By Jeff Mulder, Colliers International Chicago
By now, we all know that the COVID-19 pandemic has wreaked havoc across the world, affecting life as we knew it in the most unexpected ways. Our business, the business of office space, has been hit hard as companies almost instantly deferred or canceled real estate decisions and switched to work-from-home. The average occupancy of buildings in Chicago’s central business district (CBD) is currently 8.2 percent, according to the Building Owners and Managers Association.
One year in, and corporations are still trying to determine the best path forward and what that will look like. But evidence of change, and some signs of what the future will look like, are slowly coming into focus.
One noteworthy and reliable data point is sublease space. Colliers research reports that in the 20-plus-year history of Chicago’s office market, vacant sublease space offerings rise and peak within two to four quarters following major financial crises like the 2002 Tech Wreck and the 2009 Great Financial Crisis.
Following these trends, current sublease space offerings in Chicago’s CBD have more than doubled since March 2020. Typically in the past, tenants in the market quickly absorbed sublease spaces that were offered — usually within two quarters following peak vacancy. In this current cycle however, sublease vacancy is not expected to be absorbed at the same or similar speed as past recoveries. Based on the nature of most recent market interruption, where we were physically frozen in place, the rise of sublease vacancy in this cycle may lag several quarters behind historical trends and may not taper off until the second quarter.
Demand, critical to any recovery, is still down by more than 50 percent as of year-end 2020. While there are office requirements starting to resurface, including headquarters clients of ours, the majority of tenants looking for space today are smaller-sized and opportunistic in nature.
The demand side of the equation is currently split into three segments: smaller opportunistic tenants looking for existing conditions at below-market rates; mid-size tenants rethinking their back-to-work strategy; and larger organizations taking a wait-and-see approach to the market. Some are more concerned than others about liability exposure, which is also impacting their return-to-work decision making.
Softness in the market has created opportunities for tenants not seen in a decade. Today, there are 315 sublease spaces in 139 buildings in the CBD. While this accounts for just under 4 percent of the total available space, what is important to highlight is the quality of these opportunities. Colliers research reports that the CBD sublease average rate is just under $30 per square foot.
A year ago, the spaces that were available at this rate were second- or third-generation spaces that typically attracted tenants that were highly focused on cost with little regard for quality. This has changed drastically. Many of the spaces available for sublease today are new, and in some cases, have never been occupied.
The takeaway? By subleasing one of these newly built plug-and-play spaces, an opportunistic tenant in today’s market can avoid millions of dollars in upfront capital costs and still receive below-market rental terms that we haven’t seen in years. The true beneficiaries of this environment will be those who exercise first mover advantage.
On the investment side of the business, Real Capital Analytics recently reported tens of billions of dollars’ worth of troubled or potentially troubled loans in hotel and retail assets. Likely hearing these statistics in the news, we have had clients inquire about purchasing office buildings in and around Chicago’s CBD to leverage favorable financing and “buy the dip.” It’s a sound strategy but for current market conditions. While the tenant leasing market is very soft and tenant-favorable, landlords today are far more financially stable than in past downturns and therefore we expect to see fewer buying opportunities than in years past.
There are opportunities, however, such as 555 West Monroe, where the State of Illinois purchased a 430,000-square-foot, empty building with move-in ready conditions at a price below replacement costs. The opportunity was available because speculative developers had trouble underwriting the lease-up due to uncertain timing and income projections.
These examples are likely to be more of an exception to the rule, however, as the past downturn caused lenders to tighten their requirements resulting in landlords being far better equipped to weather a storm. Office delinquencies are on the downtrend nationally and we expect Chicago will follow suit.
While the future is murky at best, we are beginning to see light at the end of the tunnel, which is led largely by the vaccine rollout. We continue to hear from clients and prospects that they are excited to get back to the office when the time is right. But companies and workers still need to solve for the commute conundrum as health and safety remain a top priority in everyone’s return-to-work plan.
Jeff Mulder serves as executive vice president with Colliers International Chicago. This article originally appeared in the March 2021 issue of Heartland Real Estate Business magazine.