CRE in the COVID Era

Commercial real estate is typically a company’s second or third largest expense to payroll and materials. Yet, never in the twenty years that I have been a commercial real estate broker has space been on the mind of almost every single business owner and CEO.  In the last 7 months, I have seen corporate leaders make a myriad of mistakes that have cost their companies significant dollars and negotiating leverage. Herein I will discuss the current and future Chicago cre market and how to best position your company to buy low, sell high, and ensure you are getting the most out of your space while spending the least. Having completed over $1B in cre transactions in my career and being named by Crain’s as Chicago’s Top Commercial Real Estate Broker, I will also share insights into what other users of commercial space are doing and planning for, the do’s and don’ts of approaching your landlord to garner free rent or a lease restructure, and how to safely return to the work space. 

State of the current Chicago office market

As of the end of Q3 2020, an additional 3M rentable square feet (rsf) of office sublease space exists on the Chicago market for a total of 9M rsf. This is the largest amount of available sublease space in Chicago’s history. 6M rsf of new office development has recently broken ground, and 3.8M of that space is still available. The vacancy rate has climbed to 12.9%, which is the highest rate we’ve seen since 2014. Conversely, rental rate growth has dropped to .5% year over year, the lowest level since Q4 2009. Class A space is averaging almost $38 per square foot (psf); Class B is averaging $23.50 psf and Class C is averaging $19 psf.

How the current market compares historically

While it sounds like a lot of space has been added to the market, there is a total of over 500M rsf of space and almost 210M rsf of office space in the downtown market. That is less than 1% of added vacancy due to the available subleases. The 6M rsf of new development represents 1% of total inventory. The 3.8M rsf that has not been pre leased represents less than 1% of total inventory. At the height of the last two economic expansions, the vacancy rates dipped as low as 7%-8% for downtown office space. At the depth of the last two recessions, the vacancy rate climbed to as high as 17%-18%. Equilibrium, considered the point where neither the landlord nor the tenant has a clear advantage, is 12.5%. We are not too far from that equilibrium point right now. 

It’s important to understand that currently, rental rate growth is slowing. While it is predicted to start declining in mid 2021, we have not seen direct landlords dropping their rates much at all. What we have seen is additional concessions offered, such as more free rent and more tenant improvement allowances. Yes, there are many subleases on the market, but it needs to be understood that for example if you are seeking 5,000 rsf with a law firm build out and between 3-5 years of term in the central loop, no other sublease without those specific criteria will work for you. As another example, Groupon’s 150,000 rsf of space only works for those who need at least 75,000 rsf and up and are willing to be located in that area of the city. 

Jones Lang LaSalle recently reported that over the next 36 months, the vacancy rate will increase by 10% across all asset classes across the United States due to companies going out of business, downsizing, and implementing a more flexible work from home policy that does not require everyone to be in the office every day. Yet they also predict a 10% increase in demand due to economic growth and change in office density. Twenty years ago when I started in cre, the average number of square feet per person across all industries in downtown office space was 470 rsf per person. Fast forward to right before the pandemic, that density had dropped to 190 rsf per person. It is expected that the density will increase again with new space designs taking into account health and wellness protocols. 

How are retail & industrial sectors doing? 

Retail is certainly struggling the most of any sector right now, as people are changing their spending habits and online shopping has dramatically risen. Retail vacancy rate is climbing and overall market rents have dropped 2% over the last 12 months. The Chicagoland area has seen over 100 retail stores be named for closure since the beginning of the pandemic and an additional 100 are anticipated for over the next 12 months. This trend will continue to put downward pressure on a sector that was already facing some headwinds. That said, experiential retail has absorbed over 500,000 rsf of space in the last 12 months and medical uses are also on the rise. The situation is not as dire as one might think seeing the vacancies, but current market conditions will continue to force retailers to close, increasing vacancies and decreasing rents. 

Unlike retail, the industrial sector overall remains strong. Industrial has experienced almost 14M rsf of absorption in the last 12 months, fueled in part by Amazon’s acquisition of 7M rsf in 2020 alone, bringing it’s Chicagoland total occupied to over 15M rsf. Despite the fact that there has been almost 21M rsf in new construction in the last 12 months, the industrial sector still maintains a very low vacancy rate of 6%. Furthermore, rental rates have grown 4% over the last year in this sector, and that is expected to continue. The increasing growth for the industrial sector will continue to be fueled by accelerated shift to e-commerce.  

Buying versus selling

Trends with commercial acquisition and disposition is heavily dependent on location, the type of property, and how it’s priced. Chicago office has picked up investment activity in the 6 months since the pandemic. With office cre, we’ve seen $2.5B change hands over the last 12 months. 

The industrial sector has seen $4.6B in sales volume over the last 12 months and purchases prices rose 2.8% over that time. While the sector was coming off a record setting first quarter, and cooled considerably in Q2, there is currently a lot of activity with national and international buyers looking to Chicagoland’s assets, especially those properties with good credit tenants. 

As expected, retail has been met with caution from both lenders and investors alike. The demand is certainly strongest for single tenant, triple net leases. However, activity is slowing as sales volume failed to hit $400M in the second quarter for the first time since 2012. There will always be demand for properties with strong credit tenants, but there is definitely some caution being felt in this sector. 

What are business owners doing?

Out of the close to 250 business owners I have personally spoken to since the pandemic began, only two have said they plan to never come back to the office. To put that into context, one of them was already going out of business prior to the shut down and the other already had one foot out the door. My clients and colleagues are instead thinking about how to return to the office safely, when can they return to the office and what will the office will need to look like going forward. 

Currently, many business owners are seeking ways to secure free rent. This includes rent deferral, as well as negotiating lease restructures. Other business owners are seeking ways to terminate their existing leases with the plan to return when the market has softened and negotiate more favorable terms. I have not personally spoken to any business owners who office downtown but are now saying they’d like to move to the suburbs due to Covid, or vice versa. The reason we have had a huge migration of corporations from the suburbs to the city in the last few years is so employers could be near their talent, customers, and vendors, as well as dining and entertainment. Those reasons will not change.

Business owners have traditionally sought a centralized location where their employees can collaborate, share ideas and knowledge transfer to the younger generation, build the company’s culture, and build a sense of team and relationships that breeds employee loyalty. Since the pandemic began, business owners are finding that while their employees are productive, there is no team building, collaboration is more difficult, and there is little transfer of knowledge between senior and junior team members.

Since mid March, for every client I have that is downsizing or looking to shed space, I have the same amount of clients that are growing and seeking additional space. The big difference right now is that our sublease listings are getting little to no traffic. In addition, many of my clients are struggling to plan for the long term and therefore executing shorter term leases, taking a wait-and-see approach with both the pandemic and the election. I anticipate a wave of activity post-election, regardless of the outcome, and an even greater wave of activity once an effective vaccine is announced. 

How can you take advantage of the current market conditions?  

There are several ways you can go about taking advantage of the current market conditions. The first is trying to secure free rent from your landlord. It is standard procedure in the post-covid era for landlords to offer rent deferment. Be prepared to show your financials comparing last year to now. You will need to show financial hardship. You should also be prepared to show you’ve applied for and received a PPP loan. Occasionally we have seen landlords offering a few half months of rent and/or a small amount of rent abated with little to nothing in return. However, more often than not you will need to offer something in order to receive the free rent, such as added term in the form of the same number of months at the end of your lease. 

Another venue we are helping many clients to pursue is to resturcture their current lease. Should your business have a need to grow or downsize, or alternatively, be within three years of lease expiration, there is an opportunity to restructure your existing lease. I would only suggest exploring this option if your size needs have changed and/or you really need the free rent. We call the strategy a blend and extend. You blend your current rental rate down by adding term to your lease. 

One final option that some businesses are choosing right now is simply terminating their lease. It certainly depends on your situation but there can be opportunities to terminate a lease. This is dependent on many factors, including the financial situation of your company, the language of your lease, the performance of its duties by the landlord, as well as risk tolerance. That being said, I am not an attorney, and should you be considering terminating your lease, I highly recommend you speak to a qualified real estate attorney.

Best practices for returning to the workplace safely

Over the last several months, I’ve compiled what I believe are some of the most relevant and easy-to-implement ideas for safely returning to the workplace. These include shifts to utilize all office entrances, installing thermal temperature testing at entrances, installing hand sanitizing stations, applying antimicrobial paint or replacing surfaces with antimicrobial properties, providing coat/belongings check areas to reduce the spread of germs, elimination of waiting areas, setting up one way traffic patterns, increasing social distancing in common spaces & reducing seating in these areas, and installing  plexiglass dividers between cubes & tight workspaces. Even minor updates such as these can go a long way in improving quality of the work place and enabling your personnel to feel safe as they return to the office.