• Demand weak in face of jobless economic recovery

• Effects of corporate consolidation beginning to ebb

• Tenant choices are abundant, but new development is at a standstill

• Unused office cubes must be filled:  Impact of shadow space looms large over office market

TWIN CITIES MARKET OVERVIEW SECOND HALF 2002  Demand for commercial office space shut off in the Twin Cities, even as the overall economy shows signs of a modest – albeit jobless – recovery. Without sustained new office jobs from the business services, finance, legal, insurance sectors, empty offices will be slow to fill. Shadow space is also a serious issue in the market.

Many companies will need to first reoccupy underutilized space currently under lease – shadow space – prior to re-entering the market for new space. Corporate space users still await evidence of sustained economic growth along with improved corporate profits before committing to new investment and hiring. 

Tenants seeking stability in uncertain economy more inclined to renew leases
The growing phenomenon of early lease renewals continued through the year. Landlords who made accommodations to current market conditions have often been able to renew existing tenants, since many corporate executives are reluctant to incur the added expense and turmoil of relocating during a time of economic uncertainty.

Quoted rates declined for first time in six years
Average quoted rental rates, now $14.60 per square foot, declined markedly for multi-tenant office space in the Twin Cities – the first time this has happened in more than six years. Anecdotal evidence indicates a continued decline in net effective rates as well. Landlords are more aggressively offering free rent, tenant improvement packages and higher broker fees to attract and retain tenants – methods that reduce the net effective rental rate.

Vacancy at 20% with sublease space
Metro-wide vacancy rates increased significantly, from 15.9% for direct space and 19.2% with sublease space included at mid-year to 17% and 20.5% respectively at year-end. Sublease space is a significant competitive factor in the Minneapolis Central Business District, where a trend by large corporate users to consolidate their space needs into single-user, corporately owned facilities has contributed to vacancy and sublease. More than 50% -- 1.3 million square feet out of a market-wide total of 2.4 million square feet -- of all available sublease space is in the Minneapolis CBD. With sublease space included, the overall vacancy rate for Class A properties in the Minneapolis CBD is 24.7%.

 Absorption numbers also continued to weaken over the second half, fading to a negative (698,268) square feet of space across all property types and submarkets. Still, it was an improvement over the first half numbers of negative (1,127,962) square feet.

THE OUTLOOK
Landlords need to prepare for another challenging year ahead. Without sustained job growth and improving economics in the business community, the outlook is for continued softness in the Twin Cities office market throughout much of 2003. For a significant reduction in the vacancy, companies will first need to occupy existing vacant cubes and offices, then absorb the sublease space before demand for new space will begin – most likely not until early 2004. Using previous recoveries as a guide, the region will need to add in excess of 25,000 new jobs to move the market back to a 10% vacancy level.

On a positive note, the supply side of the development equation seems to be well in hand. Only about 200,000 square feet of new space will be delivered in 2003, compared with 1.2 million square feet in 2002.

For tenants, 2003 may well offer the best opportunities for advantageous leasing terms for many years to come. If demand begins to recover as expected, the market will gradually absorb the existing supply of both vacant and sublease space. Any substantial new increase in supply is likely to be several years away, especially in the Minneapolis CBD where the time frame for planning and constructing a new office tower is typically three to five years.

Corporate consolidation, a driving force in the market in 2002, will become less of a factor in 2003, as most moves from multi-tenant space to corporate campuses are already underway and most related vacancy is already calculated. US Bank, Best Buy, Wells Fargo and General Mills will all complete consolidations in the coming year.