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January 2017 
Executive Summary 

Twin Cities Multi-Tenant Market Holds Steady Course of Slow Improvement
  

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Despite pockets of surplus space in the office market, the Twin Cities multi-tenant market continued to make forward progress in the second half of 2016. The overall vacancy rate finished the year at a healthy 10.6%, and strong demand for industrial space helped give overall absorption an added boost. Although there are still some areas of the market that are flat or working to absorb excess space, rental rates have generally held firm across the board. Another positive for the market across all property types is a broad trend of renovation and redevelopment. Landlords are turning vacancies into opportunities to revitalize and reposition assets, which will provide more attractive options for tenants and help owners boost values.

Retail Remains on Solid Footing Amid Wave of Store Closures
Despite negative headlines concerning retailer bankruptcies and plans to shutter stores, the metro-wide retail vacancy rate remains at a healthy 7.7%. In some cases, the store closures are creating new opportunities in prime trade areas where space is limited. Plans are already underway to backfill vacancies created by a wide range of retailers from Sports Authority to Sears. Restaurants, coffee shops and grocers are among those sectors that still have a big appetite for expansion. Grocery wars are heating up with an increasingly crowded field of competitors. New entrants such as Fresh Thyme Farmers Market and Hy-Vee are vying for both locations and market share with a deep pool of established players, specialty grocers and discount clubs. Retail investors continue to battle a shortage of for-sale property. Grocery-anchored properties remain the most coveted property type among institutional investors with quality grocery-anchored properties trading at cap rates of 5-6.75%.

Strong Demand in Northwest Submarket Lifts Industrial Absorption
Industrial proved to have more gas in the tank to pull out a strong finish in 2016. An uptick in leasing activity in the Northwest submarket helped propel second-half absorption to 930,766 square feet (SF)—nearly double the mid-year forecast of 550,000 SF. Signs that employers are continuing to hire and expand should help keep that momentum going in the coming year. More than 1.1 million square feet (MSF) of positive absorption is predicted for the first half of 2017. Robust demand in the Northwest metro is also likely to spark build-to-suit and speculative construction in the Hwy. 610 corridor in the coming year. Building sales remained active in all submarkets, particularly in the Southwest, which saw prices rising to new highs—even for older, less-functional properties with clear heights lower than 20 feet. That situation seems likely to continue in the coming year as well-capitalized buyers keep aggressively hunting for deals in the best locations.

Office Recovery Slows Amid Stiff Headwinds
The Twin Cities office market took a step back in its recovery in the second half of 2016 with metro-wide absorption that ended the year in negative territory at -336,793 SF. However, it is important to note that the overall health of the office market is more positive than those numbers suggest. First, Wells Fargo moved out of a large block of multi-tenant space and into its own campus, causing a negative effect on absorption without the market losing jobs. Longer-term leases are more prevalent, which has contributed to an environment where there is less lease rollover and greater stability in market rents. While new development remains scarce, both downtown and suburban landlords are moving forward with major renovations that will help to fill vacancies and create added pricing power on rents. The Minneapolis CBD was ground zero for surplus space returning to the market, notably due to a handful of big moves. At the same time, Downtown Minneapolis is benefitting from a growing momentum from tenants, including the likes of Amazon, that are choosing to locate in the urban core.

Buyer Demand Outweighs Available Supply of For-Sale Property
High investor demand continues across all sectors as buyers seek higher-yielding investments in secondary markets such as the Twin Cities. Multi-family continues to shatter records in pricing and sales volume. Transactions in that sector jumped 50% to reach $1.5 billion in 2016. Despite a lack of inventory, the office market also reported a near-record year of $1.4 billion in closed transactions, thanks in part to two second-half sales—33 South Sixth-City Center and Ameriprise Financial Center. Although buyers remain discerning, there is an appetite for both high-quality, stabilized properties as well as clear value-add plays with NOI growth and upside potential. Higher interest rates will have an impact on future transactions. However, capital is expected to remain plentiful and relatively cheap compared with historical levels.

Multi-Family Sets New Records in Occupancy, Investment Sales
The multi-family sector remains white-hot with historically low vacancy, above-average rent growth, robust development and a record year of investment sales. At 2.5%, the Twin Cities vacancy rate is now the lowest in the country. Rental rates also continue to rise at a healthy clip with a metro-wide average annual growth rate of 5.3% as of third quarter. That performance is even more impressive given the steady supply of new space that has been delivered to the market since 2012. An estimated 3,900 market-rate units were completed in 2016. Value-add conversions are dominating investment transactions. Apartment sales surpassed a record-high $1.5 billion in 2016, and all but $130 million of those deals included Class B and Class C assets.

Medical Office Logs Slow, Steady Growth Amid Tumultuous Change
The Twin Cities medical office market remains healthy with a low vacancy rate, a slight bump in rental rates and a strong investor appetite for property. There is a steady stream of new space being added to the market with 446,278 SF delivered in 2016 and another 459,000 SF in the pipeline for 2017. However, the majority of that activity is focused on system-driven, single-user buildings rather than multi-tenant space. There was very little multi-tenant space completed in the second half, which contributed to relatively flat absorption. In addition, changes within the healthcare sector, such as consolidation, doctor shortages and new service models, are a few of the many trends impacting real estate requirements for medical office users.

Hotel Development Continues Even as Sector Races Toward a Peak
The Twin Cities hotel sector has enjoyed a prolonged upswing with 76 consecutive months of revenue and rate growth. However, hotel owners are bracing for a change with views that the sector is rapidly approaching its cyclical peak. The forecast for key fundamentals, such as RevPAR (revenue per available room) and average daily revenue (ADR), calls for slower growth ahead. The building boom continued in 2016 with 3,100 new rooms delivered and another 4,900 rooms planned or under construction for 2017. However, developers are starting to tap the brakes amid signs that momentum is decelerating. It remains a seller’s market, yet values have likely hit the high-water mark and investors are expected to be less willing to pay premium prices going forward.

Developers Wary of High Land Prices as Construction Costs Rise
Speculative buyers have moved to the sidelines as many of the distressed sales and bargains available in the wave of the recession have disappeared. The land market is once again being dominated by those developers looking for land they can put to use immediately rather than hold for future use. Although many of the best multi-family sites have already been snapped up, there continues to be steady demand for apartment sites both in Minneapolis and the suburbs. Demand for industrial sites remains high. However, amid rising labor and building costs, occupiers are more sensitive to land prices. Despite returning demand from home-buyers, residential developers are proceeding cautiously. Homebuilders are also wary of overpaying for land, especially as higher construction costs are squeezing profit margins.

Outlook
A vibrant Twin Cities economy that is delivering both job growth and historically low unemployment should continue to fuel demand for space across all property types. Although development is returning, new construction remains in check, which bodes well for continued improvement in absorption and vacancy. The Twin Cities also remains an attractive target for investors looking to capture higher yields in secondary markets. At this stage of the market, buyers are being more selective and careful in their underwriting, but there continues to be a large pool of bidders with abundant capital to invest. The office market is expected to continue facing a few short-term speed bumps. Notably, the Minneapolis CBD will continue to struggle with a surplus of Class B space, and vacancies in a handful of downtown buildings will continue to skew overall office absorption numbers in 2017. However, the bigger picture is more positive, especially for sectors such as multi-family sales, which remain white-hot with new activity and demand.

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DISCLAIMER 
The Compass report, published since 1997, is created by Cushman & Wakefield NorthMarq experts using Twin Cities commercial property data from the last six months of 2016. The data used for this report has been obtained from sources which we deem reliable. While every effort has been made to report accurate data, Cushman & Wakefield/NorthMarq cannot guarantee the accuracy of this market report. Furthermore, we cannot assume responsibility for any omission of data which may occur. It is our intent to provide the best possible information regarding the office, industrial, land, retail, multi-family and investment markets while leaving the reader the responsibility of further verification before using this report for business and/or financial decisions.

This report includes information for multi-tenant office, industrial and retail projects greater than 20,000 square feet and multi-family for-rent properties. Not included are owner-occupied, government or single-tenant buildings. Not all information and insights we've collected can be published in any given volume.

 
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