Commercial Real Estate - Let’s Make A Deal

With more commercial space available locally, maybe now’s the time to make a move.

The commercial real estate market is showing signs of recovery from its dramatic 2009 plunge, but vacancy rates are still high. “In 2008, anybody in the brokerage business was running around with their hair on fire,” remembers Mike Herl, partner and vice president of brokerage services at Inland Companies. “So many things were happening—build-outs, leases, all kinds of deals. But the brakes were put on last year, and it was amazing to see how quickly business decreased, as well as how much.”

Projects involving private industry and small business seem to have been hit hardest, with government, university, municipal and medical projects less so, although no sector was immune to the recession, observes George Gialamas, president and CEO of The Gialamas Company, Inc. “The consolidation of large companies has affected the overall market, as has less readily available financing,” he says.

Commercial office space was hard hit because of the large build-out of that space leading up to the recession, notes Geoff Vine, president of Stevens Construction Corp. “And for businesses affected by the economy, it wasn’t the time to expand or upgrade, or move to a shiny new space,” he says.

“People have been staying put or even downsizing as they’ve become more frugal,” Vine continues. “There are spaces that were full for a period of time, but now have vacancies because companies have reduced staff or closed one of their offices or reduced their space needs to address overhead cost situations.”

Blake George, a senior broker at Lee & Associates, which specializes in the industrial, retail and office sectors, confirms that while the local retail and industrial real estate markets have held up well, office space has not. “We’re seeing a lot more vacancy and there’s a lot more to come,” he says. “That includes ‘shadow vacancy,’ where a company is paying for, say, 5,000 square feet but only using 3,000. When their lease is up, they’ll lease 3,000 square feet. There’s a lot of fixed overhead in the office market.”

Better than the National Picture
Still, Gialamas says, compared to the national market, “the Madison area has been more fortunate in some ways with the university and state and federal offices located here. We haven’t been affected to the degree that other regions have.”

It also helps that local businesspeople tend not to be highly aggressive risk-takers. “I think we’re more stable and a little more conservative; we didn’t get as far out there as in some places,” says Vine. “The banks here didn’t make those risky decisions either, and banks and private developers didn’t get so far extended.

“We’re less hurt here than in other areas where things got out of control,” he adds. “Our wound will heal more quickly because it’s not as deep.”

George cites statistics from the CoStar Group, a national real estate information company. “We’ve done very, very well compared to the national numbers,” he says. “Our local industrial sector was at about 7 percent vacancy versus more than 10 percent nationally in fourth quarter 2009, and in the office market we ended 2009 at about 9 percent vacancy, where the national rate was around 13 percent.”

A combination of politics and a tight lending environment actually helped the local market. “Bankers being picky about loan approvals going into the recession was a good thing, and the fact that getting projects approved takes a ton of time in Madison actually helped keep us from overbuilding,” says George.

Light At The End Of The Tunnel
For Inland Companies, which has offices in Milwaukee and Madison and provides commercial real estate brokerage, property management, investment sales, real estate development, construction and facility maintenance services, things have picked up this year. “We’ve seen a pretty big uptick in sales transactions of $2 million or less,” reports Herl. “It’s not the big numbers we’re accustomed to seeing, but to see movement, to have people out selling, is very welcome.”

One trend he’s noticed is increased entrepreneurship, as people who have lost jobs start businesses. This is leading to more transactions in retail space and B- and C-class office space. (The Urban Land Institute defines class A space as having excellent locations, high-quality tenants and professional management; class B as having good locations, high tenant standards and little obsolescence; and class C as typically 15–25 years old with steady occupancy.)

Stevens Construction is also seeing improvement. The company is a leader in the construction of large wood-frame and concrete-frame structures, with expertise in the student living, apartment and condo, senior living, hospitality and water park markets, among others. “We’ve had more opportunities since the first of this year than in the past year and a half,” says Vine. “In 2009, people were just waiting for the year to be over. Now they’re more optimistic, and at least investigating whether they can get projects going. We’re in growth mode and are looking to hire two people in our preconstruction department to investigate the opportunities coming to us.”

Throughout the recession, Lee & Associates has remained very busy on the leasing side. “If companies can’t get capital to build, they lease,” says George. “If a new company can’t get financing it will lease, and downsizing companies are leasing as well.”

The Gialamas Company, a provider of class A commercial real estate development, brokerage, leasing and management services, continues to see new tenants move into the many buildings in its Old Sauk Trails Office Park. But Gialamas sees continued high unemployment and economic uncertainty as challenges to the market in 2010. “I’m more optimistic about 2011,” he says. George is as well. He believes data available by the end of 2010 will help to more precisely forecast where the commercial real estate market is headed. “2009 was a freefall, with nothing to compare it to, but by the end of this year we’ll know where the vacancies are, what things are selling and renting for, and whether there’s equilibrium in the market. When we see the trends, we can plan, and that’s what will give us confidence going into 2011.”

As things improve for businesses and they look for new space, they’ll likely look toward infill property and renovating existing buildings or offices. “It’s more cost-effective than starting with brand new property,” says Vine. “From the developer’s standpoint, they already have the property, and maybe the core and shell of the building, and can reconfigure space that may be vacant from the recession. They’ll try to fill their vacancies before building new structures.”

A Buyer’s Market
With the volume of commercial space available, property owners and landlords are more willing to provide incentives than in the past. Herl is seeing that on the leasing side. “A lot of the deals I’m working on involve incentives,” he says. “For strong, creditworthy tenants, I’m seeing landlords, on five-year leases, charge less and take a loss in the first two years, break even in year three, make money in years four and five, and cross their fingers that the tenant will stay another five years.
br> “Or they’ll offer free rent for a period to help offset moving costs, or do an entire build-out for a tenant,” he continues. “If they aren’t in the position to do a build-out, a landlord will often lower the rent per square foot for a few years provided the tenant does its own build-out.”

Other landlords are ramping up square footage. “Let’s say a tenant needs 3,000 square feet, but sees themselves needing 5,000 down the road,” Herl says. “A landlord may have a 5,000-square-foot space available, but doesn’t want to break it up. The landlord may give the tenant access to all 5,000 square feet, but only charge for 3,000 square feet the first year and 4,000 the next.

“Some are even saying, ‘Tell them to make me an offer,’” explains Herl. “Landlords know what they have, and brokers like me have to find out what tenants want that would make them go into a space. Then we do a proposal.”

If business owners would prefer to own their space, but can’t afford it right now, George recommends they lease it with an option and lock in the price. “Then when things get better in a couple of years they can still buy it at a good price,” he says.

“Smart landlords are renting space they’d prefer to sell, and doing non-typical things like land contracts,” he adds. “They’re also offering greater flexibility in the term [length] of leases, and are willing to wait longer for tenants—they might cut a deal now for someone who’s going to move in this summer. Before they’d have said no and taken their chances.”

Property owners are also subleasing. “Sometimes when businesses downsize, they’re on the hook for their space and need to get out from under their rental bill, so they come to us for help subleasing the space,” Herl says. “Some businesses are taking advantage of it. They may have been in class B or C space, and with all the class A space available they’re taking a step up, maybe at the same price they were paying before.”

This influx of vacant space for sublease has added a new challenge to the market, Gialamas believes. “It can create a false sense of what the real estate rental rates really need to be to sustain healthy growth, support the tax base and promote future development,” he says.

“Vacancy rates are higher than the banks would like, and there’s pressure on landlords to fill vacant space. This has influenced pricing, which in the long run may not be healthy for the tenants or the landlords that support them,” he cautions.

And even in a buyer’s market, tenants have to use common sense. “Some of them are pretty aggressive right now,” says Herl. “I’m not sure if they’ve heard stories or read about incredible deals, but I’ve seen some offers come through that are very unreasonable. Landlords may be hurting a bit, but they aren’t crazy—they won’t get themselves into a losing situation for the next five years. I’ve also seen landlords and tenants working together very nicely.”

The Space Available
Businesses have diverse choices when it comes to choosing space, among them, multiuse developments. “Development types go in phases,” Herl says. “We’ve seen urban sprawl in housing go out of favor in the Madison area, we went through a huge condo building spree, and now mixed use, with apartments upstairs and retail or offices downstairs. Municipalities like to see those.”

Sustainable, green building practices and LEED certification is another big trend. “There’s a real focus on this because businesses are looking at the long-term value of what they’re buying in a building,” says Vine. “Developers are spending some money up front to have projects meet LEED requirements because they know there will be benefits in energy savings and lower operating costs over the long haul.”

That’s a marketable commodity to prospective buyers or tenants. “Whether you’re building an office, student housing or apartments, to be able to say you’ve built it to LEED specifications is attractive to the end user and the communities you’ve built in. They know the buildings will be cost-effective and of higher quality,” Vine says.

A Regional Economy
In the coming years, many businesses filling our area’s commercial space will come from other places. “If you’re in Janesville, Milwaukee or Chicago and your business growth opportunities are few, you might look at the Madison market,” says George. “Some people see it as a threat to have outsiders coming in, but they’ll bring in new ideas and ways of doing business—we hope the old adage, ‘A rising tide floats all boats,’ applies and everyone will benefit.”

And as for now, Gialamas sums it up. “Demand is down and inventory is up, but there are still great opportunities with great companies in this area.”


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