Developers brought incredible swaths of new, Class A office space to market last year, and they are on track to deliver close to the same amount in 2020. While this has led to higher vacancies in B/C assets, some investors are still drawn in by the steadiness that those buildings offer.
The Chicago market should see 4 million square feet of sparkling new office space this year, according to Marcus & Millichap data, a little short of the 4.8 million square feet that developers brought online in 2019. This space—which will increase the MSA’s office stock by nearly 1 percent—should lead to a rise in vacancies to 15.9 percent per Marcus & Millichap projections.
Of the 16 largest leases from last year that Marcus & Millichap tracked, three quarters of them were in the West Loop. The submarket is so hot that even smaller footprints in the area are drawing attention, particularly for vendors looking to get close to anchor tenants like McDonald’s and Google. This has pushed pre-leasing to 70 percent, far higher than the market average of 40 percent.
Outside of the West Loop, a number of spec office developments—the largest being Bank of America Tower, which is on schedule for a September occupancy—will elevate overall vacancy rates. Even as we get deep into this cycle, construction levels remain near the cyclical high, abridging potential backfill opportunities for buildings down the quality scale.
Investors, however, have thus far not been put off by negative absorption in Class B assets. In fact, deal flow for mid-tier properties in 2019 increased as a percentage of total transactions according to Marcus & Millichap research. This trend should endure in 2020 as stabilized, Class B properties where tenants are locked into multi-year leases will likely attract investors over value-add acquisitions. The average cap rates for these properties fall in the high-7 percent range, which attracts out-of-state capital.
There are even abundant opportunities at the extreme end of the quality spectrum. As first-year returns for Class C properties average more than 8 percent, investors (whether local or from out of state) who are more risk tolerant can find significant upside potential in the right assets.
Looking ahead, rents are expected to rise, despite the time it will take to absorb all the new office space coming online. Marcus & Millichap projects average asking rents to rise to $27.09 per square foot by year’s end, a 3.4 percent increase.
Google, Amazon, Facebook and other employers have announced headcount expansions, which should aid in absorbing new Class A space—but those new hires won’t all be in 2020. In the meantime, owner-occupiers and/or buyers who have a committed tenant in tow will seek out discounted Class B and C properties as the office investment market becomes more risk averse.