Open Season

Times are tough for downtown office rentals

Over the last two years, the city of Minneapolis has suffered through the worst market for downtown office space in a decade. The vacancy rate has jumped from 10 percent in 2000 to 23.1 percent at the end of last year, according to a recent report by United Properties. Rental rates have hardly fared better, falling from a peak of $15.14 per square foot for Class A buildings in 2001 to $13.69 last year--a 10 percent drop. Even the value of downtown office buildings, as assessed by the city, has declined slightly. The latest hit occurred earlier last month when NRG Energy, emerging from bankruptcy, announced that it was vacating six floors of the AT&T Tower and moving its headquarters to the East Coast.

The primary reason for this dreary statistical snapshot of downtown is the struggling economy. In this respect, Minneapolis is little different from other cities across the country. According to real estate research firm Reis Inc., the nationwide office vacancy rate is 17 percent, the highest level in a decade. And downtown St. Paul is in even worse shape than Minneapolis, with nearly a third of its office suites sitting empty.

But a couple of factors unique to Minneapolis have also so far thwarted a downtown recovery. Most significantly, several large corporations that have been lynchpins of the downtown office market have purchased or built their own headquarters in recent years, leaving large voids in the buildings where they used to rent. Both American Express and Target Corp. have relocated the bulk of their workers into new downtown locations. Those two companies alone formerly leased roughly half of the space in Minneapolis's premier building, the IDS Center. In addition, Wells Fargo Mortgage left downtown to take over the former Honeywell headquarters in south Minneapolis, while many of Pillsbury's employees have been relocated to Golden Valley since the company was acquired by General Mills. "It's a brand-new ballgame without those players," notes Jeff Hart, a senior associate at Colliers Turley Martin Tucker, which owns the Northstar Center and 1221 Nicollet Mall, among other buildings.

The downturn in the office market has not been as disastrous as during the economic drought of the early '90s, however. At that time, the problem was exacerbated by a glut of office space. Four new buildings, including LaSalle Plaza and Dain Rauscher Plaza, were just coming online when the economy soured. Many real estate companies found themselves overextended and in no position to weather a protracted period of high vacancy rates. The end result was a plague of bankruptcies and foreclosures across the country. "We saw a lot of buildings go back to the lenders back then," recalls Hart.

The previous crash left both bankers and developers somewhat chastened. In the intervening years, lending institutions have become much more vigorous in analyzing the financial health of potential developers. "The lending practices 10 or 15 years ago were significantly different," says Jim Montez, senior associate at United Properties, which owns numerous downtown office buildings. "They'd give you the money if you showed up with a drawing. There's just a much higher level of scrutiny about where the money's coming from now." The end result is that just one building, Kinnard International Center, owned by United Properties, has gone belly up in the current slump.

The other good news for downtown developers is that there aren't any office buildings set to open in the near future. The only proposal on the horizon is for a 250,000-square foot office tower at Second Avenue South and 11th Street, but most analysts believe that the project will never get off the ground. "Nobody would be foolish enough to come into downtown and build a building in this desolate market," says Hart. Adds Montez: "I don't see us having a significant high-rise office tower built before 2008--and even 2008 is aggressive."

In recent months there have been some signs that the market is beginning to rebound. The first positive indication came in September, when U.S. Bancorp agreed to sublease 278,000 square feet in the Pillsbury Center through 2016. The tower had been struggling to fill the space vacated by Pillsbury following its 2001 merger with General Mills.

Corey Whitbeck, director of leasing at the IDS Center, says that he's already inked six expansion deals this year--compared to just two such transactions in all of 2003. This has resulted in roughly 20,000 square feet of additional leased space. Despite the departure of American Express and Target, Whitbeck says that the building is now 86 percent full. "I've done a heck of a lot more showing this quarter than I've done in any quarter in the last year and a half," he says.

Montez believes the key to revival will be smaller businesses, which rent anywhere from 5,000 to 30,000 square feet of space and constitute the vast majority of tenants. "You can get focused on trying to find these elephants and you're so busy chasing the elephants that you don't see the mice," he notes. "And that's what you've got to get. You've got to get the mice. We hadn't seen a lot of those in the last two years. To see them back out is a great sign."

 
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