Finance Midwest

Behind the Apparent Commercial Real Estate Recovery: A Look at Chicago’s Middle Market

By most measures, the national commercial real estate market is well into its recovery phase. And Chicago, the nation’s third largest metropolitan market, is following this trend. It may not be recovering as quickly as coastal markets such as New York, Los Angeles, San Francisco and Washington, D.C., but all of its vital signs are pointing up

By Matthew S. Darin

Principal at Frontline Real Estate Partners and Managing Director at MorrisAnderson

By most measures, the national commercial real estate market is well into its recovery phase. And Chicago, the nation’s third largest metropolitan market, is following this trend. It may not be recovering as quickly as coastal markets such as New York, Los Angeles, San Francisco and Washington, D.C., but all of its vital signs are pointing up. In the second quarter of 2011, industrial leasing activity in Chicago increased by more than 37 percent compared to 2010, according to commercial real estate firm CB Richard Ellis. The city’s retail market posted a 9.7 percent vacancy rate, a 220 basis point decrease from 2010.

However, a closer look at the market reveals a different picture, both for Chicago and for the nation as a whole. Obscured by the positive trends and increased transaction velocity is an important distinction between asset classes. While there are significant signs of improvement in the CRE market, the bulk of that growth is concentrated at the extremes of the asset-class spectrum. This “barbell effect” has left the middle remaining weak, with full recovery a long ways off.

The Two Ends of the Spectrum

Reports of substantial improvement in Chicago’s commercial real estate market have relied heavily on data from Class A and trophy properties. This top tier of the market benefits from long-term, stable income streams generated by creditworthy tenants. For these types of properties, prices are back to peak levels, with demand far exceeding the supply of available assets. Huge sums continue to chase stable core properties in major markets, such as downtown Chicago, especially in the multi-family and retail sectors. An index of non-distressed, trophy properties in six large cities, including Chicago, has risen 26.7 percent since Dec. 2009, according to Moody’s.

The distressed end of the market has seen a parallel renaissance of investor interest, with several large pools of notes recently being snapped up from the market. In June, Chicago bank MB Financial announced that it had agreed to sell a portfolio of 631 loans, the majority of which were non-performing or sub-performing, to Colony Capital. Similar deals have sprung up around the country as investors looking to place capital in the CRE market take advantage of the opportunity to acquire large portfolios at bargain basement prices.

The Hidden Story

While these improvements are grabbing headlines, a different story is unfolding in the middle market of the commercial real estate industry, defined as:

  • Class B and C properties, many of which are older properties with functional obsolescence or deferred capital expenditures
  • Properties in secondary and tertiary markets, such as the outlying suburbs of the Chicago metro area and the collar counties, where recent commercial development was dependent upon new home developments that are now either stalled or in foreclosure
  • Properties under $10 million in size, representing a major segment of the overall CRE landscape
  • Properties leased to local, non-credit tenants, such as unanchored shopping centers and industrial properties.
There are a number of factors weighing down the recovery of the CRE middle market.

First, while the recession has officially ended and many larger companies have returned to business as usual, most middle-market companies remain in a recessionary mindset. The National Federation of Independent Businesses’ optimism index is still deep in the trough it hit the bottom of in 2009. In August, only 21 percent of survey respondents said they were planning on making capital outlays in the next three to six months.

Second, it continues to be extremely challenging to finance CRE purchases with conventional debt financing. Total outstanding loan balances tied to Chicago-area properties are now nearly 40 percent lower than they were at their peak in 2008, according to Trepp, LLC. The minimal debt financing that is available for CRE is targeted to the larger, stabilized properties that fall outside of the middle market. Meanwhile, local and regional banks catering to the middle market are still working through challenges with their existing CRE portfolios. These banks had a greater percentage of their money tied up in CRE, so the return to a normalized lending environment will take longer for them.

Finally, there continues to be a lack of investor appetite for middle-market commercial real estate properties. Most available capital is focused on either the stabilized core properties or the enticing opportunities available in the distressed market. Investors are concerned about the fundamentals of buying properties with non-credit tenants, and have little opportunity to leverage their purchases with debt financing.

The Reset Button

Until this year, the “extend and pretend” policies of lenders and special servicers created a dearth of transaction activity in the CRE market. However, a new trend emerged this year with banks more actively disposing of notes and REO properties, initiating foreclosures and appointing receivers. Banks are proactively dealing with properties that have languished over the last several years and now require active management. This is a positive sign for the market; we are dealing with the challenges and have begun the process of hitting the “reset” button.

There is no question that the market has experienced major improvements compared to 2009 and 2010. Certain segments of the market have even returned to pre-recession levels. However, we are still in the early to middle innings of a “reset” of the overall commercial real estate market. The middle market, which was most adversely affected by the great recession, continues its slow road to recovery, and the potholes along that road are on full display in the Chicago area, especially in the outlying suburbs and the collar counties. Until the Chicago economy improves, economic uncertainty diminishes and real estate fundamentals stabilize, Chicago’s commercial real estate market will experience continued challenges.

About the Author

Matthew Darin is a principal at Frontline Real Estate Partners, a real estate consulting and advisory firm, and managing director at MorrisAnderson, a leading financial and operational advisory firm specializing in insolvency services. Darin earned dual bachelor’s degrees in accounting and business administration – management information systems from the University of Illinois – Urbana-Champaign, graduating with honors. He is a Certified Public Accountant and a licensed Real Estate Salesperson in the State of Illinois. Darin can be reached at