Down to 110 million you really have two classes of real estate. It's not A, B, C or A and B+. It's really the Class-A, which are the Sears Tower and AT&T [buildings] that are absolutely full.

We really have not marketed Sears Tower for two years. We have to address some net absorption. Goldman Sachs has gone from 90,000 sq. ft. to 250,000 sq. ft. Salomon Smith Barney has gone from one floor to three floors.

So if that market is $40 to even $50 gross, then you have, in my opinion, almost everything else. That would be buildings such as Mark Goodman's 550 W. Washington, which have been very successful. But you have a completely different market that really has no space available.

NREI: Paul, I'd like to get you and Frank to chime in here.

Frank Franzese: Developers and landlords are always going to make an argument that it's a tight market, and I tend to agree that, from a Class-A perspective, yeah, we're below 5% [vacancy]. But if that's the case, then the rents clearly should have spiked a lot higher, and they haven't.

Rents have stabilized for the past six to eight months. Your peripheral buildings, your 550-type suburban-type buildings are going to attract a certain element of tenant, but that tenant is not going to go to an AT&T-type building. That type of tenant is looking for more of a suburban feel. It wants to be closer to the train stations and other amenities to attract labor.

With respect to 123 North Wacker, not every tenant always wants large floorplates. I tend to agree that they do want a 25,000 sq. ft. floorplate. That's an ideal size. And a landlord's going to look at that and, I'd venture to guess, you're not going to go much bigger than 30,000 to 35,000 sq. ft. That starts putting some risk in the project.

But last year, we represented a tenant that was a 100,000 sq. ft.-plus [user] that wanted small floorplates. They wanted to consolidate a number of their subsidiaries. Sometimes a small floorplate serves well because it allows subsidiaries to maintain their identity, but it also allows the tenant to achieve the leverage of a larger tenant. Some of these small floorplates will do well.

If [developers] continue to build, you're going to see a softening in the market. Next year, you don't have much new development, but you've got a lot of back-fill space to account for. That's the great equalizer.

Goodman: Steve's analysis is very astute, but then you measure that against the flow of money. We're always out of sync. The money is always flowing at one time, and you're coming on line with 4 million sq. ft. That's the history of our office market, because everyone sees everything at the same time. So when you're trying to fill a 1.5 million sq. ft. requirement, you've got 4 million sq. ft. that comes on line at one time. Then you absorb that over three years at a 1.5 million sq. ft. average, and someone's getting hurt on the rent. That's when the brokers begin asking for concessions, and all of a sudden you're not hitting your pro forma.

Fifield: Lenders have made it difficult. When we went to finance the Quaker Tower, we had $20 million in equity and we were 84% preleased, and it was an effort to get a lender. Someone made the point earlier about financing spec buildings. You have to jump through some hoops. Naturally, that will restrict supply.

This is musical chairs on the finance side, meaning someone is going to be left out. Lenders are starting to differentiate between the 40- and 50-story buildings in the Loop and saying, “We have room for one, maybe two more.” The guy that wants to do the third one is going to wait three years for the cycle to come back to him. On the periphery of the Loop, there seems to be a fair amount of demand for the $30 gross occupancy cost space. A couple more will be built there, but none of these buildings are very big. You put three of these buildings up, and they equal one UBS Tower.

Beaver: When One North Wacker was built, there were few large blocks of space available. By being the first out, we were able to capture a lot of big-block users. If you look at the tenancy of One North Wacker, we have a few single-floor [users], but most of them are multi-floor.

I don't see things quite as optimistically as Steve. These tenants are coming out, and the number of large blocks available is significantly higher now than a year or two ago.

The other point is, most people could command the layout of One North Wacker and achieve a 7% to 10% [increase] in efficiency over some of the older buildings with smaller floorplates. So you could justify the economics of moving into new space at higher rents because the overall occupancy costs didn't materially change. The question's going to be, are these older buildings going to respond — are we going to see some depressed rents with the older stock?

Paul Kopecki: We have to see those rents be depressed. We're taking for granted a trend here: all of the development is West Loop and near the transportation hubs. That's where our tenants want to be. If there's a hunk of space available in the East Loop, that's going to be tough to fill because our guys who live in the suburbs and come down and get off the train don't want to hop on the bus to get to work.

The old residential saying, “location, location, location,” still applies. One reason you guys were so successful at One North Wacker is you've got a great location. We almost take that for granted, but we shouldn't.

Goodman: It's a good market, and, yet, in spite of that, I'm finding that the tenant reps are still coming at us for a hunk of flesh.

Kopecki: That's our job.

Goodman: You have tenants in the market whose leases are up who are coming off these fabulous bargains. My sense of it is I've got a guy who bought a $1,000 suit for $100, and he's waiting for the liquidation sale to occur again.

Nikitas: I think about attrition and other factors in the market, like the attrition of Amoco and Morton Salt, and we weathered that relative to occupancy levels at a time when Sears Tower was redeveloped.

Sears moved out of Chicago. Ameritech moved out of Chicago. So Sears Tower and a lot of the Class-A buildings had Class-B and C tenants trading up because the rent was $5 net. There are some guys in Sears really paying below-market rents. I know, Mark, you competed for a law firm coming out of Sears that's literally paying $20 gross based on the lease that they signed in encumbered space in a terrible market. Tenants aren't going to stay in Sears Tower when they say, “Can you give us a proposal to review?” and it's literally $40 to $45 gross. They're leaving, and they're going to space that's $30 gross, which is what they've done, sign a lease at 123 Wacker for half of what they would pay at Sears Tower. That's a phenomenon that's not isolated to that one tenant or to our building.

NREI: Paul, granted, every tenant is different, but what are the general trends that are emerging?

Kopecki: Certainly you have the technology trend — technology in terms of what we use as brokers. With the increasing consolidation of our clients and with more subleases, I must get seven sublease e-flyers a day, whereas a couple of years ago there was no such thing. You can take that e-flyer that you receive from another broker, cut and paste it to your needs and forward it along to your client and get them exactly what they need in a clear, colorful, meaningful way.

Years ago, it would take nine to 12 months to transact a deal. You went out and determined a client's needs and you got a preliminary tour. You sent RFPs out. You got the responses back. You did another tour. You negotiated for a while. You selected, and then you spent four months doing the lease negotiation. No more.

With the tech firms, there's now e-time, and with e-time, it's tour, select and go. We've done transactions in the span of three to four weeks that used to take a year. The down side of that from the landlord's perspective is that some of those transactions don't stick. has been in the news recently. They went belly-up yesterday. Nine months ago when we were representing 90,000 sq. ft. for one of our clients in the Merchandise Mart, came to us and said, “We must have this space.” We were a little bit thoughtful, thank goodness, and we asked for a $1 million letter of credit. They balked, and while they were balking another dot-com came in with a much better credit stature. We doubled the letter of credit to $2 million, and we made that deal.

Hindsight is 20-20, but we rode the right horse, because now MVP is gone. There's a 40,000 sq. ft. hole in the East Loop that needs to be filled. It all comes back to securitization. Landlords are looking for securitization now, where a year ago maybe anything went. Now, if you're not totally secured from a landlord's perspective, you're not going to make that deal.

Franzese: Chicago has weathered that new-media technology sector better than either of the coasts. In speaking with my counterparts in New York and San Francisco and L.A., subleases are starting to hit those markets. Chicago's a little more diverse. We didn't take on as many of those kinds of industries. Chicago was fairly segregated in that respect. There were certainly some [tech start-ups] in the northern submarkets because some of the venture capital people wanted to start something closer to home. The real subleasing is coming from some of the old-line companies that are just giving back space, whether it's an Amoco or Morton or Monsanto.

I'll go back to Mark's point where he said “Why are you taking a pound of flesh from us?” We're not doing it. Landlords are really creating that opportunity. We're simply taking what's offered and trying to improve it on behalf of our clients, and we're realizing that the landlords are acquiescing.

Goodman: As tight as the market is, there's still an ability for brokers to demand that, and the landlords have to have some ability to make some concessions to make the deals because another landlord will if they don't.

Franzese: The better the credit of the client, clearly, the landlord is going to make better concessions, as it should because the client's earned that position. So, we're not seeing the rates of the early 1990s. That's a shame for our clients, but we are seeing that the landlords are making money. You haven't seen the spike in the marketplace like you did on either coasts, but you haven't seen the downfall like you have on either coast.

Nikitas: The spiking happened about 18 months ago, so I don't see how rents possibly could spike in the Class-A market. We have done transactions at $28 and $30 net. I think One North Wacker's done a $30-net transaction. That's still comparable to rents in ’87 and ’88. However, in ’87 and ’88 you would get a law firm with a completely non-recourse, $55, tenant work letter. On a net basis, they'd get some serious abatements. We're still giving $35 and a work letter, which was what was given in 1987. That's a pretty solid return to the landlord relative to that market 13 years ago.

I see an inflationary increase in our rates, maybe a little better subject to the demand for space because there's not a lot of supply.

Fifield: Our market started to recover in 1994. In 1994 and 1995 we had a couple of years where, because there was virtually no supply added, we had rents go up 8% to 10% per year. It's not like the market has collapsed. We've just slowed down to 3% to 4% per year increases, which are necessary for any new construction anyway because our construction costs aren't going down.

Goodman: You really need to be at $28 to $30 net to achieve the appropriate fair-market return when you take into consideration the underwriting costs, the lender demands and what you have to reserve for TI [tenant improvements].

Beaver: I agree. Depending on how you're capitalized, the new high-rise construction costs are at $230 to $260 per sq. ft. Basically you need an 11% cash-on-cash return when you're through with the project. If you impute the carry-on equity, the project cost is probably closer to $300 to $325 [per sq. ft.].

You'll notice that none of these new buildings have sold. There's a real story behind the exit strategy and what's going to happen with these new projects. The alternative is you can go out and refinance because the interest rate costs today are 7% to 7.5% and getting better. The good news is that they are extremely re-financeable. The flip side is it's very challenging. The Germans are out of the market. There's a lot of equity that's not in the market today that typically would be the buyer. The pension fund market, for the most part, is saturated with office.

Lockridge: I'll weigh in on the debt side. Refinancing is going to become more of a challenge. What we've seen from a lending side is that a lot of the lenders are full-up on office. In the past two years, Heller has done $1 billion in office financing. The majority of that has been acquiring buildings where you have below-market rents. You're counting on these law firms that break $20 to bump up to $40. What we're finding is that we still have some room in our portfolio to do office, but we can't do big deals because when you try to syndicate that to another lender, nobody's up for more than $10 million. You're finding that the big groups like Deutsche Bank that can put together these club deals, they're really the ones that are controlling the market.

NREI: I thought we'd close by asking everyone for a prediction for the coming year.

Franzese: You're going to see, for lack of a better phrase, a pregnant pause in this first half. I believe in the third and fourth quarter confidence will bounce back, and we'll move forward.

We don't have any overlap from last year. People are just a little nervous right now. I don't believe rents are going to go as high as people think because we're going to have a surplus of sublease space. With the exception of the captive tenant that creates an inflationary high rate, you're going to have very competitive rates.

Tabing: The city will see a much more vital theater district along Randolph Street, which is part of the vision to make downtown more of a 24/7 destination that will be a catalyst for bars, restaurants and the like to follow. We've heard in

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