Twin Cities retail real estate market still vibrant Office, industrial vacancies probably peaked Low interest rates fuel active investor market The first half of 2003 again shows a booming retail real estate market. With vacancy for all retail property types topping out at 5.3% -- a decrease from the 6.1% rate at mid-year 2002 -- retailers, developers and brokers are responding to the latest trends in lifestyle centers, fast casual dining and grocery anchored centers. United Properties believes vacancy rates have peaked for office and industrial space in the Twin Cities, and remains optimistic about the continuing prosperity of the region’s retail and medical office real estate markets. More than 2.8 million square feet of retail space is currently under construction, with 2.1 million square feet scheduled to open this calendar year. Virtually all growth is occurring in community centers (1.9 million square feet) and grocery-anchored neighborhood shopping centers (373,000 square feet). Office and industrial markets continue to be challenged, as vacancy takes one more slide to the bottom.  But optimism is creeping back into the Twin Cities with the reduction of available subleases and creative reuses for existing industrial space. Activity for many brokers in those Twin Cities’ sectors has come from business owners trying to take advantage of low interest rates by purchasing property for their business’s operations rather than leasing it. Grocery Store Wars Heating Up In Twin Cities The grocery store segment will be worth watching in the coming months, as the recent sale of 30 Rainbow Foods stores to Roundy’s brings another very good operator into the Twin Cities. A renewed Rainbow brand, plus the possible entrance of another national chain, could mean significant competitive pressure for established Twin Cities grocers. Specialty Retailers React to Consumer Behavior Fast-casual Dining Away From Regional Malls Retailers have been quick to spot and capitalize on some significant changes in consumer behavior in the Twin Cities. For example, a number of specialty retailers such as Talbots, Abercrombie & Fitch, Banana Republic, Williams Sonoma, Brooks Brothers, Ann Taylor, Coldwater Creek and J Jill are foregoing their traditional home bases in regional malls for locations in lifestyle centers and “town center” developments, such as Maple Grove’s The Shoppes of Arbor Lakes, which will open in September. National fast-casual dining chains are entering the Twin Cities in explosive numbers. Several other major retail segments are also growing rapidly, both through the expansion of retailers already in the market and through the entrance of several key regional and national players seeking to capitalize on the buying power and appetite of Twin Cities consumers. Office, Industrial Markets Continue Along Bumpy Road The vacancy rate in the office market increased to 18.4%, 21.1% including sublease space, from year-end 2002 levels of 17% and 20.5%, respectively. In the Minneapolis Central Business District (CBD), vacancy increased more than 2%, to 20.2/23.7% from Dec. 2002. Vacancy in the St. Paul CBD was flat at 20.1/21.1% compared to year-end. However, the rate of the increase in sublease space on the market is slowing — a sign that the worst of the 30-month downturn in the office market may be at hand. Overall sublease space in the office market shrank to 1.8 million square feet, lower than the 2.4 million square feet of sublease space available at year-end 2002. In the Minneapolis CBD, sublease space declined 35% over the last six months to 900,000 square feet. Vacancy in the Southwest submarket climbed to 17.3/20.4% at mid-year, compared to 14.7/18.3% at year-end 2002. Real estate professionals anticipate the addition of 160,000 square feet of office space in the second half of the year through corporate consolidation of Best Buy Company. High vacancy rates continue to pressure office rental rates, which stand at an average of $11.89 per square foot today compared to $12.56 per square foot at year-end 2002. High levels of concessions are also reducing landlord returns. Vacancy among Twin Cities’ industrial properties also increased to 15.9/17.8% at mid-year versus 14.6/17.6% at year-end 2002. Absorption declined to negative (1,035,866) square feet after showing a positive gain of 405,866 square feet in the second half of 2002. Bulk warehouseproperties fared the best with 97,838 square feet of absorption, primarily due to several significant leases in the Northwest submarket. Leverage-Driven Investors Spur Active Investor Market Access to low-interest-rate capital is fueling a surge in real estate investment activity by smaller, leverage-driven investors who through the use of leverage can outbid many institutional buyers such as pension funds and real estate investment trusts (REITS). A good supply of for-sale options, brought to market by failed manufacturing companies, and low interest rates are making the prospect of buying versus leasing an attractive option for a number of industrial companies. Low interest rates have helped many commercial property owners weather the downturn, enabling them to refinance real estate holdings and lower ongoing costs. Pricing has remained relatively high, although below peak levels, for well-leased and maintained office and industrial properties. The investment market is increasingly polarized, however, as investors are significantly discounting properties with more substantial vacancies and other challenges. Investor demand for multi-family properties also remains high in spite of weakening fundamentals, with some buyers purchasing properties today based on an anticipated early recovery for the apartment market. Vacancy in the apartment market declined slightly to 6.5% versus 6.6% six months ago. However, this rate is expected to move higher as new construction will deliver more than 3,000 new apartment units to the market this year. Medical Groups See More Benefits To Off-Campus Locations; Woodwinds Health Campus Creating Medical Corridor In Woodbury Demand for off-campus medical office space continues to grow in the Twin Cities, most notably in fast-growing suburban areas such as Maple Grove, Burnsville/Lakeville, Woodbury and Lake Elmo and in major medical corridors such as the Fairview-Southdale Hospital/France Avenue corridor in Edina An emerging medical corridor is taking shape in Woodbury, in the vicinity of HealthEast Care Systems’ and Children’s Hospitals and Clinics’ Woodwinds Health Campus. A variety of healthcare organizations are jockeying for position in the northwest suburban region, especially along the I-94 corridor through Maple Grove and continuing west toward St. Cloud. Consumer spending is still strong enough to support growth in retail real estate demand, especially in outer-ring suburbs where the population growth is strongest. Several major national and regional retailers, including another grocery chain, are actively seeking to enter and/or expand in the Twin Cities area in anticipation of the next wave of economic expansion in the area. New development in the lifestyle center and open air power center arenas, including the planned September opening of The Shoppes of Arbor Lakes in Maple Grove, will also buoy the retail market in the future. THE OUTLOOK  Healthy demand for retail real estate will continue into the foreseeable future. Consumer spending is still strong enough to support growth in retail real estate demand, especially in outer-ring suburbs where the population growth is strongest. Several major national and regional retailers, including another grocery chain, are actively seeking to enter and/or expand in the Twin Cities area in anticipation of the next wave of economic expansion in the area. New development in the lifestyle center and open air power center arenas, including the planned September opening of The Shoppes of Arbor Lakes in Maple Grove, will fuel the retail market in the future. Relatively anemic growth in the national economy, combined with gains in productivity, is restraining employers from adding the jobs needed to rekindle demand for office and industrial space. Even though the office and industrial markets have probably peaked in terms of rising vacancy rates, flat demand will continue to put downward pressure on rental rates for the balance of the year. Corporate consolidation has resulted in several major companies seeking to convert some larger single-tenant buildings into multitenant office and industrial properties, especially in the “Golden Triangle” area in the Southwest submarket. Adding these buildings, which were not originally designed for multitenant use, will likely negatively affect absorption numbers over the next six months. Commercial real estate investors may find the Twin Cities market offers above-average potential over the next 12 to 18 months, as the space markets in office and industrial tighten. Much will depend on how quickly the overall Twin Cities job market returns and how robust that job recovery becomes.  Because the Twin Cities remains poised for strong recovery, due to the variety and depth of industries represented here, it is likely that the real estate picture turns much rosier in the next 12-18 months.