August 6, 2019 by Brian Rogal

The Chicago Conundrum: Megadevelopments Ramp Up As Investors Get More Cautious

Photo: Courtesy of Related Midwest

Investment in the city has already gone into a steep dive.

Chicago’s CBD recorded only one sale in the second quarter, Ruben Espinoza’s $22M purchase of 19 South LaSalle, bringing the year-to-date investment total to just $244M, the lowest first half total for any in two decades, according to a July report issued by MBRE.

“There are some concerns about Chicago, and mostly people are becoming cautious because of uncertainty over what’s happening with property taxes,” Waterton CEO David Schwartz said.

New Cook County Assessor Fritz Kaegi began overhauling the assessment system this year, after promising to end what many voters saw as the inscrutable way properties were valued, and eventually shift the tax burden from homeowners to commercial landlords.

“For institutional investors, these are not red lights that will stop everything, but they are at least yellow lights of caution,” Schwartz said.

The city could see a slowdown in interest, McCaffrey Interests Senior Managing Director Clayton McCaffery said. 

“The biggest threat to Chicago is all the uncertainty on taxes and especially on assessments,” he said. “People don’t know what their bills are going to be, and we have already seen assessments in Evanston that have gone up by 100%.”

“If there is some uncertainty that runs the risk of wiping out 20 to 30% of a project’s value, that’s going to give some people pause,” he said.

The fact that both Chicago and Illinois have such precarious finances also does not inspire trust, Schwartz said.

Moody’s Investors Service earlier this year called the state one of the least prepared to withstand a recession. And just as newly elected Mayor Lori Lightfoot took office in the spring, city budget officials announced the 2020 budget shortfall could hit $740M.

Marcus & Millichap Regional Manager Steven Weinstock said there have been recent improvements to state governance, and that may bolster confidence.  

“The argument you hear a lot of potential buyers make is that the state had a lot of turmoil under its last governor,” Marcus & Millichap Regional Manager Steven Weinstock said. “I just tell them to look at what our present governor is doing.”

The state got some good financial news on July 31. Citing increased revenue and the signing of a “plausible and achievable” budget for 2020 by Gov. J.B. Pritzker and the legislature, Fitch Ratings changed Illinois' outlook from negative to stable, although it didn’t adjust its low credit rating. Fitch estimates the state has about $200B in long-term liabilities, with pensions accounting for 80% of the total. 

The scale of Chicago’s future mega-communities will require massive investment. Sterling Bay said its Lincoln Yards development will cost between $5B and $6B and cover about 50 acres of former industrial land on both sides of the North Branch of the Chicago River in Bucktown and Lincoln Park, eventually holding 12M SF of buildings, including office towers and 5,000 residential units. Related Midwest’s plans for The 78 are even more ambitious and call for 13M SF on what had been a 62-acre vacant lot just south of downtown along the river’s South Branch. Both plans received city approval in the spring just before Lightfoot took office.   

Developers plan other communities that, taken together, will have as big an impact. These include Lendlease and CMK Properties’ Southbank and Riverline developments, which will rise on the river just north of The 78, and together have up to 3,700 residences, costing about $2B to develop. JDL Development’s One Chicago Square, a $850M, 76-story, 1.5M SF mixed-use tower under construction in the city’s River North submarket, is just one of the many towers set to rise over the next few years.    

Other transformative developments are also just over the horizon.   

Farpoint Development plans a massive redevelopment project at the site of the former Michael Reese Hospital on the Near South Side, and developer Landmark Properties has proposed to construct a series of skyscrapers with thousands of new residences over existing train lines adjacent to Soldier Field.

These projects will require billions of dollars of investment, a tall order in a cautious investment market.

Still, Chicago has a set of attributes that, despite everything, may attract the resources needed to fuel its expansion. 

“Both Chicago and the Midwest provide attractive returns that investors can’t get elsewhere in the country,” Weinstock said.  

As of the second quarter, the average cap rate for an apartment property in California costing above $1M is 4.6%, and in the Northeast the rate stands at 5.9%, according to a Marcus & Millichap report using data from CoStar and Real Capital Analytics. In Chicago, similar properties trade at a 7.1% cap rate.

Rates like that should protect Chicago, at least from an investor’s perspective, if the nation falls into a recession, he said.

“We have a soft landing built into our numbers. Investors here will have room to be a little bit wrong, and still get good returns, because the Midwest has a built-in flexibility whereas the East and West Coasts don’t.”

Photo: Courtesy of Torque/Eric Masi

JLL Managing Director of Research and Strategy Christian Beaudoin said Chicago builders should also approach development with confidence due to the post-recession rise of millennials, many of whom will continue looking for apartments near the downtown core.

“There is uncertainty when it comes to Chicago, related to political and fiscal concerns, but these are outweighed by the demographic shift,” he said.

The number of jobs in the Central Business District jumped to 613,000, a 28% increase since 2010, according to a capital markets overview by HFF. Using census data, the firm found almost 40% of Chicago's 25-plus-year-olds now have a bachelor’s degree, more than New York City or Los Angeles.

McCaffrey said transformation of Fulton Market from an aging industrial district just west of downtown into an office and tech center shows the potential for major expansions.

Chicago’s tech labor pool grew 10.5% since 2013, and with 166,620 workers, just surpassed Boston to become the sixth-largest tech market in the country, according to CBRE, which recently published an analysis of the nation’s top 50 tech markets. 

“Chicago has a dense talent base, and capital tends to follow,” Beaudoin said.

“The demand story is very good in Chicago, and it’s proven itself out,” Schwartz said.

The Chicago office market has absorbed about 2M SF annually for the past six years or so, he added, which shows it can handle what Sterling Bay, Related Midwest and others can build. 

The pace of Chicago development is set to increase. In the last five years ending Q3 2019, developers delivered 13.57M SF, and in the coming five years, the market is projected to deliver 19.62M SF, according to researchers from Cushman & Wakefield, who used CoStar data. 

Beaudoin doesn’t worry about the faster pace, or that the megadevelopments will work at cross-purposes by stealing each other’s investment dollars or users, as they likely will not break ground or grow at the same time.

“The reality is all of these projects will deliver over several years and even multi-decades,” he said.

McCaffrey said many other American cities like Washington, D.C., New York City and San Francisco also have giant, equity-fueled projects underway, ones that dwarf even Chicago’s grandest plans, including Related’s Hudson Yards on Manhattan’s West Side, and Amazon’s future campus in Northern Virginia.

“It’s not a surprise that all this is happening at once,” he said. “People started feeling good about the economy around the same time, and then it took several years to get projects going.”

He also feels that by joining this national wave, Chicago is just shedding some of its conservatism and finally getting started on necessary projects.

“We have had these huge swathes of land that have been sitting mostly empty for years and years, and we’ve wondered why nothing is being done there.”

Photo: Courtesy of Sterling Bay

Neither Sterling Bay nor Related Midwest would comment on the financing of their respective megaprojects, but the ability of Chicago developers to score big investments was shown last fall. JDL had been set to launch its One Chicago with Sterling Bay as a major investor, but the latter pulled out to focus its attention on Lincoln Yards and its West Loop office towers, among other projects. JDL quickly picked up Wanxiang America Real Estate, a subsidiary of a China-based company, as a new partner, and this spring, New York-based Square Mile Capital Management agreed to make a $260M investment in the project.

“We saw this as a great opportunity to provide a structured investment in a development project that is extremely promising, given the ongoing local demand for high-quality residential and retail product,” Square Mile Capital Managing Director Matt Drummond said.

“The fact that JDL was able to backfill this project so quickly after Sterling Bay pulled out validates the argument for Chicago,” Weinstock said.

But Schwartz thinks it is more likely problems could develop over the long term.

Projects like Lincoln Yards and The 78 have undergone enough planning over the years that their funding is teed up, and ready to deploy as corporate office users and multifamily tenants show up, he said. But the uncertainty that hovers over the market means getting brand-new projects of similar ambition out of the ground wouldn’t be easy.

“Starting from scratch today would be much more difficult than it was six years ago.”

This story was independently produced by Bisnow news staff. RSM was not involved in the production of this content.

UPDATE, AUGUST 6, 7 P.M. CST: Data from Cushman & Wakefield on the amount of office product developers are projected to create in the next five years was added.