Wednesday, September 6, 2017

Zombies say: start building a downtown Cleveland office tower soon

Based on market trends, including a big chunk of zombie
office space, it's time to build a large amount of new office
inventory in downtown Cleveland. The new inventory could
be anchored by a major tenant such as with the $450 million,
1.1 million-square-foot, 32-story Northwestern Mutual Life
tower now  under construction in downtown Milwaukee.
(PHOTO: Milwaukee Business News)
In the movies, zombies can't put two words together. In Cleveland real estate development, they are sharing a subtle yet compelling message of encouragement.

Zombies in downtown Cleveland are former office buildings awaiting renovation with significant portions of them due to be converted to non-office uses, usually residential and occasionally hotel. Some of them will retain some office uses. But the portion of these buildings due to be converted is the zombie portion. It's a zombie because it's no longer being marketed as an office property. It's dead as an office building, but won't be demolished. It's coming back to life.

So what are these zombies saying? "Start building a large amount of new office inventory in downtown Cleveland."

Why? Because the rule of thumb in real estate development is that, when an office market's vacancy drops below 10 percent and rents are rising, it can support a speculative new office building.

Downtown Cleveland (referred to as the Central Business District or "CBD" in real estate reports) in 2017 has more than 19 million square feet of office space, according to major real estate firms Colliers International and Newmark Grubb Knight Frank (NGKF). That 19+ million square feet is the total among all office classes -- Class A (highest quality spaces with above-average rents), Class B (average office space with average rents) and Class C (lowest quality spaces with below-average rents).

By the way, the Cleveland CBD office inventory exceeds the total suburban office inventory of 17 million square feet, a fact that many people may not realize.

NGKF Vice Chairman Terry Coyne said the zombie office inventory in the CBD is huge, measuring more than 1.28 million square feet, with 827,553 square feet in Class B and 452,692 in Class C. Downtown Cleveland’s zombie properties include some or all space within each of the following:

  • Standard Building
  • Leader Building
  • 75 Public Square
  • Garfield Building
  • Halle Building
  • Former Cleveland Athletic Club
  • 925 Euclid Avenue
  • Superior Lofts
  • Tower at Erieview
  • Terminal Tower
  • 3101 Euclid Avenue

"Zombie space adversely impacts the vacancy rate of the Class B and Class C CBD markets," Coyne wrote in a recent document he calls his Zombie Placemat. "The amount of vacant and available space in the CBD is overstated when the zombie properties are included."

The Class B CBD market has 24 percent vacancy. But when the zombie property space is removed from the data, the Class B vacancy rate declines to 18.2 percent. Similarly, Class C CBD market vacancy drops from 22.4 percent to 15.4 percent when the zombie properties are removed, the report notes.

And when figured into the total downtown office inventory -- including all three classes -- the overall CBD market vacancy drops from 17.5 percent to 12.6 percent.

NGKF wrote in its most recent report that, year over year, the overall Cleveland (CBD and suburban) "office market vacancy was down a hefty 140 basis points from 17.8 percent in second-quarter 2016. In fact, second-quarter 2017's 16.4 percent vacancy rate marked the lowest vacancy percentage the office market has seen since third-quarter 2001, when it dipped to 15.6 percent."

Furthermore, NGKF notes the CBD once again paced the market in terms of rental rate, both in terms of increases and highest rent. In the Greater Cleveland market, average asking rent rose $0.18 per square foot from $17.88/SF in first-quarter 2017 to $18.06/SF. Downtown, the average rent now sits at $19.20/SF, up $0.37/SF from first-quarter 2017. The Class A average asking rent in the CBD increased by $0.50/SF, coming in at $22.50/SF.

If the office market continues to support growing rents and available space tightens at current rates, CBD vacancy could drop to or below 10 percent in just two years. Considering it takes 18-24 months to build a significant new office building in downtown Cleveland, now would be a good time for a real estate developer or two to get a project or two rolling.