Chicago Metro Area

Second Quarter 2008

SALES SLOWING, BUYERS FINDING OPPORTUNITIES IN SUBURBS
After a solid performance in 2007, office fundamentals in Chicago began to soften in the first half of this year due to a cooling local economy. For the first time in five years, the metro’s office-using industries are forecast to trim payrolls, driven largely by cutbacks among housing-related financial firms. This downturn is anticipated to be short-lived, however, and the area’s office market is projected to make a relatively quick recovery. Suburban areas will be hardest hit this year, particularly the Northwest Suburbs submarket, where many smaller mortgage companies have closed in recent quarters. This trend, coupled with heavy speculative construction in the suburbs, will place upward pressure on suburban vacancy through 2009. The CBD office market, on the other hand, is relatively insulated from housing-related weakness, and fundamentals in the area are anticipated to remain healthy this year. Absorption downtown is forecast to keep pace with additions this year, but increased deliveries in 2009 may lead to higher vacancy going forward. The gap between buyers’ and sellers’ price expectations is slowing sales activity throughout the metro area, with most of the deceleration being recorded in the suburbs. Buyers have been increasingly reticent to enter the suburban office market because of weakening fundamentals; however, well-located, well-designed assets, particularly those in the west and southwest employment corridors, will continue to garner interest. Investors with market knowledge and elevated risk tolerance are seeking value-add properties in the Northwest Suburbs and O’Hare submarkets, where cap rates are in the low- to mid-8 percent range. These areas offer convenient access to key arterial routes and have below-market rents, creating upside potential. Opportunities to add value are rarer in the CBD, as the area consists primarily of Class A space. These trophy assets, which have cap rates in the low- to mid-6 percent range, attract institutional buyers. The small number of Class B/C offerings recently sold in the CBD have posted initial yields in the low-7 percent range.

2008 ANNUAL OFFICE FORECAST
0.1% decrease in total employment

Employment: Roughly 5,000 jobs are forecast to be cut in Chicago this year, a modest 0.1 percent reduction that follows a gain of 0.5 percent in 2007. Office-using sectors are projected to eliminate approximately 1,300 spots for a contraction of 0.1 percent.

2.6 million square feet will be completed

Construction: Completions are expected to reach nearly 2.6 million square feet in 2008, adding 1.1 percent to inventory. Last year, new construction totaled 1.2 million square feet, all of which was in the suburbs.

100 basis point increase in vacancy

Vacancy: Reduced demand, driven by losses in the financial industries, is forecast to push vacancy up 100 basis points to 16.4 percent by year-end 2008. Weakening employment conditions in the suburbs will account for most of this increase, as the CBD remains relatively healthy.

2.9% increase in asking rents

Rents: Decreasing occupancy will lead to slower rent growth this year. Asking rents are forecast to finish the year at $27.35 per square foot, rising 2.9 percent, while effective rents gain 1.9 percent to $22.39 per square foot. Last year, asking and effective growth was 4.2 percent and 5.3 percent, respectively.

ECONOMY
6%
Year-over-Year Change

Employment Trends
Nonfarm Office-Using

Job growth in Chicago has slowed to 0.5 percent during the past year with the addition of 24,000 employees, down from a gain of 43,000 positions in the previous 12-month period. Expansion in the professional and business services sector did not completely offset losses in the financial activities segment. As such, office-using employment has contracted by 0.3 percent, or nearly 3,000 employees, over the last 12 months. In the second quarter, several financial services companies throughout the metro, including Wachovia, Freddie Mac and Bank of America, announced job cuts. Early estimates have total losses in these businesses at around 1,200 positions. Office-using employment growth in Lake and Kenosha counties has outpaced the rest of the metro. Roughly 2,000 new jobs have been added to the areas during the past year, a 1.9 percent increase. The portion of the metro that includes Gary, Ind., did not fare as well, with payrolls in the region’s office-using industries remaining flat over the last 12 months. Outlook: Roughly 5,000 jobs are forecast to be cut in Chicago this year, a modest 0.1 percent reduction that follows a gain of 0.5 percent in 2007. Office-using sectors are projected to eliminate approximately 1,300 spots for a contraction of 0.1 percent.

4%

2% 0% -2%

04

05

06

07

08*

* Forecast Sources: Marcus & Millichap Research Services, BLS, Economy.com

Office Completions
4
Millions of Square Feet

City Suburban

3 2 1 0

CONSTRUCTION
CITY

No new office space has come online in the CBD over the past 12 months, although construction activity has accelerated recently. Builders have 4.5 million square feet under way downtown. The largest project slated for arrival this year is the first phase of Joseph Freed & Associates’ 400,000-square foot Block 37 development. The project is more than 80 percent pre-leased and is scheduled to be completed during the fourth quarter. Outlook: Developers are on pace to add nearly 780,000 square feet of office space in the CBD this year. Deliveries are expected to accelerate in the coming years, as 3.7 million square feet is scheduled for completion in 2009 and more than 8.6 million square feet is planned. Some projects could be delayed, however, if the economy continues to cool.

04

05

06

07

08*

* Forecast Sources: Marcus & Millichap Research Services, Reis

Vacancy Rate Trends
24% 20%
Vacancy Rate

City Suburban

SUBURBAN

16% 12%

Despite minor stock reductions from conversions or adaptive reuse, suburban office stock has increased by approximately 1.5 million square feet year over year, up 57 percent from the preceding 12 months. The West submarket, along the I-88 Corridor is anticipated to receive the majority of this year’s deliveries, as well as one of the metro’s largest projects, the 235,000-square foot Orchard Corridor Office Park. This area is slowly becoming an employment hub; developers have an additional 2.9 million square feet in the planning pipeline for the submarket. Outlook: Builders are expected to complete more than 1.8 million square feet of office space in the suburban submarkets this year, following the delivery of 1.3 million square feet in 2007.
Marcus & Millichap

8%

04

05

06

07

08*

* Forecast Sources: Marcus & Millichap Research Services, Reis

page 2

Office Research Report

VACANCY AND RENTS
CITY

Year-over-Year Change

Steady absorption in the city core has improved vacancy in the CBD by 170 basis points to 13 percent over the past 12 months. Vacancy in the Class A sector has declined 200 basis points to 12.6 percent, while vacancy among Class B/C properties has fallen 110 basis points to 13.6 percent. Asking rents climbed 3.8 percent during the last year to an estimated $30.69 per square foot in the second quarter, while effective rents gained 4.7 percent to $25.69 per square foot. Outlook: As slowing employment growth limits expansion plans downtown, vacancy is expected to rise 90 basis points to 13 percent by year-end 2008. As a result, asking and effective rent gains are forecast to slow to a still-healthy 3.3 percent and 2.4 percent, respectively.

6% 4% 2% 0% -2%

Asking Rent Trends
City Suburban

04

05

06

07

08*

* Forecast Sources: Marcus & Millichap Research Services, Reis

SUBURBAN

The average vacancy rate in the suburban submarkets has risen 80 basis points during the past year to 19.3 percent. The area’s Class A properties recorded a 30 basis point year-over-year uptick in vacancy to 20.1 percent, while vacancy in Class B/C product increased 90 basis points to 19 percent.

Sales Trends

Median Price per Square Foot

Over the last 12 months, asking rents in the suburbs have advanced 3.4 percent to $22.89 per square foot, while effective rents have gained 2.7 percent to $18.40 per square foot. Outlook: While tenant demand is expected to grow going forward, supply additions will place upward pressure on suburban vacancy rates through 2008. Vacancy in the suburbs is forecast to reach 20.1 percent this year, 110 basis points higher than the rate at year-end 2007. Asking and effective rents are anticipated to rise 2.2 percent and 1.1 percent, respectively.

$180 $160 $140 $120 $100

City Suburban

04

05

06

07

08*

SALES TRENDS**
CITY

* Trailing 12-Month Period Sources: Marcus & Millichap Research Services, CoStar Group, Inc., RCA

Fewer office listings in the CBD have pushed transaction velocity down 19 percent during the most recent 12-month period. Demand remains strong for city office assets, keeping the median price relatively stable at $158 per square foot for the past two years. Cap rates have risen over the last 12 months to the high-6 percent to low-7 percent range.

Medical Office Vacancy

Vacancy Rate

Outlook: Sales activity in the CBD will be heavily dependent on past operating fundamentals and lease terms. Healthy investor interest will persist but may be hampered by reduced offerings this year, placing mild downward pressure on cap rates.

14% 12% 10% 8% 6%

Metro Area United States

SUBURBAN

Transaction velocity in the suburban submarkets has decelerated 13 percent year over year, as investors have shown increased wariness over office-using employment prospects. The area’s median price has increased 2.4 percent to $137 per square foot during the last 12 months. Outlook: With cap rates increasing, owners may be inclined to list properties to take advantage of current pricing. Local buyers are expected to intensify their interest in high-growth areas like the West submarket.

04

05

06

07

08*

* 2Q Estimate Sources: Marcus & Millichap Research Services, CoStar Group, Inc.

** Data reflect a full 12-month period, calculated on a trailing 12-month basis by quarter.

Marcus & Millichap

Office Research Report

page 3

CAPITAL MARKETS
BY WILLIAM E. HUGHES, SENIOR VICE PRESIDENT, MARCUS & MILLICHAP CAPITAL CORPORATION

Alan L. Pontius Senior Vice President, National Director National Office and Industrial Properties Group Tel: (415) 963-3000 apontius@marcusmillichap.com

The Federal Reserve held the fed funds rate at 2 percent during its June meeting. The Fed had cut the rate by 275 basis points since last September, but the potential for inflation stemming from elevated food and energy prices remains a concern. Office mortgage originations in the first quarter were down 75 percent from one year earlier and 21 percent below the previous quarter. Much of the decline was driven by conduits, which recorded a 96 percent year-over-year decrease in originations. Lenders remain cautious, resulting in lower loan-to-values (LTVs) and higher debt-service coverage ratios (DSCRs). On average, LTVs are at 60 percent to 70 percent, while DSCRs are 1.20x to 1.30x. Portfolio lender spreads for office properties are currently 175 to 250 basis points over 10-year swaps. Several major conduits are talking about re-entering the market in the second half, but pricing is the immediate barrier to coming back into the market. The yield on the 10-year Treasury rose to 4.2 percent in June but has since dropped to 4 percent. Through the rest of this year, the yield on the 10-year Treasury is expected to remain in the high-3 percent to mid-4 percent range.

Prepared and edited by

Josh Gisselquist
Research Associate Research Services Tel: (602) 952-9669 jgisselquist@marcusmillichap.com For information on national office trends, contact

John Chang
National Research Manager Tel: (602) 952-9669 john.chang@marcusmillichap.com Chicago Office:

Greg LaBerge
Sales Manager glaberge@marcusmillichap.com 8750 W. Bryn Mawr Avenue, Suite 650 Chicago, Illinois 60631 Tel: (773) 867-1500 Fax: (773) 867-1510 Chicago Downtown Office:

CITY SUBMARKET VACANCY RANKING
Rank
1 2 3 4 5

Submarket
City North City West River North West Loop Central Loop

Vacancy Rate
5.2% 7.6% 10.5% 11.1% 13.3%

Y-O-Y Basis Point Change
70 -50 -80 -220 -290

Effective Rents (psf)
$17.04 $15.99 $21.56 $29.33 $25.51

Y-O-Y % Change
0.6% 0.8% 2.2% 9.9% 5.7%

John Przybyla
Regional Manager jprzybyla@marcusmillichap.com 333 W. Wacker Drive, Suite 200 Chicago, Illinois 60606 Tel: (312) 327-5400 Fax: (312) 327-5410 Oak Brook Office:

Tim Rios
Regional Manager trios@marcusmillichap.com One Mid America Plaza, Suite 200 Oakbrook Terrace, Illinois 60181 Tel: (630) 570-2200 Fax: (630) 570-2210

SUBURBAN SUBMARKET VACANCY RANKING
Rank
1 2 3 4 5

Submarket
North Southwest South Loop West Northwest Suburbs

Vacancy Rate
13.2% 20.0% 20.4% 20.9% 21.2%

Y-O-Y Basis Point Change
0 290 400 140 50

Effective Rents (psf)
$19.66 $13.95 $23.32 $17.67 $17.76

Y-O-Y % Change
2.9% -1.8% 1.9% -1.4% 0.9%

Price: $150
© Marcus & Millichap 2008 www.MarcusMillichap.com

Notes: Employment growth is calculated using seasonally adjusted quarterly averages. Construction, rent and vacancy figures exclude build-to-suit, flex-space and medical office properties unless otherwise noted.
The information contained in this report was obtained from sources deemed to be reliable. Every effort was made to obtain accurate and complete information; however, no representation, warranty or guarantee, express or implied, may be made as to the accuracy or reliability of the information contained herein. Sources: Marcus & Millichap Research Services, Bureau of Labor Statistics, CoStar Group, Inc., Economy.com, Property & Portfolio Research, Real Capital Analytics, Reis, Torto Wheaton Research Services.

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