Midwest experts forecast six commercial real estate trends in 2020

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Throughout 2019, the U.S. commercial real estate market held strong despite ongoing talk of a possible recession, tariff wars and concerns over the future of property valuations and construction costs. While the industry anticipates similar headwinds in 2020, most commercial real estate experts remain generally optimistic, according to a 2020 CRE outlook by Deloitte.

“Some economists feel a recession will come eventually, and that’s being factored into the equation in deals across the country when it comes to pricing,” said Steven Weinstock, first vice-president and regional manager of Marcus & Millichaps Chicago Oak Brook office. “But I think it’s too early to ask where the fire engines will be. In Chicago, for example, we still have a large number of construction cranes. The central business district continues to attract leading employers and the young talent they are looking to hire. For many investors, the Midwest has become the preferred place for safe bets, offering better returns than those available in many coastal markets.”

In the Chicago area, developers are moving full speed ahead on a number of high-profile mixed-use projects. Somerset Development has tapped Wight & Company to reimagine the traditional suburban office campus with Bell Works Chicagoland, a mixed-use “metroburb” on a 250-acre site that formerly housed AT&T’s headquarters.

In the heart of downtown, Related Midwest, the Chicago office of Related Companies, has started infrastructure work for The 78, a 62-acre mixed-use neighborhood development along a half-mile stretch of the Chicago River in the South Loop. The project continues the southern expansion of the city’s central business district by adding 4 million sq. ft. of office space and a world-class interdisciplinary research center known as Discovery Partners Institute (DPI).

As firms forge ahead with new deals and developments, here are six trends that will impact commercial real estate in 2020, according to some of the industry’s leading Midwest experts.

Recession-proofing 101

There’s been plenty of talk among economists and real estate experts about a possible recession. Yet with the stock market climbing to an all-time high, strong consumer spending and better-than-expected job gains, those fears have started to ease – at least temporarily. But that hasn’t kept real estate investors from taking steps to shield their portfolios from a slowdown, even if a full-blown recession isn’t on the immediate horizon.

“Buyers and borrowers are saying this is a good environment to be working in – the cost of capital is cheap and that should continue to fuel transactions,” said David Bradley, regional manager of Marcus & Millichap’s Chicago Downtown office. “However, one day there will be a recession. And as painful as the last one was, it taught the industry some valuable lessons that are informing the decisions being made today.”

Marcus & Millichap is advising some of its office, retail and industrial clients – particularly those who are holding assets for the long term – to consider flexibility when restructuring existing leases, a strategy that may include lowering rates, extending terms or some combination of both. “Investors are also being mindful of portfolio diversification as they look to enter new asset classes or geographic markets,” noted Bradley.

Structured Development, known for its pioneering retail and loft office projects, has shifted its focus to mixed-use and opportunistic investments such as District Brew Yards in Chicago’s West Town neighborhood, the country’s first brewery collective with a pour-your-own beer hall. And the addition of rental housing to larger developments like NEWCITY, Structured’s 1 million-sq. ft mixed-use complex in Chicago’s Lincoln Park neighborhood, reflects the intentional diversification that developers will continue to pursue in 2020.

“To build for the long term, we must first focus on market segments that are long lasting,” said Jeff Berta, senior director of real estate for Structured Development. “For example, market-rate rentals seem to have staying power over for-sale condominiums, and they’re especially resilient given that they fulfill a basic need – housing – that transcends economic cycles. We also make sure buildings have flexibility for multiple uses in case initial tenants don’t work out. And we diversify by assets, type of tenants, geography and more.”

In order to keep their portfolios healthy, some investors are turning to healthcare real estate, a sector whose growth has been fueled by the country’s aging population and passage of the Affordable Care Act. “In 2020, look for more clinics and outpatient facilities to make their way to Main Street locations that, historically, have been dominated by retail,” said John Wilson, president of HSA PrimeCare. “A key difference between the two is that healthcare is less susceptible to broader shifts in the economy.”

1333 S. Wabash; Chicago, IL; CMK Companies; Darris Lee Harris Job#1363

“The possibility of a recession is contemplated in current underwriting,” said b, senior vice-president of investments at The Habitat Company. While market and asset class diversification can help insulate an investor from an economic downturn, can underwriting withstand potential downward sensitivities? “Understanding what transpires if unit renovation premiums fall short, market rent growth wanes or a future refinancing is compromised can help guide the upfront structure and execution strategy,” Sullivan said.

Smart investors also will prepare for a potential recession by reducing debt or taking advantage of the low interest rate environment through a refinance, according to Rob Bond, president of Bond Companies. He also recommends increasing cash reserves to cover any unanticipated expenses at the property level. “Improving your cash position will help investors weather any downturn, offering stability for both the property and its owners,” Bond added.

Show me the ESG

The adoption of environmental, social and governance (ESG) policies is having a profound impact upon the real estate industry, as more investors seek out socially responsible deals and commercial tenants opt to lease space in buildings whose design and operation align with their own corporate objectives.

According to John Mlade, senior project manager of sustainable and healthy environments at Wight & Company, healthy building certifications like WELL, from the International WELL Building Institute, are drawing interest from building owners, property managers and tenants alike as companies become more committed to addressing ESG principles. These certifications involve standardized performance criteria that can be monitored and measured for impact on a building’s occupants, providing metrics that can demonstrate a company’s commitment to ESG goals.

“Measurement is so critical in the ESG framework, which is why companies are playing closer attention to healthy building certifications,” said Mlade, who is certified in WELL, Living Future and LEED. “Because of its focus on the building itself, LEED addresses some of the environmental aspects of ESG, whereas WELL, which is people-driven, considers metrics that would more closely align with social and governance criteria. All of this shows the important role real estate plays in helping companies achieve their goals for sustainability and corporate social responsibility.”

“Passive” office amenities

Which amenities do corporate tenants really want? While new office buildings have taken a page from the multifamily and hospitality sectors by introducing expansive fitness centers, game rooms and lounge areas, it’s the amenities that may not be visible during a property tour that will have the biggest impact in 2020 and beyond.

“More companies are asking for spaces that best support their employees and the work they do, not necessarily offices with the flashiest or most surprising amenities,” said Janet Lougee, vice-president and director of interiors at Wight & Company, which recently designed a new downtown Chicago headquarters for Legacy.com. “With the Legacy.com offices, we placed open workspaces and common areas near windows to maximize exposure to natural light. Whereas previous corner offices would have been reserved for the C-suite, they are now occupied by spaces like the Legacy.com Café, allowing all employees to enjoy city views in a relaxed social setting.”

Connectivity to the outdoors is also an intentional design feature at Fulton East, a 90,000-sq. ft. office building under development in Chicago’s Fulton Market District. Surrounded by low-rise landmarked structures, the development is rich in natural light and abundant “breathing room” with floor-to-ceiling windows, as well as spacious balconies on each floor and an 8,000-sq. ft. rooftop garden park for outdoor meetings and social functions.

“With research supporting that access to elements like natural light, fresh air and green space are valuable to employees’ health and well-being, office design is becoming increasingly impacted,” said Fulton East developer Bob Wislow. “That’s certainly the case at Fulton East, where tenants will enjoy amenities that help their employees seamlessly incorporate wellness into their daily routines by taking meetings on a balcony, hosting employee events or client presentations on the rooftop park, or walking to one of the neighborhood’s many restaurants.”

According to Larry Bond, chairman of Bond Companies, today’s employers are more conscious than ever about how connections with nature support employee health and performance. At Second Home Hollywood, a 2-acre co-working campus in East Hollywood, Calif., Bond modeled individual office suites after LA’s famous bungalow court residences. These 60 pod-like workspaces are connected by meandering pathways surrounded by nearly 6,500 trees and plants. Exterior walls of curved, transparent acrylic, with windows that open, allow for fresh air and views of the property’s lush landscaping.

“The beauty of these offices is that they don’t feel like an office,” said Bond. “By bringing the outdoors in, tenants are awash in natural light and surrounded by nature. This is precisely the type of work environment that engaged companies are seeking, yet frankly doesn’t exist anywhere else in the U.S.”

800 Fulton, a 19-story, 450,000-sq. ft. office/retail building under construction in Chicago’s Fulton Market District and leased by Cushman & Wakefield, is another office development that promotes connectivity with the outdoors, featuring a unique stair-step design that permits large terraces and green space on many floors, as well as a rooftop garden. But that isn’t the only connection that matters. In addition to being designed for LEED Platinum and WELL Silver certification, the development is expected to achieve WiredScore’s Wired Platinum designation, which recognizes the highest level of internet connectivity and has been shown to increase rents, based on research from CoStar Portfolio Strategy.

“We saw significant interest in 800 Fulton even before its groundbreaking, and that’s partially due to its forward-thinking design, which considers not only how companies operate today, but also the infrastructure they will need in the future,” said Jack McKinney Jr., a managing director in the Chicago office of Cushman & Wakefield who is handling leasing for the development.

Another overlooked amenity that has become increasingly important to office users: attentive property management.

“The property manager can be a significant value-add, particularly for remote owners who may be in a different part of the country but want to ensure a good experience for tenants,” said David Petersen, CEO of NAI Hiffman. “In the past, a property manager may have just been expected to ‘keep costs down and the building clean.’ But the race for talent has expanded the property’s manager’s role in both the city and suburbs. Now, he or she is expected to be very hands-on, not only ensuring a building is properly maintained and operated, but also delivering concierge-level service to occupants, similar to what you would experience in a hotel or residential building. Today, it’s the speed of the concierge response that differentiates one property management company from another.”

Highest and best use?

The legalization of recreational marijuana on the state level has created a “green rush” among commercial real estate firms looking to tap into the fast-growing industry while navigating regulatory hurdles associated with a substance that is still illegal under federal law. The industrial sector in particular is poised to benefit from the need for cultivation and growing facilities, which often are located in converted warehouse space.

Commercial general contractor Englewood Construction, which has collaborated with cannabis firms on dispensary and cultivation facility projects across the country, says this industry is leading to a new pipeline of construction work – both in building facilities, as well as retrofitting existing commercial space to grow, distribute and dispense cannabis product.

Chuck Taylor, director of operations for Englewood Construction, noted that because the industry is still in its infancy, cannabis-related projects require flexibility and careful scheduling from a construction and development standpoint. “These projects don’t follow the typical progression because cannabis firms frequently move forward with construction planning while they are still pursuing licensing in order to be up and running when legalization goes into effect,” he said. “The review and approval process is also much more in-depth, since many municipalities are still interpreting new state laws and deciding what regulations they’ll add at the local level. While the rules vary from state to state, it’s helpful for our clients that we’ve worked on cannabis projects in multiple markets, so we can anticipate questions or issues that are likely to arise at the municipal level.”

Financing is another challenge that assets with cannabis tenants face, according to Matt Wurtzebach, senior vice-president in the Commercial Finance Group of Draper and Kramer, Incorporated.

“Currently, financial institutions under the purview of federal regulators, such as nationally chartered banks, life insurance companies, CMBS lenders and others, may not finance properties with cannabis tenants,” Wurtzebach said. “In many cases, this includes tenants that serve the industry without touching the product.”

The conflict between state and federal law has also led to some post-closing challenges, particularly on new lease review and approvals, Wurtzebach added. In response, some lenders are starting to change loan documents and lease forms to spell out any cannabis tenant restrictions. Prospective borrowers can turn to debt funds and some state-chartered banks, but each has different requirements and may also prohibit such uses.

House meets warehouse

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Proximity to labor has always been a key consideration for industrial developers. And while robotics, drones and autonomous trucking have revolutionized the way goods are manufactured, stored and distributed – in some cases, assuming roles once filled by people – supply chain automation has made human labor more important than ever. As e-commerce and logistics companies seek out talent with the skills needed to keep operations running smoothly, they’re paying close attention to not only where facilities are located, but also how they’re designed.

“Automation is dramatically changing the face of the industrial workforce,” said David Friedland, executive director and Chicago Industrial Group leader at Cushman & Wakefield. “By 2025, it’s expected that 10-15% of all manufacturing, transportation and storage, and retail jobs may be replaced by automation. Today’s automated plant is driving the need for upskilling at the very time there is a decreasing and aging workforce. Employers need industrial and warehouse space that will attract employees and encourage them to stay – in some markets, this may include on-site amenities, nearby restaurants and the like.”

Industrial developers agree that while there’s a definitive shift to automation, warehouse jobs will never be eliminated. In fact, workers are logging more time on commutes to travel where warehouses are popping up.

“Today’s e-commerce customer expects near-immediate delivery, so warehouses are being developed closer to population centers than ever before,” said Robert Smietana, vice-chairman and CEO of HSA Commercial Real Estate. “An emerging labor trend tied to this expansion is that qualified warehouse workers are willing to follow the jobs for the best opportunities – even if they have to travel longer distances.”

In some cases, industrial and retail uses are coexisting in the same developments. CA Industrial, the industrial investment and development division of CA Ventures, recently broke ground on CA Elk Grove, a 146,029-sq. ft. speculative Class A warehouse in Elk Grove Village, Ill., near several expressways and O’Hare International Airport. The new warehouse is being built on the majority of an existing retail center, with a portion – 7,800 sq. ft. – remaining as retail and restaurants.

“CA Elk Grove shows how, in today’s market, location isn’t just about how close you are to roadways and infrastructure,” said Michael Podboy, president of CA Industrial. “There’s a greater emphasis on the environment we are creating to help tenants attract and retain employees. And as a company that develops and operates across asset classes, we understand the experiential nature of real estate and how it applies to industrial. Even with vacancy at record lows, the build-it-and-they-will-come philosophy doesn’t work. But build it right, and they will come faster.

It’s no secret that homeowners are tapping their home equity due to low interest rates – according to the Mortgage Bankers Association, nearly 60% of mortgages originated as of Nov. 15 were for refinances. And, going into 2020, commercial property owners are doing the same as they look to pull out equity while avoiding a sale that would require them to pay capital gains taxes or redeploy proceeds before they’re ready to commit to a new deal.

Although the Mortgage Bankers Association doesn’t specifically track cash-out refinances on commercial properties, it did note in November that the low interest rates are causing strong levels of commercial and multifamily borrowing. In fact, in the third quarter of 2019, the dollar volume of loans for healthcare properties saw a 239% year-over-year increase, while industrial, office and multifamily dollar volumes rose 42%, 36% and 16%, respectively. Collective volume was up 24% over third-quarter 2018.

“Many investors across the country are capitalizing on the low interest rate environment by doing cash-out refinances – a move that often allows them to lock in a lower rate and pocket the difference between the original loan and new loan, which will be higher upon property stabilization,” said Cushman and Wakefield executive managing director Jeff Altenau, who leads the firm’s Equity, Debt & Structured Finance team in the Midwest. “We’re seeing this in both urban and suburban submarkets, and across asset classes, especially in cases where owners are unable to achieve their desired sale price.”

According to Oakbrook Terrace-based NAI Hiffman, cash-out refinances have been an increasingly popular strategy among owners of office buildings in Chicago’s suburbs, where occupancy rates have been under pressure as firms have migrated to the city. As of September 2019, year-to-date refinancing volume exceeded $750 million for suburban Chicago office properties, compared with less than $500 million for all of 2018.

“Attractive interest rates and the ability to redeploy equity into other investments, or into the existing asset as a means of generating increased rents, have made refinancing very attractive to owners of larger office properties in Chicago’s suburbs,” said Art Burrows, senior vice-president at NAI Hiffman. “In Cook County, where commercial landlords are waiting to see how much property taxes will rise as the newly elected assessor adjusts historically low valuations, the decision to refinance allows owners to hold onto their assets until there’s more certainty on what those tax bills will ultimately be. That clarity, along with increased appetite for suburban office space, may allow owners to achieve a higher sale price down the road.”

This story was provided by TaylorJohnson, a public relations agency.

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