400,000-s.f. Office Building to Start Construction in Chicago

Dec. 31--Fifield Cos. is planning for what has become a rare breed: a speculative downtown office development.

This summer Fifield plans to begin building a 400,000-square-foot, 16-story office structure at 625 W. Monroe St. that will take about two years to complete. But unlike the four office buildings it has developed in the popular West Loop submarket since 1997, the company has not yet signed an anchor tenant for the latest.

"We're confident in the Chicago office market," said Fifield President Rick Cavenaugh. He pointed to the company's last West Loop project, at 550 W. Adams St., which sold earlier this year for a lofty $378 per square foot, roughly 50 percent above the average price for the area.

Cavenaugh's bullishness is buoyed by tenants' eagerness to move into new space, the record dollar volume of office sales in 2006 and the likelihood that investors will clamor for more Chicago property to buy in the next year and beyond.

Still, Fifield faces the risk of building into a sluggish leasing environment.

Rents are projected to be flat next year--slightly below rates charged in 2000. Yet vacancy rates are likely to remain in the mid-teens, well above the 10 percent that marks a healthy market.

The big drag on Chicago office property leasing is the region's slow-growing economy and weak job creation.

As a result, developers continue to lure tenants from older offices, leaving some buildings nearly half empty.

In other words, 2007 will essentially be a tenants' market.

"Landlords are moving around businesses that are already here," said Richard Gatto, an executive vice president at Skokie-based Alter Group. "There's very little fresh meat."

Normally office building development is spurred by declining vacancies and rising rents. But not so in Chicago.

Perhaps this oddity arises from Chicago's nature as a pro-development city in the long languishing Midwest.

"The history of the Chicago market is an imbalance of supply and demand," said William Deyo, a principal at Atlanta-based Goddard Investment Group LLC, which has been searching for an office building to buy here for a year. As the market approaches equilibrium new projects arise, he said, and that usually pushes down rents.

"They drain rental rates for all landlords so there's downward pressure on rents but high operating expenses," Deyo said.

However, some developers find ways around such obstacles.

Consider Alter, the developer. It will start construction in three weeks on an office building at 111 W. Illinois St. with only about 30 percent of its space committed.

"Why develop when there's so much supply out there?" Matthew A. Ward, an Alter senior vice president, asked rhetorically. From the tenants' perspective, he said, "When they calculate the bottom line, they do better in new buildings."

The anchor tenant for Alter's building will be Erikson Institute, a graduate school in child development, which will pay about $20 million to buy 75,000 square feet for use as an office condominium.

"Owning is more economical than renting," said Erickson's president, Samuel Meisels. In addition, the space is being tailored to the school's needs. "We'll have clinical areas and reinforced floors under our library," Meisels said.

Same advantages

In 2007 those who lease office space will find the same advantages that they have since 2001, when downtown vacancy rates shot up to 13.3 percent from 7.1 percent in 2000 when the average asking rent was $28.16.

By the end of 2004 vacancies had hit a high of 17.8 percent and have been slowly drifting down since, according to Jones Lang LaSalle Inc.

At the end of 2006, 14.3 percent of the office space is available for lease or sublease at an average asking rent of $26.83. Landlords will still attract tenants with offers of free rent, although less of it, said Bill Rogers, a Jones Lang LaSalle managing director.

"It will still be a tenants' market," Rogers said of the city's 132 million square feet of downtown office space.

Tenants may take a bit more space, rents may rise slightly for new space with good views, but he said current trends will prevail.

This year, about 4 million more square feet of space was taken off the market than was put back on it, Jones Lang LaSalle reported. This phenomenon is called positive net absorption.

Usually that means strong leasing activity, but for contemporary Chicago that's hardly the whole story.

"Some of this is false absorption," said Rogers.

In part it reflects at least 1 million square feet that has been taken off the market as buildings are sold or converted into commercial or residential condominiums, he said.

Meanwhile, Chicago-based brokerage Grubb & Ellis Co. estimates that in 2006 only 573,743 square feet was absorbed downtown, leaving it with a vacancy rate of 16.4 percent, said research analyst Simone Schuppan.

Weak job creation

Despite the central location and solid transportation infrastructure that makes Chicago the type of global hub and gateway city that investors seek, its office market continues to struggle in the face of weak job creation.

By November Illinois had gained 74,600 jobs this year for its 16.8 million residents, and 2007 is expected to return slightly better results. That performance pales when compared to 1998, when strong economic growth generated 126,500 net new jobs, according to the Illinois Department of Employment Security.

The performance of the downtown rental market here, "is more about jobs than anything," said Albert H. Scherb Jr., president of Ameritus LLC, a Chicago commercial developer.

"No matter how you parse it, Chicago is still the capital of the Rust Belt, and when we lose jobs to foreign countries it hurts and makes a recovery slower," Scherb said.

Weak growth, high vacancies and soft rents foiled Goddard Investments' property search here.

"I'm amazed at the prices being paid compared to the real estate fundamentals," said Cairman and Chief Executive Robert Goddard, who bypassed Chicago to purchase a 275,000-square-foot office building in Dallas this year.

Chicago's record-breaking property sales in 2006, he said, "were driven by the capital available, not the office market performance."

This year Chicago commercial property transactions amounted to $5.1 billion, or $228 per square foot, compared with 2004 when sales were valued at about $2.4 billion, or $182 per square foot, said Stephen J. Livaditis, senior managing director at the Chicago office of Eastdil Secured LLC.

He expects 2007 to be another year of strong sales activity and rising prices. "With transactions in New York City now being priced over $1,000 per square foot we anticipate that Chicago's average price per square foot will continue to increase significantly," he said.

The eagerness to acquire real estate reflects national and global trends as well as local dynamics, said Dan Fasulo, research director at Real Capital Analytics, a New York firm that tracks property sales.

"In 2006 a wave of capital has focused on global U.S. cities, and Chicago is certainly one of them," he said.

On a cautionary note, however, fierce competition for buildings may cause investors to leap before they fully scrutinize property financial results, some observers warn.

Furthermore, landlords may welcome high sales prices when they sell buildings, but the high prices, coupled with rapidly rising construction costs, pose some risks for owners managing properties, said Tiffany Winne, a managing director in the Chicago office of New York-based brokerage Studley Inc.

They may want to raise rents. However, if tenants balk, she said, "Investors may find better uses for their money going forward."

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