By Jim Costello

Like much of the U.S., the Chicago region experienced a migration to the suburbs during the 1970s and 1980s, and infrastructure has fought to keep up with this transformation. Some of the transfer was accompanied by severe urban decay as the city of Chicago itself lost residents and businesses. Today, however, the population erosion has reversed and Chicago now bills itself as "The City that Works."

Chicago is a most American of regions. Employment growth has mirrored the nation as a whole since 1970 with every spike or pause in the national economy reflected locally. The diverse mix of industries that contribute to local employment is more similar to the nation than the larger regions of New York and Los Angeles. Additionally, economic diversity in Chicago is on par with other large metropolitan regions in the U.S.

The region's size and similarity to the U.S. as a whole makes it attractive for REIT and publicly traded real estate company investment. The economic fundamentals that drive property performance in Chicago are similar to the nation as a whole and therefore about as predictable as the national economy. Also, the sheer size of a market with more than 8 million people provides liquidity as there are a number of active investors in all property sectors, unlike smaller markets in the U.S. dominated by a few local players.

However, Chicago does have its own characteristics affecting REIT holdings, although not a perfect reflection. For instance, while employment in the region has tracked closely with that of the U.S. as a whole since the early 1970s, on average the growth in employment has been slightly lower at 0.3 percent versus 0.5 percent. This slower growth directly impacts multi-family REITS.

Employment growth helps to drive household formation, and in turn demand for housing. With a slower average trend in demand for new housing and much older stock of small and privately held apartment buildings within the city of Chicago, it is not surprising that multi-housing sector REIT holdings in the Chicago region are relatively low compared to that of other sectors.

Each property type has its own unique story that in part will determine the outlook for overall future market performance. A summary of the office, multi-family, retail and industrial sectors follows.

The Office Sector

The shift to suburban locations is especially pronounced in Chicago's office market. More than 90 percent of all office space was in downtown locations in the 1950s but less than 60 percent was in downtown by 2000. The fastest periods of suburban office growth were in the 1970s and 1980s when the amount of suburban office space increased an average of 10 percent per year versus 3 percent growth for downtown office space. However, suburban growth has continued and from 1995 to 2000 only about 12 percent of new office space was built in the downtown submarkets.

As the market faces a downturn in the post September 11 era, it may draw comparisons to the last market slowdown in the early 1990s. As in the past, the fear is that the office market faces an extended period of rising vacancies, falling rents and eventually descending cash flows. In the early 1990s in Chicago, suburban construction shut down into 1991–1992, while the downtown submarkets delivered an average 2.7 million square feet per year, severely overbuilding the market. Today there is the potential for at least 2.1 million square feet per year to enter the downtown submarkets in 2002–2003, close to the levels of completions in the early 1990s that overbuilt the market.

The main difference between now and then is the overall market size. Completions across the entire market from 1989 to 1991 averaged nearly 4.3 percent of supply while from 1999 to 2001 they only averaged 2.6 percent of stock despite approaching similar levels of completions. The market is simply much larger today and it would take more substantial office completions to overbuild it. As construction moderates and demand picks up with an economic recovery looming in late 2002 or early 2003, vacancies are expected to stabilize and rent growth should turn positive. With these market conditions and average lease turnovers, growth in cash flows should increase in 2004–2005.

The Multi-Family Sector

The housing sector in Chicago is largely comprised of single-family homes. Permits in the single-family housing sector have held steady at an average of about 25,000 per year from 1993 to 2000. However, single-family housing prices have increased a total of 15 percent from 1998 to 2000, according to OFHEO (an oversight agency for Freddie Mac and Fannie Mae), pricing some consumers out of single-family residences and raising demand in the multi- family market. As a result, multi-family housing permits have been rising from less than 6,000 in 1993 to an average of 11,000 per year in 1999 and 2000.

As demand from the economy slows, demand for multi-family housing will fall and vacancy rates will increase. However, the vacancy increase should moderate over a very short period of time, providing steady average growth in cash flows.

The Retail Sector

The total supply of shopping center space increased 5 percent annually from 1980 to 1990, overbuilding the market as real personal income only rose at an annual rate of 2.6 percent. The recovery since has varied by shopping center type, with some sectors particularly impacted by shifts in the space needs of retailers.

Relating personal income to the gross leasable area of each shopping center type as a measure of performance, neighborhood and community shopping centers (generally grocery store-anchored strip malls) have shown improvement that seems to lag that of Chicago's regional shopping centers (generally large enclosed malls). From 1993 to 2000, real personal income per square foot in neighborhood and community centers grew at an average annual rate of 1.4 percent per year versus 1.7 percent for regional centers.

In reality, neighborhood and community centers had an easier time than regional centers during the 1990s, facing fewer competitive pressures from retailers experimenting with new shopping center formats. Power center construction (generally strip malls with one big box tenant) increased rapidly during the 1990s as retailers began to experiment with non-mall retailing. In today's market, regional centers sell primarily soft goods such as apparel rather than the mix of hard and soft goods they've had in the past. Hard goods have transferred to power centers. Real personal income per square foot for the total of regional and power center space grew at an average annual rate of only 0.5 percent from 1993 to 2000, versus the 1.4 percent for neighborhood and community centers. With personal income per square foot rising, retailers have been able to increase sales and, in turn, property owners have been able to raise rents.

With the relative share of sales moving against them and the current economic weakness, cash flows at neighborhood and community centers will be impacted for a few years; however, these centers should recover. Some sales will transfer to new competitors in standalone retail space, but the advantages of serving a local area will lessen this impact.

The Industrial Sector

The warehouse market is the largest portion of the industrial sector in Chicago, constituting roughly 45 percent of the space. The demand for warehouse space is a function of inventories, for when firms produce goods they must be stored before reaching their final destination.

No good economic data is available to measure inventories at the metropolitan level, but employment and output information should approximate inventory data. Manufacturing employment in the Chicago region had been rising through the 1990s as favorable exchange rates and demand for products from innovating local firms spurred a manufacturing renaissance. Firms like Motorola and, as it was known before merging with 3COM, U.S. Robotics, helped produce jobs throughout the region.

Manufacturing employment has been falling in recent years with increases in productivity but more recent declines are also symptomatic of the manufacturing recession that pre-saged the nation's current economic weakness. This slowdown is escalating availability rates in the industrial property sector, but given lease lengths it is not expected to undermine cash flows for the sector as a whole. Some individual properties may face harsh cash flow issues due to a primary tenant leaving for space with more modern specifications but on average cash flows will weather the economic decline, and as construction falls off availability rates will moderate.

Closing Thoughts

The ongoing national economic weakness will be largely reflected in Chicago's economy. Torto Wheaton Research's outlook for each of the property sectors incorporates a strong element of reduced demand for an extended period. However, the overall outlook for cash flows in the region is generally favorable. This economic slowdown will only be a temporary cyclic downturn as opposed to the extended structural declines that caused havoc with the City of Chicago in the 1970s. Lease lengths will generally protect cash flows from most of the expected economic weakness and as a result the commercial property sectors in this most American of regions should weather the downturn well.

Jim Costello, a senior economist at Torto Wheaton Research, is a Chicago native. He specializes in the analysis of office markets including the production of TWR's core U.S. Office Outlook report, but also consulting projects and reports for international markets.

Breakdown of REIT Holdings in Chicago Market and REIT Universe
Sector	REIT Holdings in Chicago	Universe of REIT Holdings	Percentage of REIT Universe	Sector Size in Chicago	REIT Penetration of Chicago Market
Industrial	62,819,961 sf	700,863,934 sf	9.0%	989,186,000 sf	6.4%
Multi Family	27,024 sf	1,170,935 sf	2.3%	1,487,681 sf	1.8%
Office	33,778,280 sf	611,062,221 sf	5.5%	198,884,000 sf	17.0%
Retail	26,201,414 sf	1,040,906,293 sf	2.5%	143,327,688 sf	18.3%
Source: TWR REITsmart, SNL Securities, CoStar, NRB, CMDG, Department of Commerce

Sweet Home Chicago REITs Ranked By Chicago Holdings
Company	Square Feet, 2000
CenterPoint Properties Trust	25,822,263
AMB Property Corporation	11,822,263
Equity Office Properties Trust	11,190,188
Prime Group Realty Trust	10,897,864
Simon Property Group	7,938,758
ProLogis Trust	7,837,932
Inland Real Estate Corporation	6,453,679
Apartment Investment & Management Co.	6,403,900
First Industrial Realty Trust, Inc.	6,242,255
Cabot Industrial Trust	4,572,004
Kimco Realty Corporation	4,422,625
Charles E. Smith Residential Realty Inc.*	4,096,150
Duke Realty Corporation	4,077,209
Equity Residential Properties Trust	4,013,700
AMLI Residential Properties Trust	2,756,550
Prentiss Properties Trust	2,754,174
TrizecHahn Corporation	2,434,000
General Growth Properties	2,302,046
Great Lakes REIT	2,049,998
Home Properties of New York, Inc.	1,905,700
CarrAmerica Realty Corporation	1,881,854
The Mills Corporation	1,699,808
Forest City Enterprises	1,389,750
AvalonBay Communities, Inc.	1,101,600
Glenborough Realty Trust Incorporated	1,095,786
Parkway Properties, Inc.	1,067,746
Developers Diversified Realty Corporation	1,007,092
Archstone Communities, Inc.*	951,150
New Plan Excel Realty Trust	929,600
Federal Realty Investment Trust	773,000
Malan Realty Investors, Inc.	594,813
Vornado Realty Trust	321,000
*Merged in October 2001 to form Archstone-Smith. Source: Torto Wheaton Research