High Vacancy Means It's A Tenant's Market, So Why Are Rents Staying The Same?

It isn't easy being a tenant representative these days. The downtown office market has a historically high vacancy rate, and with so many workers still plugging away on their computers at home, the Central Business District remains underpopulated on workdays. That has led many tenants on the hunt for new office space to expect lease deals more affordable than pre-pandemic days, when the market was tight and demand kept escalating.

But it isn't like that. Although the top-line statistics on vacancy would normally foster a tenant's market, rental rates have been stubborn, staying roughly in place since the onset of the coronavirus. And those expecting great deals sometimes have to adjust those expectations.

“It can be frustrating and confusing to tenants,” Cresa Chicago Senior Vice President Michael Marrion said.

Although many companies are still formulating their new workplace strategies, including how many employees will come back to the office and on what days of the week, many leases will still be expiring in 2022 and 2023, he added. That means deals have to get done.

It isn't necessarily a bleak picture for tenants. Landlords seem willing to give more generous tenant improvement packages and other sweeteners, and as office tenants attempt to entice workers back downtown, many are also willing to pay more if it means employees will have access to top-flight amenities.

Still, brokers need to have that conversation about rental rates.

“The quoted asking rents are still where they were two years ago,” Marrion said. “It’s difficult for people to tour an empty Loop and then hear their rents are still going up.”

According to Colliers International, the average asking rental rates for downtown Chicago in Q4 2021 stood at $42.48 per SF. That is just a slight decrease from the $42.95 recorded by Colliers for Q4 2019, when the office market looked very different. The vacancy rate then was 12.3%, and the market was seeing about 1.5M SF of quarterly absorption. By contrast, in Q4 2021, vacancy had risen to 17.9% and the market saw more than 4M SF of negative absorption during the year.

In some ways, it has been easier to be a landlord rep over the past few months, according to Telos Group Senior Vice President Nikki Kern. Her company has represented dozens of downtown landlords in lease negotiations in the past few months, and she never has to break the bad news to tenants those rents aren't headed down.

“Once they get to my side, they’ve been educated by their own brokers that that’s not the case,” she said.  

One factor sustaining rental rates are Chicago’s new, sparkling trophy assets, Marrion said. According to Colliers, in the run-up to the pandemic, more than 7M SF of new offices were under construction or planned. Buildings such as Hines’ Salesforce Tower in River North and 110 North Wacker Drive haven't had much trouble filling up their spaces, and that has boosted landlords’ confidence to hold the line on rents even as the pandemic continues.

“That’s pulled everyone up, even in average Class-A buildings,” Marrion said. 

Law firm Kirkland & Ellis agreed last year to occupy about half of Salesforce Tower, bringing it close to full occupancy, and investor Oak Hill Advisors gave a vote of confidence to the Chicago market by agreeing late last year to purchase a controlling interest in 110 North Wacker Drive, a deal valued at more than $1B, according to the Wall Street Journal.

And in Fulton Market, where developers added several millions of square feet in the past few years, landlords kept scoring deals in Q4. MoLo Solutions, a third-party logistics company in the transportation industry, signed a lease for 93K SF on the 14th and 15th floors of Shapack Partners’ 167 North Green St. and was just one of several logistics companies deciding to expand in Fulton Market.

“Fulton Market witnessed its best-ever quarter for leasing, as new development, and Class-A buildings across Downtown remain largely unaffected by the pandemic, enjoying high occupancy rates and commanding record-high rents,” according to a Q4 report by Savills.

A lot of tenants are actually eager to pay more if it means an office with better amenities, Kern said. With so many companies moving into trophy buildings, a lot of spaces have opened up in other Class-A buildings, perfect for Class-B tenants that want to trade up and lure back employees currently enjoying the comforts of home.  

“We’re not seeing a lot of tenants move in the other direction,” she said. “They are choosing the better buildings in the market and are willing to pay higher rates.”

“A detailed look into these relocations revealed that existing Chicago tenants were willing to pay 36-38% higher than their current gross lease rate for the opportunity to upgrade to a Class-A asset,” according to Colliers’ Q4 report. “Tenants relocating to Class-B were willing to pay 5-11% higher than their existing gross lease rates.”

Leasing activity is also accelerating, Colliers found. In 2020, 761 downtown office leases were signed, compared to 991 throughout last year, with 348 of those coming in Q4.

The reforms instituted to property assessment by Cook County Assessor Fritz Kaegi have also helped sustain rental rates, Marrion added. Kaegi won office in 2018 after promising single-family homeowners to put more of the tax burden on commercial properties, including office towers, and the jump in taxes meant hits to owners’ bottom lines. Tenants renewing leases and hoping to get better deals due to the high vacancy in so many buildings typically get surprised.

“The landlords are saying, ‘No, you’re at market,’” Marrion said.    

But according to Colliers, this particular pressure may be decreasing. Landlords of Class-A buildings in the West Loop, for example, did hike rents throughout much of 2021 due to county tax increases, but now that taxes have been factored in, there was a slight decrease in Q4, with rates sinking from $51.02 to $50.90 gross.

“However, the popularity of Class-A space in the West Loop will keep face rates steady,” Colliers reported.

One more barrier for tenants is the returns investors expect. Many downtown buildings were purchased when the office market was riding high before the pandemic, and the lenders financing these acquisitions couldn't know Covid-19 would knock the bottom out of the office market for several years, according to Kern.

“The owners still have to pay their mortgages, so the rental rates just have to be maintained,” she said. “Nobody is interested in devaluing their real estate by lowering rates.”

That doesn’t mean landlords aren't showing any generosity. Both Marrion and Kern said owners seem willing to boost tenant improvement packages by roughly 20% over pre-pandemic deals, funds that companies can then use to upgrade their spaces.

That is an important consideration, especially for those that need to get offices ready for returning employees, Marrion said. Still, with the pandemic also touching off a supply chain crisis, the increasing costs of construction are eating up the additional funds.   

“Over the last twelve months, costs increased 21.5% nationally and 16.1% in Chicago,” according to Mortenson Construction’s latest cost index.

Landlords have also proven more willing to provide tenants with other benefits, such as several months' free rent, if that’s what it takes to get deals done, Kern said.

“Landlords are not getting off scot-free.”