Chicago Office Supply Growth
Screeches to a Halt
In 2018, new office construction was at record highs as developers met the increasing demand for sleek, amenity-rich glass and steel downtown workspaces. The pandemic put a quick stop to that trend. In 2021, supply chain disruptions delayed projects and extended timelines, even as people returned to in-person work. Now, in 2022, as the pandemic is waning, a new set of challenges are slowing office construction further—only 1.6 million s.f. are currently under construction, compared to the 7.2 million s.f. in 2018 (Exhibit 1). Hybrid work models and a volatile economic climate have shifted tenant demand and caused ground-up developers to reconsider new construction, especially amid rising costs and tighter financing conditions. A handful of projects have already been rethought (e.g. 655 W. Madison) or scrapped altogether (e.g. 850 W. Washington), and the slowdown is not limited to Chicago. Amazon recently announced plans to pause construction on six office towers across the U.S.
Exhibit 1: Total SF Under Construction
WHY IS NEW SUPPLY DECELERATING?
Exhibit 2: Producer Price Index: New Office Building Construction Costs (year-over-year % change)
3. The Federal Reserve embarks on tightening cycle, raising financing costs. The Fed is committed to beating inflation through higher interest rates, even at the risk of causing a recession. The 75 basis point increases in June and July 2022 were the biggest consecutive rake hikes since the double-digit inflation era of the 1980s. Higher borrowing costs affect both current owners and new developers. Existing landlords may recognize the importance of improving existing space to compete for tenants but using increasingly expensive debt to finance capex—all while a recession looms—is risky. Ground-up developers are also less likely to build new inventory when the costs to borrow (and construct) have increased and the market is already oversupplied.
Exhibit 3: Total SF for Sale
Exhibit 4: For Sale Asking Price PSF
HOW THE SUPPLY BALANCE REACHES EQUILIBRIUM
While there are pockets of strength in the Chicago CBD office market, risks remain over the medium term. The number of distressed assets in the CBD has been increasing alongside rising vacancy rates. Owners of dated, lower-quality buildings are under pressure as tenants prefer new, high-quality offices in in-demand locations. Declining occupancy levels for unimproved Class B and C buildings could lead to more distressed sales and foreclosures. The CBD is already seeing a selloff of lower-quality assets, as no Class A buildings traded hands during Q2, and only 2 of the 43 properties currently for sale are Class A. What’s more, several Class C office properties in the CBD have been targeted for adaptive reuse. 29 S. LaSalle and 65 E. Wacker are buildings currently being converted from office to residential; 123 W. Madison and 105 W. Adams have recently hit the market as potential targets for multifamily conversions.
Finally, active ownership is one particularly effective way to successfully navigate this market cycle. As we recently wrote, active owners willing to invest additional capital in their assets and negotiate with tenants can perform well relative to the overall market. In an environment dominated by the flight-to-quality, active owners can compete by improving their offerings.
There is enough existing product on the market to satisfy current demand, in general. Therefore, there is no need for additional supply, even though competitive pressures will favor active owners who treat tenants well and improve their assets. As the supply-demand balance moves toward equilibrium, the headline vacancy statistics may worsen in the short-run. But this weakness provides opportunities for strategic investors to enter the market at a lower basis, invest in repositioning or adapting the existing assets, and stabilize the CBD in the long run. It’s early in the process, but this transition is already underway.