Twin Cities Commercial Office Market Poised To Rebound

• Vacancy rates decline in four of seven submarkets, although overall market absorption numbers for 2^nd half still negative

• Tenants taking advantage of soft conditions to move up in property class

• Marketwide return to positive absorption seen for 2004

For the first time in two years, all signs are pointing to the beginning of a multi-year recovery in the Twin Cities multi-tenant commercial office market. Vacancy rates declined in 4 of 7 markets, and over the same period of time overall demand for space expanded into positive territory in five submarkets – including the two largest submarkets, the Minneapolis Central Business District (CBD) and the Southwest submarket. Without the negative absorption in two submarkets – the St. Paul CBD and the Northwest – the market would be showing positive absorption for the first time since 2001. Most promising is the 311,589 sq. ft. of positive absorption in Class A space across the market.

Although overall demand continues to be somewhat flat and rental rates are continuing to weaken in buildings with vacancy in virtually all submarkets, the overall feeling among seasoned observers is that the beginning of the market recovery is just around the corner.

Rising Vacancy Rates Have Run Out Of Steam

Certainly there is ample evidence in the end-of-year numbers to support the landlord case for guarded optimism, such as the dramatic reduction in negative absorption between the first and second halves of the year. Overall second half absorption was negative 204,980 sq. ft. compared with negative 654,473 sq. ft. in the first half of the year. The annual total of negative absorption is 859,453 sq. ft., while still painful to landlords, was less than half the negative 1,800,000 sq. ft. recorded in 2002. By taking out downtown St. Paul’s negative absorption of 490,344 sq. ft., the market would have shown positive absorption, leading us to conclude that real demand – in five of seven submarkets - is slowly returning to the multi-tenant market.

The market-wide vacancy rate is also beginning to lose some of its upward momentum, inching up just one half percent over the past six months to 18.9% from the mid-year rate of 18.4%. Available sublease space remained steady at just less than

1,900,000 sq. ft.  The overall combined vacancy rate for direct and sublease space is at 21.6% at year-end.

Falling Rental Rates Entice Tenants To Upgrade

Conditions remained favorable for tenants, with almost 13 million sq. ft. of vacant space on the market. Rental rates continued to decline during the second half, although the curve is flattening as many landlords are now increasing their use of concessions such as free rent in lieu of lowering their net rates. The average net rental rate in the Twin Cities is now $11.68 per square foot, compared to $11.91 per square foot at mid-year.

Many tenants are taking advantage of lower rates and abundant space options to upgrade to better space, including a movement from Class B to Class A space. Second half metro-wide absorption figures reflect this trend: absorption of Class A space was positive at 311,589 sq. ft. versus negative absorption of 564,559 sq. ft. for Class B space.

Without the burst of corporate consolidation that led to newly-vacated space in the St. Paul Central Business District, the overall vacancy rates for the Twin Cities office market actually would have declined in the second half. Of the three markets that experienced an increase in vacancy for the second half, the St. Paul CBD experienced the most dramatic increase in vacancy rates, from 20.1%/21.2% at mid-year to 26.8%/29% at year-end. Corporate consolidation by US Bancorp and Conseco drove the vacancy rate higher.

Positive Absorption Returns To Minneapolis Central Business District

Vacancy in the Minneapolis CBD dropped just slightly, from 20.2%/23.7% at mid-year to 20.1%/23.1% at year-end. More significantly, the Minneapolis CBD showed positive absorption of 122,515 sq. ft. over the second half – including 179,275 sq. ft. of positive absorption among Class A properties – versus negative first half absorption of 494,292 sq. ft.

The southwest submarket edged out of negative territory by posting strong demand for Class A space, resulting in overall positive absorption of 5,025 sq. ft. Vacancy in that submarket also declined slightly to 17%/19.6%, versus the mid-year rate of 17.3%/20.4%.  While Class B and C space is still under pressure, it appears that the large hole in the “Golden Triangle” in Eden Prairie is beginning to fill in.

Several key transactions helped reduce the West submarket vacancy rate, from 17.9%/20.4% at mid-year to 16.6%/20.1%. Second half absorption was positive at 94,817 sq. ft. In the Northwest submarket, continued strong demand for Class A space – particularly in the Maple Grove area – was offset by declining strength in the Class B and C markets. Overall absorption turned to a negative 29,406 sq. ft., versus positive first half growth of 40,796 sq. ft.

Landlords in the South/Airport submarket reported positive overall absorption of 90,956 sq. ft. for the second half and positive 121,914 sq. ft. for the year. Ongoing challenges at one particular property – Metro Office Park -- contributed 3% of the total vacancy in the submarket, which stood at 14%/16.6% at year-end versus 16.1%/18.6% at mid-year.

In the Northeast submarket, demand for space is keeping vacancy rates well below the market average in the Midway area while landlords in other areas such as Roseville continue to struggle to maintain current occupancy levels. Overall vacancy increased from 13.5%/14.3% at mid-year to 13.8%/16.1% at year-end.

THE OUTLOOK

It is still too early to project a full recovery in demand for office space in 2004, but the market is definitely regaining enough of its momentum to project a modest amount of positive absorption in the range of 500,000 sq. ft. for the region. Although the vacancy rates may drift lower in some submarkets, tenants will continue to enjoy an abundance of options for space in the coming year. That in turn will lead to further downward pressure on rental rates until the supply of space is returned to more moderate levels. The trend by some companies to outsource traditional office jobs to overseas markets is of growing concern to real estate professionals in the Twin Cities and elsewhere, as those jobs are needed to fill office space here as well.

Developers are certainly looking ahead to the next phase of growth in the market. More than 5 million sq. ft. of new projects are in the planning stage, however we certainly don’t anticipate any meaningful speculative office development to start for several years, as only 105,000 sq. ft. of new construction is scheduled for delivery in 2004.