The Downtown Office Glut

My solution: More commercial-to-residential conversion of east and east-central loop office space. I say office buildings from Clark to State be converted to partially-residential, while everything east of State become almost entirely residential. From Crain's: Downtown office overload Loop vacancies exceed other cities' as construction outstrips job growth By Alby Gallun * How bad is the downtown office leasing market? It's "probably the softest I've seen it since I came here in 1971," John Buck, the dean of Chicago office developers, told a gathering of his peers last week. It's so bad that some landlords are leasing office space at a loss, something they haven't done in a decade. So bad that the owner of the IBM Building, until recently a premier corporate address, is considering selling off some of the skyscraper's space as office condominiums. So bad that some landlords are giving up on the office market and going residential. With more than 26 million square feet of vacant office space, downtown Chicago is among the weakest markets in the nation. Conditions are improving in other big cities, but they are likely to get worse in downtown Chicago before they get better. The most pessimistic observers don't see a recovery until 2007. Why? Downtown Chicago is one of the few markets where developers, Mr. Buck included, have continued to build new skyscrapers, adding supply to a market already suffering from weak demand. Developers have added 9.5 million square feet downtown since 2000, with another 2.4 million on tap. "It's just a recipe for prolonged pain," says George Kohl, Midwest-area director for Dallas-based Trammell Crow Co. LURE OF SHINY NEW THINGS After dipping as low as 8.2% in 2000, the downtown Chicago vacancy rate hit a new high of 17.2% in the first quarter, according to CoStar Group Inc., a Maryland-based research firm. That's higher than vacancy rates in New York, Los Angeles and San Francisco. Glittering new skyscrapers like the Hyatt Center and 111 W. Wacker Drive are skimming the cream from the market: top-drawer law and financial services firms willing to pay premium rents for prestigious addresses. Defections are hitting some of the city's most recognizable skyscrapers. Sidley Austin Brown & Wood LLP plans to move out of Bank One Plaza into a new tower being built next door at 1 S. Dearborn St. Mayer Brown Rowe & Maw LLP recently left a Philip Johnson-designed high-rise at 190 S. LaSalle St. for the Hyatt Center at 71 S. Wacker Drive. At Aon Center overlooking Millennium Park, anchor tenant Kirkland & Ellis LLP plans to leave for yet-to-be-built quarters at 300 N. LaSalle St. And IBM Plaza faces the loss of Jenner & Block LLP, which is talking with developers keen on building Jenner a new home. But unlike previous building booms, this one doesn't coincide with the strong job growth needed to stoke demand for office space. Office employment in the Chicago area dipped as low in 956,000 in 2003 from 986,000 in 2000, though it has scratched its way back to 974,000, according to Economy.com Inc. The anemic job market makes it hard for landlords to fill the space left behind when tenants decamp for new buildings. The leasing slump is great for tenants, who are getting deals not seen since the mid-1990s. At some buildings, rents are so low and concession packages so generous that landlords lose money on leases. Such so-called negative net effective leases have become more prevalent in 1970s- and '80s-vintage buildings in the East Loop and Central Loop, says John J. Goodman, executive vice-president and regional manager at Studley, a broker that represents tenants. LOSING MUCH LESS Yet such money-losing transactions make sense in many cases because landlords stand to lose much more if the space sits empty. They must pay real estate taxes and operating expenses on vacant space, costs that are normally passed on to tenants. So they are often better off leasing the space, even at a loss, because it allows them to lower their carrying costs. "The average 20,000-square-foot space sits vacant for about 20 months," says Todd Mintz, executive vice-president at Equis Corp., a Chicago tenant brokerage. "That's a lot of downtime for the landlord and a lot of extra expense." He says most of the transactions he has completed this year have dipped into negative territory for landlords. That includes a 75,000-square-foot lease that his client, Private Bank & Trust Co., recently signed at 70 W. Madison St. As concessions have soared in recent years, effective rents have plunged, even for downtown Class A buildings. The average Class A effective rent dropped to $4.76 last year after peaking at $14.88 a square foot in 1998, according to recent Studley report.The lousy leasing market has forced some landlords to get creative. Walton Street Capital, which plans to buy the building at 55 E. Monroe St., is considering converting some of the space to residential condos after key tenants departed for other buildings. When will the market bounce back? "Unless we get some job growth and some growth in key industries, this could linger for years," says Trammell Crow's Mr. Kohl. James M. Costello, a senior economist at Boston research firm Torto Wheaton Research, is more optimistic, predicting job growth in the downtown service sector will pick up, and Loop office vacancies will start falling next quarter. Yet developers keep building, making it even harder to predict a recovery. "For three years I've been saying that it's got to happen next year," says Jack McKinney, president of J. F. McKinney & Associates, a Chicago-based brokerage firm. "So my crystal ball is opaque.">