The Twin Cities commercial real estate market remained under duress in the first half of 2010 as vacancy and absorption numbers continued their downward slide amid ongoing uncertainty in the larger economy. However, the pace of decline has slowed and activity levels are starting to improve.

Vacancy rates in the office, industrial and retail markets are at their highest level in 20 years or more, and most segments of the market continue to report negative absorption:

• Office: 19.9%/22.8% vacancy, negative 209,000 sq. ft. absorption in the first half of 2010, versus year-end 2009 vacancy of 19.6%/22.3% and negative absorption of 867,000 sq. ft.
   
• Industrial: 16.7%/19.3% vacancy, negative 492,000 sq. ft. absorption in the first half; year-end 2009 showed 15.8%/18.1% vacancy, negative 308,000 sq. ft. absorption.
   
• Retail: vacancy rates of 10.2%/11.5%, negative 8,900 sq. ft. absorption in the first half; year-end 2009: 10.1%/11.4% vacancy, negative 479,000 sq. ft. absorption.
   
• Medical Office: 11.5%/12.2% vacancy, 3,700 sq. ft. positive absorption in the first half; year-end 2009: 10.8%/11.5% vacancy, 118,000 sq. ft. positive absorption.

Investment activity was muted as well, despite some loosening in the credit markets. Opportunistic investors are still waiting for a wave of distressed properties to manifest. Much of the distressed product coming to market is priced higher than what buyers are willing to pay.

Opportunistic buyers are having more success in the land market. Residential land began trading again late in the first half as national homebuilders took down some of the existing inventory of finished residential lots in select metro communities such as Plymouth, Maple Grove, Chanhassen, Chaska and Woodbury. The homebuilders are buying to build moderately priced single-family homes, and some are paying 50 cents on the dollar or less compared with the pricing of three or four years ago for the land.

Activity Levels Improving
More space users are probing the office and industrial space markets, but the increased activity has not yet resulted in any substantial increase in volume for direct space transactions. A majority of first-half office transactions were renewals, often for less space and/or at more favorable terms. More retailers are under pressure to change their footprint to help adapt to market conditions, forcing some to consider downsizing strategies.

Moving costs—always a barrier to relocation—are being offset by higher concessions and lower rental rates, making relocation more of an attractive option for office and industrial users. Industrial users, including manufacturers who may have expanded somewhat inefficiently in their current location, are now considering moving if they can achieve greater efficiencies in a new building.

Developers Breaking Little New Ground in 2010
At least existing landlords won’t be competing against new multi-tenant product for a while. New construction is at a standstill in the multi-tenant office and industrial markets. Medical office is slightly more active, with 360,000 sq. ft. of new product under construction. Just 290,000 sq. ft. of new retail space is under construction, including a 200,000-sq.-ft. redevelopment of a Menards in Eden Prairie.

Most new development in the industrial, office and retail markets is user-driven and occurring at in-fill locations in first- and second-ring communities. A few large corporate users are also putting up new buildings, such as the $120 million office building that United Health Group is constructing on its Minnetonka campus.

Multi-family is the one area that continues to see both healthy investor interest and steady growth in new product. Investor demand for high-end apartment complexes is as strong as in 2006-07. Government agencies and municipalities are helping provide liquidity for new product, both market-rate and affordable. Apartment vacancies are declining as well.

On the Horizon: More Hard Sailing Ahead
The real estate markets will continue to face strong headwinds over the next six to 12 months, with rental rates under downward pressure and more distressed property sales. Space users will be more opportunistic in their leasing decisions, which will keep the heat on landlords.

The market will need to see private-sector job creation and a significant improvement in consumer confidence to create a sustainable recovery in retail sales and demand for space.

Several large office space users are close to making decisions on their future space, including two federal GSA requirements involving 500,000 sq. ft. of space in the South/Airport and/or Southwest submarkets and some professional service firms in the Minneapolis CBD. US Bank has signed a lease for 340,000 sq. ft. at Meridian Crossings for its St. Paul operations center. 

Expect continued downward pressure on rental rates in all but the multi-family market. Landlords will battle fiercely to attract and retain tenants, even in the previously unscathed Nicollet Mall office building corridor in the Minneapolis CBD where a number of large space leases are due to expire in the next couple of years.

If this recovery follows the pattern established by previous major setbacks (such as in the early 1990s), a number of factors will soon come into play. First and foremost, rental rates will be under additional downward pressure—the office and industrial markets are already seeing that—for an extended period of time. Landlords can read that as today’s deal will be better than tomorrow’s.

Second, more distressed property selling will also contribute to negative rate pressure. New owners, buying at lower price points, will be better positioned to profit at lower rental rates than those owners who purchased properties—or built new ones—during the pre-recession boom.

And third, even as activity returns to the market, absorption rates will remain low as many tenants will continue to right-size their space needs to account for lower employee counts and slower economic growth.

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DISCLAIMER 
The Compass report, published since 1997, is created by NorthMarq experts using Twin Cities commercial property data from the first six months of 2010. The data used for this report has been obtained from sources which we deem reliable. While every effort has been made to report accurate data, NorthMarq cannot guarantee the accuracy of this market report. Furthermore, we cannot assume responsibility for any omission of data which may occur. It is our intent to provide the best possible information regarding the office, industrial, land, retail, multi-family and investment markets while leaving the reader the responsibility of further verification before using this report for business and/or financial decisions.

This report includes information for multi-tenant office, industrial and retail projects greater than 20,000 sq. ft. and multi-family for-rent properties. Not included are owner-occupied, government or single-tenant buildings. Not all information and insights we’ve collected can be published in any given volume.