2019 Commercial Real Estate Industry Outlook

How would you characterize a commercial real-estate market where rents today, in many cases, are unchanged from 10 years, 15 years, even 20 years ago? One might think it a market in distress. But anecdotal instances of that, while telling in some respects, don’t reflect the overall dynamics of the Kansas City region’s office and retail commercial real estate market. Assessing the strengths and challenges of that economic sector, fifteen key executives from prominent commercial real estate firms gathered Feb. 18 at the Crossroads offices of Ingram’s for the 2019 Commercial Real Estate Industry Outlook assembly. Steered in their two-hour deliberations by Aaron Mesmer of Block Real Estate
Services and Rollie Fors of Colliers International, the participants addressed growth in rents—in those areas where it has been witnessed—rising construction and building operating costs, how the workplace preferences of Millennials continue to change work spaces, and other topics shaping this vital segment of the local economy.

Grounded in Stability
The Kansas City office market has seen improvements with vacancy rates, which are lower, and to some extent, rents that are higher for choice facilities with the right amenities. Aaron Mesmer kicked off the discussion by asking, is that trend sustainable?

Owen Buckley of LANE4 Property Group sees success as something that will come through the stability of the regional market. “We’re in the Midwest and we’re conservative, and we try not to build too much, so that should keep us in line here,” he said.

Greg Swetnam of Kessinger/Hunter & Co. noted that the vacancy rate for Downtown office space in Kansas City at the end of 2013 was 22 percent, with a 12.5 million square feet of available space. “Today, we’re down to about 11 percent, with 11½ million square feet,” he said. “So the market has shrunk,”
which he attributed to obsolete office space that’s being converted to residential. “It starts to drop on the vacancy side, and it starts to drop on the office side.” Other than that, he said, there’s a lot of cross-town movement, but not a high volume of organic growth.

Bob Johnson, of R.H. Johnson said he sees the same thing. “We have near 100-percent occupancy rates” on properties the company deals with.

“I think the market still has some  run left in it,” said Bucky Brooks of Copaken Brooks. “We’re in a good
economy, and as far as office space, people still have an appetite for the cool space, not boring space, to recruit and be productive. This whole mixed-use driver is a lot of it. Kansas City is never over-built too much.”

But particularly telling was a recollection from five years ago, he said, when a leading data analytics firm
predicted that this region would experience 5-plus percent annual rent growth in office in the coming years. “I thought to myself, ‘I’ve never seen anything like that in my entire career,’” Brooks said, but “I think we’ve about done that for the last five years in the highest top-quality space.”

But “the gap between new construction and second-generation space is still extremely wide,” said Travis Helgeson of Cushman & Wakefield. “Our large  users, as they continue to grow, go into second-generation space. As that continues, you’re going to see vacancy drop until you have a user who needs to
do a build-to-suit or is going to go into new construction, because where else can they go?”

Brent Roberts, of Block Real Estate Services, said that gap, between existing Class A vs. new construction, has gone from $5 a square foot to $10 a square foot, “and until we get that gap down to $3-$4 a square foot, there’s no spec development, unless it’s left over in the build-to-suit,” he said. “Our office rates
are too cheap.”

In a glaring example of that, he said, “I ran some profiles based on Corporate Woods last fall, and our rents in some of the buildings in Corporate Woods 18 years ago were exactly the same rents as they are now—and operating expenses have gone up $3 a foot and construction costs have doubled. Our net rents today are actually cheaper than they were 18 years ago,” which should come as good news to tenants.

Newmark Grubb Zimmer’s Nick Suarez concurred that the market is shrinking, but the number of  tenants is not. “Those tenants had to backfill the buildings that continue to be office, and that certainly helped,” he said. “Organic growth with our tenants, we haven’t seen a ton of companies outside of Kansas
City come to backfill spaces, but we’ve seen some companies grow, like Spring Venture Group and Colliers. Those guys have taken a serious amount of space, and that has helped contribute to the decline
in available office space.”

Max Wasserstrom of Block Real Estate Services shared the story of a client who had found a 20-year-old lease in his office. “They’re paying the same rent now, so there’s been minimal growth,” he said. But on the flip side, “we’ve got a group we signed a lease with two years ago for 16,000 square feet, and they just signed new lease for 40,000 square feet to move to a new building, and we’re seeing a lot of that organic growth.”

John Stacy of Reece Commercial Real Estate asked “to what extent has vacancy been improved by co-working? Maybe some. But what about all the sub-lease space? There’s also a lot of sub-lease space
out there.”

Rollie Fors thinks the demand for space—“companies are growing like crazy” he said—seems as if it’s been across sector, from engineering to health care, advertising. marketing and others. “That’s been a big contributor to this low vacancy,” he said.

From the development side, said Aaron Mesmer, Block Real Estate Services has been one firm willing to engage in spec development of office space. Still, he said, “we’ve been scared to death of Sprint and the overall market—the fact that you can pick up 20-year old lease and the rates are the same.” That’ s why the firm has focused on areas like Tomahawk Creek Parkway, where there is a premium on upper-tier Class A space, in health care facilities, and other choice deals and locations. “But it’s really been spotty and you have to pick your opportunities very carefully,” he said.

Citing that squeeze between flat rents and rising costs, Mesmer asked about whether firms here, like those in other major markets, were moving to net-lease arrangements, whereby the tenants assume
more responsibility for things like operating costs, taxes and insurance.

PNC Bank, said Brent Roberts, is one prominent case where a tenant went from a full-service lease to what’s known as triple-net lease, picking up essentially all of those costs. On large properties, he said, “at 150,000 square feet, if you knock it down to triple-net, it saves you a lot of money.”

Few others, however, are seeing such deals. “I don’t know if it’s a lack of sophistication in our market or what,” said Greg Swetnam, and Rollie Fors said he had seen a bit of net-lease on single-tenant
buildings, but not on multi-tenant.

In that respect, the Kansas City market is quite different from Boston, Dallas, New York and Chicago, all of which have embraced triple-net, he said.

Jon Copaken of Copaken Brooks called the differences in leasing arrangements a complication, pointing out that at its Corrigan Station project in the Crossroads, the firm had used gross-lease arrangements.
That, he said, “puts the burden on us to control costs” but gives tenants some peace of mind in not having to worry about utility costs or other factors that might place the burden on them. “I don’t know that it’s the way all leases should go, but it does seem like we do have this model in our market that’s needlessly confusing.

If change to that model is to come, “I think it’s going to have to be a big landlord” pushing for different leasing arrangements, said Rollie Fors. Jeff Berg of Colliers International said that from the retail side, gross leases were going in the opposite direction. “It’s not prevalent at all, but we are starting to see 
that,” he said. “The tenants are probably in a better position to manage the costs.” 

A significant jump in taxes and insurance, said Greg Swetnam, is also driving changes in lease arrangements. Brent Roberts said that over much of the past decade, lease rates had fallen, and
the growth now is merely returning the market to where it was before the economic downturn.

Travis Helgeson said uncertainty about where companies will be even 24 months from now was preventing more long-term leasing. “They don’t want to commit to seven to 10 years,” he said, and construction costs, too, were keeping tenants from moving.

Asked about which areas of town were producing the most growth, Downtown and Johnson County were prominently mentioned, and things around the Country Club Plaza were tight. But there are, as
well pockets of concern. Greg Swetnam noted the property vacated by Swiss Re in 2002, which remains on the market today. “After 14-15 years on the market, at what point does it become obsolete?” he asked.

Tenants, said Travis Helgeson, are doing more with less, yielding density. “Once you start to get 5 per 1,000 parking, Downtown no longer works,” he said. “The economics just don’t make any sense.”
Bob Johnson of R.H. Johnson Co. said his firm is doing deals all throughout the area, but noted that “there hasn’t been a lot of new retail built the last three to five years.”

And as some retailers phase out of business, he said, opportunities arise for new kinds of retail to move into those spaces. “ But there’s still too much retail space out there, overall,” he said, and “the
A-space is still A and the B-space is either very adaptable to reuse or repositioning.”

A fair amount of infill is still going on, said Jeff Berg, especially in areas that are known for good public schools nearby. “And any time you see acres and acres of parking,” he said, “you might look to
densify that.” 

Aaron Mesmer told of a client who had a property dominated by a grocery store for 25 years, but planned to knock that store down and potentially go with multifamily or mixed-use—again, an indication that
some owners are seeking projects with greater density. That’s because there are more lucrative
uses for land being vacated by retail operations.

And none of that, suggested Bob Johnson, should come as a surprise. “If you look at retailers who have failed in the last five years, “these were the ones on life support 10 years ago. Nobody was surprised that Payless Shoe Source is going out, nobody was surprised when Sears was going out. Toys R Us never reinvented themselves in 20 years.” That’s always happened in the past, Johnson said, “and there are certain retailers who are in the way of internet shopping and peril. They didn’t react and are mostly gone now, or will be in a few years. But there’s still great retail demand and our occupancies are the same as they were five years ago, in the low to mid-90s.”

If you have big-box retail space in a good area “there’s plenty of demand there,” said Jeff Berg, who says he gets a lot of calls asking for big-box space, particularly in Johnson County.

Office Spec
Aaron Mesmer asked whether, on the office space side, the market could support more speculative development, and turned to Jon Copaken about his experience with those projects.

“We don’t have these big chunks of spec, but we’re building. At Lenexa City Center, we have 40,000 square feet of spec and it’s leasing up,” Copaken said. “Everybody’s question, including ours, is are there 1 million square feet of those people out there, or 200,000 square feet of those people? But with building stock that averages 30 years old, and there’s a lot of Class A that’s 30 years old, people will pay for something new that’s in the right spot and done well.”

Corrigan Station is an example of that, he said. It’s in a market where the average rents were high teens to low $20 a square foot. Corrigan Station was able to command considerably higher rates, in the mid $30s range, and the firm expects to see even higher rent its proposed Strata tower Downtown.

Concern over costs, however, might be displaced, Copaken said. “For us, we fight over the last cent, but companies look at how little of their cost is actually rent. If one good employee is attracted by the
right space, that additional production can more than make up for the difference in the rent they’re paying.”

“That’s what were seeing on the Plaza,” said Max Wesstersrom. “Were seeing those companies that need to retain or attract new talent are willing to pay up to get those people. Obviously, with the low unemployment rate, there’s a fierce competition to get those employees, and I think we’re starting to see that on the real-estate side.”

What kinds of amenities are making  those kinds of differences? “Rooftop terrace, gyms—everybody wants a gym,” said Wasserstrom. Jon Copaken said Corrigan Station’s move to get things like elevator service to a rooftop deck “was as expensive as  any other rent-payment floor, so it’s a hard thing to hold onto.” Some amenities barely survived the firm’s cost-cutting efforts, “but it was and continues to be important” for attracting tenants, he said.

To the extent that construction and rehabilitation efforts are geared toward attracting Millennials, Greg Swetnam noted  that the action is not limited to those living and working Downtown. “The commute
out to Johnson County is so quick, I see a lot of kids that reverse commute: They move Downtown to live and be around all the energy, then they hop in the car and drive to Johnson County to work.”

Kansas City as whole “is a little bit of everything” when it comes to workplace design, he said, and the contrast between  Johnson County—the biggest submarket in the area—and Downtown reflected
that diversity of both building design and lifestyle options.

Sprint

It’s almost impossible to have a conversation about commercial real estate in Kansas City without addressing the 3.9 million-square-foot elephant in the market: The Sprint campus in Overland Park. The
pending merger with T-Mobile will not only cost this region a Fortune 100-level company (it fell off that list after Japanese parent Softbank acquired a majority stake), it could leave tens of thousands of office
space vacant should there be layoffs or consolidations.

“The saga continues,” said Greg Swetnam. The campus, originally designed for 14,500 workers, has been shedding people and jobs for more than a decade, and leasing out some of that space. To the outside
world, Sprint is a big deal, but the market has been accommodating change there for a long time.

“The market has been competing with Sprint,” said Brent Roberts, but even if there were a new buyer how much can you change it? “You can freshen it up, but you have limited floor plates, you have limited
structured parking. It will mess up our spec development, but for your average tenant size in Johnson County, 3-4-5,000 square feet, it doesn’t really have an impact.”

Then, too, Swetnam said, it’s been more than 20 years since the first buildings on that campus opened, and there is now an issue of whether they are sufficiently updated or in step with current office trends. But every building on the campus is stand-alone, said John Stacy, and has its  own parking, “so I think it still has its own life.”

Part of the challenge with turning it into space for a series of tenants, said Brent Roberts, is that the campus was designed for a single tenant. In certain cases among the 17 buildings there the design of a building means “you can’t split the floor.” “It was never made to be a multi tenant facility” and to fix those things, he said, “the cost probably doubles.”

Estimates of how much office space could come onto the market at the site range from lows of 950,000 to as high as 1.3 million square feet, those at the table said—enough to continue raising questions
among prospective clients about what the impact of Sprint might truly be.

 Still, said Nick Suarez, “we’re not seeing Sprint dominate the conversation.” 

What are the chances, asked Kim  Bartaolos of Block Real Estate Services, that a company of sufficient size could be recruited to fill that space? “Tenants don’t come to the Kansas City area because of
office space,” said Greg Swetnam. “They come because of the jobs” and the work force that can fill them.

But, as Jeff Berg noted, prospective retail clients in that part of Johnson County are consistently asking, before exploring options there, “what will happen with Sprint?” Whether the potential changes will, in fact, affect operations of nearby commercial operations, there’s a perception that they will. From a positive perspective, Berg said, “nobody has said no” to a deal in that area based solely on concerns
about what will happen with Sprint. 

The Retail Factor

While those who work in office and their retail counterparts work in different realms, there are points where the two intersect. Thus, what’s happened in the retail sector has affected decisions by officebased companies about where to locate, and the types of services immediately available to employees.

That retail space opening up has been filled, in part, by office operations, and some of that has taken place at Zona Rosa, considered a model retail site when it opened a generation ago, but struggling
today.  Part of the challenge in the retail world is the conflict between the public sector planners and the consumer, some at the table said. The concept of walkable community may fly when a Downtown resident is considering whether a grocer, dry cleaner or drug store is immediately accessible.
Outside the two square miles that make up the Downtown loop, however, personal transportation reigns supreme, and no amount of streetcar expansion or mass-transit advocacy is going to change that any time soon. Until it does, efforts to pound that square policy peg into the round hold of consumer preferences will challenge retail operations.

“Cities need to get realistic,” said Owen Buckley. “The shopper wants convenience.” Office workers who park their cars for the day while they are at work are a different commodity than someone trying to get to a retailer, he said, and “consumers want that quick in and out.”

The key to success with developing retail properties, Buckley said, was keeping flexible—LANE4’s plans for 95th and Metcalf being a prime example—but more important is the value proposition of the
land under a project. Eventually, he said, “good things happen to good real estate.”

That should come as a hopeful message to the owners of sites like Zona Rosa, the former Metro North Mall site and other properties. “They won’t be the original product, but they will find a use,” said
Jeff Berg. 

That prompted a question from John Stacy: Has the concept of New Urbanism worked well anywhere?
In at least one locale, it appears, the answer will be “yes.” The city of Lenexa has reinvented itself with Lenexa City Center, home of not just the City Hall operations, but a thick quilt of office space,
residential lifestyle choices, restaurants and civic draws like an aquatics center, library and even space for college students through Park University’s satellite campus.

“New Urbanism can work with the right balance,” said Kim Bartalos, but part of the Kansas City challenge currently is that “we have more per-capital retail space than many other communities.”

The upside for commercial realty specializing in office space, as Jon Copaken noted, is that whether a project involves New Urbanism or is simply a matter of retail that is well-done, “office workers want to be a part of that.”