With Value-Add Downtown Office, A Rising Class-A Tide Floats All Boats

There is over 4M SF of new office product coming to downtown through 2018. As larger companies lay claim to most of that footprint with new leases, opportunities are emerging for investors to buy Class-B and C office buildings, push rents and maximize the returns on their investments.

Class-B and C office buildings accounted for 81% of the $1.3B in office sales volume through the end of Q3, partially because few trophy buildings are for sale but also a sign investors recognize the potential for returns in these assets. Transwestern Executive Vice President Ryan Foran said the strength of the Class-A office market carried over to Class-B and C inventory.

International capital is looking more often at Class-B and C buildings and finding a wealth of opportunity in the East Loop, between LaSalle and Wabash streets. Those buildings were warehouses a few decades ago and converted to offices. The buildings' bones are still in solid condition, and there is a glut of space waiting to be leased or sublet.

According to MB Real Estate's Q3 CBD report, there is 3.2M SF of Class-B downtown office space available, and 1.1M SF in vacant Class-C inventory. The vacancy rate among Class-B office inventory dropped 38 basis points in Q3 to 12.63%. By comparison, the openings of 150 North Riverside and River Point contributed to Class-A vacancy increasing 2% during the quarter.

MBRE's CBD report recorded 52 tenants downtown seeking office leases of at least 50K SF. That makes the Class-B office market very landlord-friendly. And there are few opportunities for tenants to lock in sub-$30/SF rents.

"For the cheapest tenants, the best they'll be able to do is $32-$33/SF. The rents in the Class-B market are higher than historic averages, but still good for tenants seeking high-quality office space," Foran said.

For tenants playing in the Class-B and C sectors, their options to lock in the best rents are to either sublease or seek office space outside the Loop. The latter move would not be advantageous for companies seeking to attract and retain millennials who are flooding downtown seeking work. Subleases are attractive for companies because the terms are short — between one and four years, on average — and they are already built-out and ready for companies to move in. This gives companies some breathing room to determine their next steps, forecast growth rates and determine if they want to sign a longer-term lease, or hop to a new sublease.

"Either way, tenants are getting into a higher level of building product at a lower rate, and solving someone else's problem," Foran said.

The strength of the market gives landlords the upper hand in new lease negotiations, and they are upgrading offices on a space-by-space basis. Foran said new leases need to be a minimum of three to five years before a tenant will receive a TI package. Owners are investing in capital improvements like upgraded HVAC systems and spec suites to attract potential tenants.

A bigger story happening in the value-add office space is the repurposing of buildings with large floor plates into amenities packages. Foran said property managers and brokers have done great work coming up with plans to maintain the historic or landmark status of Class-B office buildings while becoming attractive to the younger workforce with the addition of bike rooms, fitness centers, food options in lobbies, lounges and conference centers.