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Downtown Office Conversions Impact Market

Tuesday, January 10, 2017

Question: If vacancy rates seem so high, why is the office space game still so vibrant and healthy in Cleveland?
Answer: Conversions.

Over the past two years, the vacancy rates for Class B and Class C office properties in Cleveland's Central Business District (CBD) declined primarily due to conversions of office space into residential apartments. The current market vacancy rates for Class B and C offices in the CBD are 24% and 22.4%, respectively. However, we've developed a "Zombie Office Vacancy Report" which eliminates all buildings that are currently being converted into apartments - or soon will be. The deeper and more accurate analysis reveals forecasted vacancy rates of approximately 18.2% for Class B offices and 15.4% for Class C offices.

While these rates are still high, they do paint a different picture of the trends for rates and concessions for CBD office. Drilling down further into our "cool" office space (high ceilings, older buildings, exposed brick, wood floors) vacancy rate, we estimate approximate vacancy of only 12.6% based on a sampling of downtown properties that amount to approximately 2.9 million SF.

The overall health of the market is being driven by conversions. The annual net absorption of office space in 2016 was approximately 254,000 SF. However, the absorption for "cool" office space is currently keeping pace with supply. Rates in these older buildings also rival newer Class B buildings at $16 to $17 per SF gross, (and are oftentimes higher). Even better, these spaces have lower tenant improvement dollars, netting the landlords a higher overall return. This trend has been spotted by a few perspicacious developers. The leader in this submarket - the Caxton Building - has seen an increase in rents over the past year for both parking and office that other landlords to the psychiatrists (who are also renting space in a "cool" office building).

Rick and Ari Maron spotted this trend a few years ago when they leased approximately 80,000 SF to our client, Rosetta Marketing, in the former PNC building on Euclid Avenue and East 6th Street. They converted old 1960s-type office space into something one might see in SoHo. The space was never marketed and the tenant moved from the suburbs to downtown to be closer to urban amenities; paying a rent at the high end of the B market.

Graystone Properties took advantage of this emerging aesthetic when they decided to convert the former Tyler Elevator building at East 36th Street and Superior Avenue - which they had owned since the 1970s - into loft office space. Without the use of tax credits, Graystone repurposed this million-square-foot-plus property into a neighborhood of retail, office and warehouse uses called Tyler Village. The development is performing so well they now charge for indoor parking in an area of town where parking is free and abundant.

Jim Doyle and Fred Geis developed a campus of buildings in Midtown at 6500, 6700 and 7000 Euclid Avenue called MidTown Tech Park. The entire campus is near-full and a majority of the tenants are either from the suburbs or are spinoffs from the Cleveland Clinic. Rents range from $10.00 to $15.50 per SF net, equal to or higher than CBD or suburban rents. Two of the three properties were warehouse conversions.

Recent examples of this conversion trend can be seen in Quicken Loans' new space in the Higbee Building. This conversion of the former department store into "cool" office space now houses 450-plus employees who moved here from the old Post Office building behind Tower City. In fact, our office is handling the leasing of the remaining vacant office units in this building, offering a similar work environment as the Quicken space. Suburban companies are beginning to take notice.

Similar examples are Joel Scheer's redevelopment of the former Sammy's building in the Flats. This building has one of the highest asking lease rates of any space in our market at $21.00 per SF NNN, or $32.00 per SF gross. It offers views of the river and a rooftop deck. Fred Geis recently announced he was partnering with the Samsel family and redeveloping several mostly-empty buildings on Old River Road on the East Bank of the Flats into predominantly loft offices. These properties are on the Cuyahoga River and will have porches overlooking the water.

A three-story building in a rapidly changing area at 2401 W. Superior Viaduct is under contract to a client of ours, and a start-up company is expected to move its operations there. The company was attracted to the "loft" feel of the building and the addition of new amenities in the area, such as a brew pub being built across the street. 

These developments were, on some level, predicted by Richey Piipparinen, Director of the Center for Population Dynamics at Cleveland State University, in his research regarding the growth of well-educated millennials attracted to the authentic city of Cleveland. This new population sees Cleveland's history as an asset. One manifestation of their embracing of the cultural heritage is the desire to lease space in buildings with unique features. Assuming his track record for issuing excellent real estate predictions remains intact, landlords would be wise to consider how they can accommodate this generation on the rise.

Some 
articles have bemoaned when the next new office building will be constructed. All the while, when most people were focused on the apartment market conversions, a few developers with foresight were already building Cleveland's next office buildings through conversions rather than new construction.

So the question really should be: which office building is ripe for the next conversion? Two big properties stand out - the Rose Building, which currently houses Medical Mutual, and the former Huntington Building at 925 Euclid Avenue.

The Rose Building is currently an office building, but ripe for redevelopment. Medical Mutual is rumored to be relocating, opening up an opportunity for the Rose Building's owner to reposition the property, embracing its magnificent architecture, ample window line and location in the heart of the city. Like the former Huntington Building across the street, this property would likely fetch rates above $20 per SF and compete at the high end of the B market if properly repositioned.

The former Huntington building being redeveloped by Hudson Holdings will be a neighborhood unto itself and will earn office rents equal to or exceeding the Class A market. The company is planning a mixed-use redevelopment that encompasses retail, office, hotel and an apartment/condominium product.

Overall, these changes in our market present opportunities for both tenants and landlords, and understanding these trends helps both sides make better decisions.