MONDAY, SEPTEMBER 15, 2008
by Mark ThomtonChicagoWhat's the best way to learn the strengths and weaknesses of the Chicago commercial market? We think it's to sit down with the city's top commercial pros and ask them.
In August, staff writer Mark Thomton sat down with: Mindy Sherman, attorney with Perkins Coie LLP; Shawn Mobley, executive vice president, managing director with Grubb & Ellis Co.; R. Patricia Kelly, executive vice president, commercial real estate with Charter One; Terry Hendrickson, vice president, regional sales manager with Chicago Title Insurance Co.; Todd Vezza, vice president, investments with CenterPoint Properties; and William Montana, senior vice president, multifamily investments, NAI Hiffman.
Below are portions of the conversation:
MREN:Can we sum up what we have seen in the first half of 2008?
Vezza: The first half of 2008 the prophecy has almost fulfilled itself from where it started toward the end of 2007. We are seeing a lot less liquidity in the marketplace and people are being more cautious. It's definitely slowed down, particularly investment sales. Where that has happened we have found an opportunity as a company that is well capitalized and has money to spend. In general, over the past three months we have seen a very good pick up in activity in our business. In 30-60 days we cleared and closed almost $160 million of investments. It's not from straight investment sale brokers it is a lot of corporate users, and one off sales.
Hendrickson: I would agree that the framework for the first half of this year was laid out in late 2007. The velocity of deals, which we are very much attuned to as a title company, is down, but it is modestly down. It's not off the table. I think aside from the obvious real estate categories that we will talk about today I see one-third of my business out-of-state and downstate. There are some interesting things there in agriculture, energy, and things like coal and wind farms. I can't remember the last time I did a coal deal and I'm doing two or three of them now. There is still money to do things out there, but it is certainly down. There is reasonable activity in my opinion.
Sherman: In the legal world in the real estate practice it has clearly slowed down. Everybody is holding tight for a while. Everyone is waiting for the bump and then they will kick in, but I'm not even sure it will be this year. I still think it might be the beginning of next year before we see true deals getting done.
Mobley: We serve clients on both sides--occupiers and investor clients. On the occupier side, as opposed to the last few years, we are definitely seeing a more conservative approach to growth estimates and to lease terms. So somebody sitting in 20,000 square feet of space, they are projecting out for the future and the projections for growth are less. On the investment side we have seen investment sales dried up. For really well capitalized cash buyers it is a good opportunity out there. I have not seen they typical seller adjust their pricing expectations to where the buy side is. I think the buy side has moved down dramatically to reflect current market conditions and there are a lot of sellers out there that don't want to face the reality that there building is worth 10 or 20 percent less than it was in March of 2007. Our leasing business is holding up, it's definitely down. What actually concerns me a little bit more is if it takes 6-12 months of lag time to get a deal done, then how many deals were started this year that are going to be the early next year deals? I don't know that there is that many. The business we are closing today is an echo of what decisions were made in 2007. What I am a little worried about as a service provider is 2009 revenues because of 2008 conservatism.
Montana: I think that we will see a decreased velocity in terms of transactions. We had about seven or eight transactions in the first quarter throughout the Chicagoland area of properties with 100 units or more. Where last year we were doing about 40 transactions throughout the year, which historically is rather high for Chicago, historically you get 15-20 transactions of 100 units or more. It's a really tight market. I think you are all hitting it on the head in that you really have a couple groups of buyers out there. You have the opportunistic buyer, let's call them regional and national, and if there is not some kind of a value pop in there somewhere they are not going to buy it. The buyers that are really sitting on the sidelines are they guys who are saying "I don't want to buy something and get a coupon. I want to buy something to where there is upside potential." The hardest type of deal to sell right now is the eight or nine percent return that has no upside potential that is landlord paid heat and things like that.
Sherman: I think the opportunistic buyers are still holding off as well. They don't think the prices have come to a low point yet.
Montana: That depends where. The condominium side of things is really hurting the residential market in some areas, but here in the Midwest or here in Chicago it is not that bad.
MREN: What about a few years from now? It has been reported that 6,000 condo units coming on line. Can this market handle that?
Montana: Probably not. I think that you are talking about 6,000 units coming on in Chicago. There will also be about 3,000 units of new rental product. That is a lot of absorption to handle. The only way for Chicago to handle that is with job growth. Immigration is still strong in Chicago and has accounted for a large population growth in the last 10 years. You will see a lot of issues with the downtown rental market. There is so much of this phantom rental market downtown. I think that the market downtown will have some concessions in the next couple years, but relatively speaking it is not as bad as it was back in 2000.
MREN: The CBD has a scheduled 4.2 million square feet of Class A space coming on line in the next two years. What will mean for leasing active in the vacant class B space left behind?
Mobley: I think it is really a tale of two markets. The West Loop that we are sitting in right now remains very strong, particularly above the 20th floor in view space. It has excellent access to trains and public transportation. The West Loop remains strong. I think that with landlords in the East and Central Loop, there is reason for some fairly significant concern. You don't see new buildings coming up in the east loop. It is pretty much fully built. You have some major tenants like a Kirkland and Ellis leaving the East Loop. There will be some struggles for them. Downtown in general is still doing well and we just saw the announcement last night that Miller Coors is moving their headquarters here. There continues to be a migration of suburban tenants into downtown and it is becoming more popular to live downtown. The young people want to live downtown. The Big Ten schools graduate a ton of students each year and they all want to live in Lincoln Park, Lakeview and the South Loop. There are some good reasons why the downtown markets have some positive absorption characteristics that would be better than if you just looked at job growth numbers. BP just announced a gigantic move out of the East-West corridor to downtown, Miller Coors is coming, Careerbuilder continues to grow downtown. I'm long-term bullish on downtown even given the fact that there are these new buildings coming online that will certainly be a trouble for some landlords.
Hendrickson: I think another point is that it is interesting how in some existing buildings, 55. Monroe comes to mind, where big office spaces are playing on this desire to be downtown and creating some residential condominium spaces. In some of those buildings you get a lot for your money. They have big floor plates and a lot of interior space. I think some of that A minus or B space will be recalibrated into other uses. It is not a silver bullet, but there are uses for those buildings. With the strong desire and other pockets, like the colleges in the South Loop, positive things are happening and it will remain viable.
Sherman: As far as rental rates go, compared to New York or L.A. it (Chicago) is still really attractive. I think that it is drawing people. It's hard to downplay what Millennium (Park) has done. You can say what you want about it, but it has certainly revitalized that area and I'm interested to see what happens to the office because of it.
Kelly: The other thing I would like to add about office space is that when markets are hot people in equities and debt don't necessarily want to lock down the revenue side of the equation, but given the turbulence that is in the finance markets, people are trying to nail down the revenue side of any project repositioning.
Mobley: I think that is so true. I think that a year ago people were paying more for vacant space than they were for leased space. I really think that people were paying-up for vacancy. That's taken a dramatic turn. Nobody is buying the dream.
MREN: The Chicago market has 14 million square feet of industrial space coming on line and very little of it is leased. Is there demand to fill these facilities?
Vezza: There is a lot of space coming on the market right now. Is there demand to fill it in the near term? The answer is no. What is going to happen is that there will be an excess of supply. We have seen this before. In 2000 and 2001 it was building, building, building, and 9/11 happen and we had an overhang. That overhang took a number of years to clear and find a balance. I do think you have seen a build up of available space at O'Hare. That was a great buzz word. There is an oversupply of new product there, but it is new product with strong investors. But in the I-80 market, there are a slew of 1 million square footers out there and I don't know how many million square-foot users are there. I do think it will have another overhang. Investors are going to put the brakes on for a while and take a breath.
Montana: How do energy prices affect the decisions of investors? There is gridlock to get on I-55 or I-80 and trucks are sitting there burning $5 a gallon diesel fuel.
Vezza: It can't be ignored. It affects everyone. Now people are factoring in trucking costs, energy costs and optimizing their logistics equation. That's why firms are figuring if they should fragment their warehousing into smaller warehouses or are they going to the big warehouse and doing more trucking. Do they want to rely more on rail? It certainly will have an impact. We are factoring it into the equation. Everyone looks at logistics in industrial. You have to. If you are not, you might as well drink a beer, close your eyes and throw a dart at a board. Chicago has a huge advantage with the railroads. That's why we are a 1.1 billion square foot market. Chicago is always going to be relevant and we will always get through it. You are going to have hiccups like everybody.
Mobley: We do a lot of work with users who select Todd's company for their buildings. There is a reevaluation going on. The cheapest ways to beat your competitor was to have fewer, bigger more efficient DCs. I think that is what the models were telling you. I think the models now might be providing some different answers, with more distributed, smaller facilities closer to the point of purchase. Maybe it is about lessening drive times. O'Hare has been a great market for us as well. I am so bullish long-term on Chicago industrial because of the air and freight. You said that 14 million square feet is coming on line and my first thought was 14 million sounds like a lot, until you divide it by 1 billion. If everything fell apart it is a point and a half on the vacancy rates.
Hendrickson: I wanted to talk about a type of activity I am seeing more of and that is sale-leaseback. I would observe generally that it has picked up recently, especially with large corporations.
Vezza: Without question. There was a little bit of a dead quite for six-to-five months, but of that $160 million I mentioned earlier, I have to believe that $40 million to $50 million of that was some sort of corporate sale-leaseback from corporations. I know for a fact we are in the $40-$50 million range of sale-leasebacks.
Montana: Are there pricing pressures on the sale-leasebacks that we see in the investment side?
Vezza: The credit standards are getting tighter and the returns are getting higher. You are getting a better deal now than you were a year ago.
Montana: The acquiring purchaser?
Vezza: Yes, but don't advertise that too much. I'm not saying that in a gloating or bragging way that's just what it takes to clear.
Kelly: It is as if every price that's being paid or every debt financing that is being booked, the what-ifs are being built into the transaction. Because the market is not predictable and people can't look out six months and feel good about it, people put the what-ifs back into the transaction. Structure is back. Pricing has improved when you are acquiring.
Vezza: When I started eight years ago the question was "does the real estate make sense?" Was it the right location? It was the basics. And then somewhere around 2003 or 2004 it became a financing thing. It's gone back to the basics.
MREN: You say that financing is back to the basics. What avenues do we have?
Kelly: Clearly the capital markets don't exist anymore. Long-term financing, anything beyond five years is up to the life companies. People have always said that it is relationship lending. Well this is the time that it really is. There are life companies that are still active and they are putting term debt on the books with people they know. If you are a new client or you don't know the life companies you won't get the 10-year loan. To compound that with the state that a lot of troubled financial institution are in, I don't think this is over yet. I think we have more bad news in the financial markets. CMBS is out of business. There are significant real estate lenders that have very difficult portfolios that are not able to put new money to work. We are adjusting in a way we didn't adjust last time as an industry. I think that is helping. But the liquidity has to come back and I don't think it is going to come back until next year. There is capital and there is equity looking to be contrarian and buy bad debt and that comforts me. The last time around for me was the late 80s. This is a very similar situation in the barometer of our market, but that capital didn't exist last time around. I am seeing transactions where new money is coming in and buying distressed debt and I find that to be a very big positive sign. It's not in the magnitude it needs to be in yet, but I think people are waiting to see what happens with five or six financial institutions over the next three months and if they have owned up to the medicine they have to take in terms of write downs and write offs. That is probably the biggest concern that is out there. Has everyone acknowledged the pain that they need to acknowledge? If they have, then in three to six months things will stabilize. They won't necessarily turn the faucet on and start lending again, but they will not be worried about their capital positions.
The top 10 many of those banks are very well capitalized, but the top 20, there are a lot of regional banks in there that are working through their capital positions. That tier of banks is one we should watch very carefully.
Vezza: It seemed like for a while standards in appraisal got a little loose. Is that something the bank is looking at?
Kelly: We clearly justify or validate our underwriting with an appraisal. But we don't lend money based on loan to value. We do our own underwriting. The appraisal is historical data. If you look back a year, look at the cap rates, lease rates and we do our underwriting based on what we think the real value is, based on a going-forward scenario.
MREN: Retail construction was up in the first quarter of 2008. State Street is experiencing a Renaissance. How is the overall Chicago market fairing?
Sherman: State Street actually as it is sitting right now is doing better than it has in years. I was a part of the deal that brought Block 37. I'm pleased to see it being developed. In general though, the retail sector is not doing well. The bankruptcies have barely started as far as I'm concerned. How that will play out in the new development is yet to be seen. What we see in retail is that most landlords aren't doing any new deals. They are restructuring current deals. Michigan Avenue is still doing well it just landed Columbia Sportswear, but that is core property. That is not true retail in general. The suburban mall will see a lot of vacancy.
MREN: Will shopping patterns change for people because of gas prices?
Sherman: I think it will. The tax in Chicago will as well. My husband works in the suburbs and I ask him to pick-up stuff out there. People will stay in their city and stay closer to home as opposed to driving to discounts retailers.
Montana: That is why you have seen this explosion in towns like Des Plaines or Arlington Heights. We are going back to almost pre-car days where people clustered on rivers. Well now instead of rivers we are seeing it with train stations. If you drive on the weekend it is pretty obvious. There is nobody on the road.
Kelly: I wouldn't underestimate the impact of the 20-somethings. Even if they want the suburbs, they are going to where they don't have to have a car. They are going to where they can walk to the train. The gasoline price will change people's behavior.
MREN: How will the rest of the year play out?
Kelly: It is quiet and careful for the rest of 2008. I don't really know what brings the confidence bank. The last time around we had a much more severe liquidity problems and the regulators shut down a number of institutions and there wasn't an alternative means of providing liquidity in the market. This time there is. We have foreign capital coming into the market and there are exit strategies to the bad debt that didn't exist the last time around. I think that is why we are in for a softer readjustment than the last time around.
Hendrickson: I would anticipate the second half of this year to be softer than the first half. I would say that it will be well into 2009 before we see improvement. My company is tied to commercial and residential. Residential is way off right now. I feel fortunate to be involved with commercial, where it is off, but not off the table. If you hearken back to the mid-70s there was no money to do deals. I would point out that foreign money coming in our market and going out of our market. To me they are transactions and that is a positive thing. I think we are fortunate that Chicago is as versatile and viable as it is. There are a lot of solid basis to do business on. Is it what it was two years ago? Certainly not. Has it fallen completely off the table? I don't hear anyone saying that either.
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