Landlords fret as state budget cuts loom

Downtown St. Paul's status as a "government market" for commercial real estate has provided it with stability, if not high occupancies, for decades. But with steep budget cuts looming for state agencies -- tenants of a sizable piece of downtown's privately-owned office space -- fears are mounting that that stability will be shaken.

Over the last decade, and for many years prior, downtown St. Paul has faced some of the highest office vacancy rates in the Twin Cities. As of January, that rate stood at 23.4 percent, compared with 19.9 percent for the entire Twin Cities, according to NorthMarq Real Estate Services research.

The central business district had 72,000 more square feet go vacant than was leased -- so-called negative absorption -- in the second half of last year. NorthMarq predicts that 75,000 more square feet could be coming vacant this year.

But despite the high vacancy rates, downtown landlords could always count on the state of Minnesota to provide long-term tenant stability.

Indeed, figures obtained from the Minnesota Department of Administration, which handles the state's leasing of competitive space, show that 824,000 square feet of office space is leased by 15 state agencies or boards in seven privately owned buildings in downtown St. Paul -- that's 10 percent of downtown's universe of 8.3 million square feet of privately owned, or "competitive," office space.

Included in that total are 175,000 square feet leased by the Department of Public Safety in the Town Square building; 154,277 square feet taken by the Department of Employment and Economic Development in the First National Bank building; and 124,000 square feet leased by the Department of Health in the Golden Rule building.

The state-leased space total had been 96,000 square feet higher until Ramsey County purchased the Metro Square building in 2009, bumping it from the "competitive" to the "government-owned" category.

Those numbers could shrink even further should state agencies be required to absorb significant cuts under budget-balancing measures being considered by the Legislature and Gov. Mark Dayton.

Republican leaders in the Legislature have proposed 20 percent cuts to state agencies, while Dayton has suggested case-by-case reductions, mostly in the range of 5 percent. Either scenario would result in layoffs and reduced office space requirements.

"It's early in the legislative process," said Department of Administration spokesman Jim Schwartz. "The governor has his budget prepared and the Legislature has its proposal. What comes out in adjournment is how we'll move forward.

His agency, he noted, has planned for a 5 percent cut. "Generally, the agencies will determine how to cut, and that could affect office space, people and programs."

There's no doubt a reduction in the state's office needs would have negative consequences in a downtown accustomed to stable government tenants, said Pete Dufour, an office broker for Cassidy Turley who specializes in St. Paul.

"For a number of downtown St. Paul buildings, they are the key tenant," he said. "I'm sure they don't want to think about [agency budget cuts], but I bet they've already been hearing it from a lot of businesses, and probably from the state agencies as well."

Dufour said reductions in state government space needs would add to the challenges of stressed landlords who are already offering concessions and lowered rents to compete. But state government tenants are especially prized because of their reliability, even though the state insists on 30-day cancellation options in its leases.

"Landlords like state tenants, even with the cancellation notices, because they rarely invoke them without good reason and they always pay," Dufour said. "Given our vacancy rates, that's really what's important."

Some building owners say lease rates for even "posh" locations around Lowertown's Mears Park are available at bargain rates -- less per square foot to operate than in three nearby, newly constructed state government buildings.

Those structures, completed in the mid-2000s, added 900,000 square feet of office space along Interstate 94, much to the dismay of private landlords. They fear that, rather than move to cheaper private space, state tenants will permanently cross over into the "government-owned" sector.

"The question to me is, once the agencies start laying people off, will they begin filling out the state buildings? That would be an echo effect," said John Mannillo, a commercial broker for Mannillo Womack & Associates and a former downtown St. Paul building owner.

He said he worries that "a new normal" could be set for the downtown St. Paul office market in terms of competitive space vacancy levels should that happen.

Complicating things for private downtown landlords is that their universe is shrinking. The downtown market has lost hundreds of thousands of square feet to housing conversions in recent years -- a trend that probably would accelerate if state government reduces its lease footprint, landlords say.

In 2001 competitive space made up 58 percent of the total downtown office universe, with government-owned space at 25 percent, according to the St. Paul Building Owners and Managers Association.

But by last year, competitive space had shrunk to only 48 percent of the downtown pie, with 33 percent government-owned.

Don Jacobson is a St. Paul-based freelance writer.