business

The warehouse floor gleams like an ice rink. The brand-new Lakeville distribution center, all 282,100 square feet of it, has been sitting empty since it was finished in early 2009. They built it, the developer concedes, at the "worst of the worst time you could put up a building."

So why is Chris Willson upbeat? Because, like other industry pros in the area, he's convinced that the Twin Cities commercial real estate market, mired in one of the worst busts in decades, is turning.

"We have bottomed and we're on the way out," said Willson, senior regional director for First Industrial Realty Trust Inc., a real estate investment trust out of Chicago that's a major owner of industrial property around the Twin Cities.

The level of activity among large users looking for 100,000 square feet or more is improving, he said, and First Industrial has done about a half dozen deals in the past six months, leasing out properties that had been vacant up to three years. While there's no deal yet for the Lakeville distribution center, Willson points to two buildings in Plymouth and Medina that each recently had two users chasing them.

Such clues to a possible turnaround are being carefully scrutinized in metro areas across the country because commercial real estate is a critical leg of the economy -- as much as 13 percent of GDP by revenue, according to one industry estimate -- and is a key, albeit lagging, indicator of recovery. Opinions on just where commercial real estate is at nationally are all over the map. One thing is clear: The sector won't bounce back until companies start expanding.

Willson's "green shoots" optimism flies in the face of some dismal basic measures. Overall vacancies in commercial property across the Twin Cities are approaching a 20-year high, leased-but-empty "shadow" space is lurking everywhere and rents still seem to be sliding as landlords battle for tenants. Commercial property values in the metro area have dropped anywhere from 20 to 60 percent from the peak in 2007, by some estimates.

But Willson's got plenty of local company calling the bottom. A quick survey of local commercial developers, bankers and other industry pros indicates much agreement that the local market has hit bottom, although there's plenty of variation on the theme, along with some detractors who say the worst is still to come. The general consensus is that apartments, never hit as hard during the downturn, and medical offices will emerge first, with office, retail and hospitality space lagging behind.

David Jellison -- vice president in Minnesota at Liberty Property Trust, a real estate investment trust in Malvern, Pa., that owns about 48 suburban office and industrial properties in the Twin Cities -- sums it up like this: "I don't see how it can get a whole lot worse."

"The question is how long will we stay at the bottom?" Jellison said. "I don't see much change until 2011. We're not seeing the job growth."

Jellison notes that landlords across all types of buildings are seeing tenants return to signing five- to 10-year leases, vs. the one- to two-year leases they were signing last year. That, he said, marks improvement.

Fewer new vacancies

Ed Padilla, president and CEO of Bloomington-based NorthMarq, sees similar turns in the slowing pace of new vacancies in office and retail properties, and what he calls a "dramatic" increase in the bids for top-tier properties being put up for sale in the market.

But the improvements aren't evenly spread, he said. There's a clear bifurcation in the Twin Cities market across all property types between the core, or the best Class A buildings -- and everything else, he said.

"The core has hit bottom and is clearly on the way back," Padilla said. "For everything else, we are bumping along the bottom."

The rate at which tenants are vacating office and retail space is improving, Padilla said, as is leasing activity in industrial properties. And there are more sources of funding and better terms than a year ago.

Even the once-dead market for bonds backed by commercial property mortgages has a pulse, he said. Padilla estimates that the market will securitize about $20 billion worth of commercial real estate loans this year. That's a far cry from the 2007 record when Wall Street sold about $230 billion worth of the stuff, but up from next to nothing last year.

The improved financing picture is good news for developers.

Collin Barr, Minnesota region president for developer Ryan Cos., said banks have been easing up on the amount of equity they require developers to put into financing for projects, and interest rates are better. Ryan Cos. has seen an uptick in outstate construction jobs in the past 12 months for local clients such as Cargill, Toro and Target Corp., he said.

"By no means are we out of the woods, but it's definitely improved over a year ago," he said.

A slow recovery

Terry Kingston, executive director of Cushman & Wakefield's capital markets group, agrees the metro area is bouncing at bottom. But the recovery will be long and drawn out, he said, because of the complicated structure for bonds backed by commercial mortgages -- the big bundles of loans called commercial mortgage backed securities sold to investors.

"The big difference here today is we have a global financial linkage, which is going to take a long time to sort out," he said. "It will be several years before we start to have a real normalized real estate market."

The fact that huge numbers of those loans, as well as loans from banks and other lenders, are coming due in the next few years is a major question mark. About half of the $1.48 trillion of U.S. commercial mortgages maturing this year through 2014 are currently underwater, according to Oakland, Calif.-based Foresight Analytics, meaning the borrowers owe more on the properties than they're worth. The fear is that lenders will foreclose on strapped borrowers, dumping distressed real estate on the market and pushing depressed values even lower.

Kingston, Barr, Padilla and others said they're more concerned about the securitized loans than the loans banks have held on their books, since banks appear to be working with borrowers with unpaid loans to modify and extend them.

Workouts aren't as easy with securitized loans, they said. Those loans are administered by remote bond trustees who don't have much flexibility to modify them, Padilla said. They typically can't grant extensions of more than 18 months because bondholders need to get paid off.

'Extend and pretend'

Banks have been restructuring commercial property mortgages, sometimes extending the due date to wait out the market, a strategy dubbed "extend and pretend."

U.S. Bank, for instance, has been extending loans for one to three years on a case-by-case basis, and modifying them by, for example, giving borrowers more time to meet leasing hurdles, said Michael Raarup, senior vice president of the Minneapolis/national market in commercial real estate at U.S. Bank.

Raarup said everyone is concerned about the wave of maturing debt. But it's not as big an issue as it was last year because there are now more options to refinance and modify.

"We don't mind extending because it's mutual for both of us," Raarup said.

Raarup said he's not sure the local market has bottomed out, but said it seems like there's more activity than last year. U.S. Bank closed six loans in the first quarter for local clients, he said, compared with "probably zero to one" in the same period last year. The projects were a mix, he said, including a $14.3 million construction loan to renovate the former Days Inn near the Mall of America.

Easier loan terms

Glenn Sansburn, senior vice president and office manager for middle market commercial real estate at Wells Fargo Bank, said the bank's underwriting is still "pretty rigid" but easing. Where the bank had only been considering one- to three-year terms, it's now considering terms as high as eight years for loans on stable properties.

The bank has also been making it easier for borrowers to refinance without having to add as much cash. Banks have been willing to live with an elevated loan-to-value on existing deals, he said, if the project has reasonable cash flow to continue to support the debt.

"There's been a lot more patience in trying to figure out how to work through this, and I see that as continuing to some degree over the next 12 months," Sansburn said.

Sansburn agreed the local market is bouncing along a bottom, with pockets of success in certain submarkets but "no real upward trend yet."

"I see 2011 as being probably the year where we see some actual significant movement in the trends," he said.

All that negotiating with borrowers worries some industry watchers. Tom Musil, a real estate professor at the University of St. Thomas, said the local market probably hasn't hit bottom yet because too many banks are holding on to property, and not selling. The market can't establish a new base line for values until they divest, he argues.

Banks have been quietly recapitalizing properties, he said, bringing in new investors to add equity and restructure loans, with the original borrower taking a back seat.

National and regional banks have been slower than other lenders, such as private equity funds, to resolve distressed properties, according to Real Capital Analytics Inc. in New York. Only about 10 percent of the assets listed as distressed in the first quarter 2009 by national and regional banks were actually resolved by the end of the first quarter this year, it said in an April report.

Willson, searching for a tenant for that Lakeville distribution center, isn't discouraged.

"The music stopped. The music is starting again," he said. "I'm optimistic on that project.

"It's the nicest vacant building in town."

Jennifer Bjorhus • 612-673-4683