Office Market Will Decline Through 2010

MB Real Estate's May 2009 market report shows that sublease space is playing a large role in market troubles, having reached 3.5 million square feet - a number predicted to grow further. Vacancy including sublease space is currently around 15.3%, rapidly approaching the 16.5% vacancy rate the market saw when the dot com bubble burst around 2001. Meanwhile, Chicago's 12.2% vacancy rate, not including sublease space, has surpassed that of 2001, when vacancy was 11.4%.

"As long as this economy continues, the sublease market is going to continue to grow, evidenced by the unemployment rate and we're at the start of seeing vacancy really shoot up," says Andy Davidson, EVP with MB. "Users' space needs are going to shrink, and groups are going to be trying to renegotiate leases and giving space back early, so you're going to see those numbers start taking effect."

Davidson believes vacancy will increase for the next few years, citing the 11 million square feet delivered in the past decade, which saw negative absorption around 2001 and dramatic positive absorption in 2006 and 2007. "It's hard for me to look at the economy and say we're going to have numbers like 2006 or 2007 that are going to turn this thing around in a V-shape," Davidson says.

An additional 3.5 million square feet will be delivered this year at 155 N. Wacker, 300 N. LaSalle and 353 N. Clark. Marcus & Millichap's data shows that strong activity at each of these developments, now around 80% preleased on average, will also lighten the blow they'll deliver to the market. "This is the largest annual delivery in more than a decade," says John Abuja, VP of investments at Marcus & Millichap. "What's happening is that there's going to be an elevated amount of sublease space added when businesses relocate from other locations to these new buildings, and as a result, rents are forecast to recede."

Marcus & Millichap anticipates that by the close of 2009, asking rents will have declined 4.1% to $26.20 per square foot and net effective rents 6.6% to $20.97 per square foot, as compared to year-end 2008. The firm says vacancy is climbing at an increasing velocity, projecting vacancy to climb to 19.9% by year-end, up 380 basis points this year, as compared to a 70-basis-point growth in 2008.

"The effects of the recession were slower to hit Chicago than most of the other major markets around the rest of the country," Abuja says. "As we see supply increasing and demand decelerating, we're seeing a lot of companies trading up into class A office space for the same money they were paying for class B space. Another new phenomenon we're seeing is suburban companies looking to relocate back into the city, because the aggressive young talent want to live in the city and the high-profile, high-power recruiting firms want to attract the best and brightest labor."

Abuja says a silver lining is that the down market presents unique investments for buyers, with the greatest opportunities in the Central and East Loop, where sublease space is the highest. "The good news for those looking to buy is that these dynamics are going to allow investors to acquire downtown office assets at prices well below peak valuation," Abuja says. "The amount of wealth created for investors in this next cycle on transactions in the next 12 months is going to be dramatic."

Abuja foresees a recovery sooner than some others, forecasting a stabilization as soon as the 3.5 million square feet delivering this year is absorbed, which he predicts will be accomplished by 2010. "I feel good about the Chicago market and it'll turn around quickly," Abuja says. "The strong suit of Chicago has been and continues to be that we're really not overbuilt and supply really is close to demand."