Office N Illinois

Chicago's office market sees diverging Class A and B trends

Chicago's office market sees diverging Class A and B trends,ph1
The 50-story, 1.5 million-square-foot BMO Tower—being developed by Riverside Investment & Development and Convexity Properties, in partnership with the bank—is just one of numerous projects that will add to Chicago’s Class A office stock over the next few years.

The dynamics of downtown Chicago’s Class A and Class B office assets exhibited wholly different tracks through the first three quarters of 2019. Are there reasons to worry in the divergent trends?

According to market research data by Savills, overall Class A availability fell for the fourth consecutive quarter to 13 percent. Meanwhile, Class B availability closed the quarter at 18.1 percent, having risen for six consecutive quarters.

But according to Robert Sevim, vice chairman and co-head Chicago region at Savills, this momentum isn’t an indication of typical Class B tenants chasing cheaper rents in the suburbs or outer neighborhoods. Class A buildings, including second generation properties, tend to offer more attractive amenity packages, an important offering for those tenants—which is virtually all of them—who understand the impact they have on talent attraction and retention.

“There is a pool of users that simply want what they want,” said Sevim. “If that requires a big block of space in a new building, rather than trying to make something work in an existing occupancy, then they will go out and find that in new construction.”

Newer, Class A buildings are also more efficiently designed in terms of space flexibility. With so many office tenants rightsizing to smaller, more efficient footprints when they move, Class A offers another option that many older buildings don’t.

“The ability to do more with less is likelier in a Class A building where you have more efficient space,” Sevim said. “In addition, tenants who want to be in upgraded environments tend to find ways to figure out how to compress their occupancy needs in terms of square footage to rationalize the potential cost of a move or incrementally higher rent.”

Quality space options remained in high demand as tenants leased 2.5 million square feet of Class A space this quarter—nearly 75 percent of the total market activity. As far as location, tenants are looking west. The five largest transactions occurred in the West Loop and eight out of the largest 10 leases this quarter were in either the West Loop or Fulton Market.

These included three transactions at the redeveloped Old Post Office. Uber, Cboe Global Markets and Federal Home Loan Bank of Chicago committed to nearly 780,000 square feet combined at the 601W Companies’ ambitious redevelopment, which delivers in the fourth quarter. There are rumors that negotiations are underway for an additional 500,000-square-foot lease at the property, which could close by the end of the year.

With the coming space at the Old Post Office—as well as several ground-up office towers under development along the Chicago River—the Chicago CBD will have a lot of new options for Class A tenants. Might supply start to pull away from demand sometime next year?

Sevim points to the mild skepticism by some in 2017 and 2018 when 444 W. Lake Street, 150 N. Riverside and 151 N. Franklin all delivered within a year of each other. Though they brought more than 3 million square feet to market, they are all at or near full occupancy.

Now with new towers anchored by Bank of America, Salesforce and BMO Bank, among other projects—not to mention the continuous activity in Fulton Market—it’s natural to exhibit some apprehension for overbuilding. But all indications are that, like two years ago, those worries are likely misplaced.

“It wouldn’t surprise me if those buildings also get filled. The question is over what period of time,” said Sevim. “Are we going to see a departure from supply and demand dynamics next year? I don’t believe so. We continue to see demand for good quality product and I don’t forecast any change in that trend over the next 12 months.”

Chicago office building sales, Savills research shows, have ground to a near halt through three quarters of 2019. Through the end of August, just 17 office properties had traded this year, totaling 2.5 million square feet, with another 25 million square feet still on the market.

There remains some uncertainty about the county tax situation with a new assessor in office. However, as cost of living and other factors maintain Chicago’s attractiveness to investors, investment activity is projected to stabilize as clarity improves on real estate taxes.

“I also think there are a number of buildings that are on the market that haven’t traded but that will soon trade,” said Sevim. “So we should see an uptick in the next three months. The true comparison will be how did we do at the end of the calendar year compared to last calendar year? Also, did the trades occur at price points that were above, below or at the level that they were last year?”

While Class A availability has tightened as tenants relocate and leasing activity bustles, availabilities could soon surge as millions of square feet of shadow space may soon become available. Up to 3 million square feet is expected to be vacated in the Central Loop by 2022, which could push the submarket’s availability upwards of more than 23.0 percent.