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A twin cities profile.

Minneapolis-St. Paul had its share of the hard times that have beset the commercial real estate business. But seasoned mortgage bankers in this market have found different ways to prosper and weather the chilly conditions in the industry.

OVERBUILT AND UNDERLEASED. It's a serious urban problem, even a suburban problem, and a major concern for mortgage bankers trying to survive in a radically changing marketplace.

The overexpansion of the commercial real estate market in the 1980s, propelled primarily by very generous depreciation schedules ushered in with President Reagan's revision of the tax code in 1981, have left American cities with a lot of empty offices. The problem was fueled further by thrifts and commercial banks winning new powers in the 1980s to aggressively pursue commercial real estate lending. The bottom line is that today--in 1993--many markets have lingering inventories of unleased commercial space.

The whole experience has left institutional investors, drivers of the commercial mortgage market, far more cautious in their lending. "Unfortunately, |for us~ right now, the 1980s were a good time for business," says John Ferber, senior staff vice president and head of the commercial real estate finance department at the Mortgage Bankers Association of America (MBA). "There was a lot of money for investment in real estate, a lot of money available from the lenders themselves. The economy was good. Companies were expanding. There was a perceived need for additional space." The Economic Recovery Tax Act, Reagan's opening legislative salvo to jump start the economy in 1981 also paved the way for investors seeking attractive tax-sheltered investments. "It made it easier for investors to invest with favorable tax consequences. A short depreciation schedule, fast write-offs, sufficient inflation, good capital gains tax--all of these factors were there," Ferber says.

But now, a decade of overbuilding, coupled with the recession-weakened economy of the last few years, has taken its toll, as is clearly evident in the latest data from CB Commercial. National downtown office vacancy rates are still in their high teens, having climbed from 12.4 percent in 1983 to 17.6 percent in 1992. Suburban office vacancy rates are just as dismal, but improving slightly, dropping from 19.8 percent to 19.4 percent in the last two quarters of 1992.

Such a showing may not sound that impressive, but it marked the first time since 1984 that vacancies fell below 20 percent. At the end of 1992, net absorption, a measure of the change in occupied space and a statistic that hints at current demand for real estate, dropped slightly to its lowest level in seven years, going from 35.8 million square feet to 35.6 million square feet.

These conditions have changed the face of the commercial real estate business, and only the fittest--those smart enough to foresee the changes and quick enough to react to them--survive.

While all regions of the country have weathered these tumultuous times for commercial real estate differently, and according to different timetables, it is helpful, for a moment, to focus on some of the people and places behind the endless statistics.

In the heart of the country, the northern Midwest, flanking opposite sides of the Mississippi River, the Twin Cities of Minneapolis and St. Paul have had their own unique problems enticing commercial real estate investors to the area. The weather for one. With subfreezing winters and dripping, humid summers, just the name Minnesota sends some folks shivering. Downtown vacancy rates hover slightly higher than national averages, closing at 18.3 percent for 1992.

But more importantly for potential business tenants, Minnesota has an earned reputation as a high tax burden state. Two of the area's largest corporations, Honeywell and 3M, have expanded to other states. "There's a tradition of heavy government," says Mark Engebretson, a partner in Downey-Engebretson, Inc., a consulting firm that specializes in loan workouts. "Maybe it's the Scandinavian influence?"

Minnesota's corporate franchise tax, a tax on business revenues, is 9.8 percent, the ninth highest per $1,000 of personal income in the country. In a study commissioned by the state's Department of Revenue of effective tax rates on commercial property in 47 cities nationwide, the three Minnesota cities included in the study earned the top three rankings. St. Paul was highest with an effective tax rate of 3.99 percent, Minneapolis second at 3.68 percent, and the industrial suburb of St. Louis Park, third at 3.61 percent. By comparison, Los Angeles ranked 44th, at 0.83 percent, and Reno, Nevada, was lowest at 0.62 percent.

"It's not just the level of taxes, per se, but the attitude of state government toward them," says Jim Nelson, chief executive officer of Eberhardt, Co., a Minneapolis-based commercial mortgage banking firm and a former president of the MBA. "State and city officials here have really created problems in commercial real estate with the level of taxes because we have to compete in the national market to attract investors."

Bill Reiling, chairman and CEO of Towle Real Estate Company, a commercial real estate firm that does financing, sales and leasing, property management and other services, throws his arms up in disgust when asked about Minnesota taxes. "We've tried everything. We've written letters, we've met with |Governor Arne~ Carlson, we've met with |former Governor Rudy~ Perpich. We've given up."

He walks to a shelf in his office and brings back a single-sheet flier titled "Towle Report: National Property Tax Analysis." With colorful pie charts and bar graphs, the research division of the company outlined more grim statistics. When comparing property taxes as a percentage of gross rent, Minneapolis and St. Paul ranked one and two respectively, ahead of all the major office markets: New York, Boston, Chicago, and Washington, D.C. In Minneapolis, 24.4 percent of gross rent is funneled to property taxes; 23.5 percent in St. Paul. New York came in a distant third, at 21.3 percent.

The recommendations are clearly stated. "The reduction of the commercial/industrial property tax rate in Minnesota would significantly help Minnesota's businesses. It would also make Minnesota a more competitive state to attract new businesses, retain existing ones, and more importantly, encourage expansion in Minnesota. Property owners and lenders who are investing in Minnesota need the support of government, in the form of reasonable taxes, for the risks they are taking to help make Minnesota a great place to live and work."

Reiling falls heavily back into his chair. "I just don't know what else to do."

Though Reiling and Nelson may have lost the tax battle against state government, both have nursed their companies to health during the commercial real estate industry's malaise. But they prescribed radically different medicines for their firms. While Reiling has continued to build Towle, expanding other components of the business, Nelson has downsized Eberhardt, fine-tuning its services with a shrinking staff.

Many traditional mortgage banking companies have had to become full-service real estate firms with a commercial finance division, which conducts the business of its predecessor, servicing and originating commercial mortgages for institutional investors--usually life insurance companies and pension funds.

In the currently stalled commercial origination market, Nelson switched the emphasis away from this division of his company into the property management department. In 1988, the commercial real estate finance department brought in about half of the company's $5 million in revenues. Now, that division survived staff cuts by more than two-thirds, going from 18 employees down to 5, and pulled in about 40 percent of the company's 1992 revenues of $4 million. Property management picked up the slack, now accounting for about 35 percent of business. The real estate brokerage and consulting divisions have held steady, pulling in a combined 25 percent.

"We're doing a much better job of servicing our clients today than we were 10 years ago," Nelson says from his Minneapolis office. But Nelson readily admits that life insurance companies are requiring more from mortgage bankers. "It's a much more sophisticated business that it used to be."

The demands of institutional investors for more detailed and thorough servicing are to be expected, Nelson says. Environmental considerations and regulations mandated from the Americans with Disabilities Act demand a more thorough property analysis. "It's a sensitive time in the industry. Unfortunately, life insurance companies are not compensating commensurate with increased demands."

Nelson is very contemplative and reflective on this bleak Minnesota winter afternoon. A large round table swallows up his office, and his chair turns easily from the table to his desk, shoved inconspicuously next to the wall as if good for extra drawer space. Nelson grew up in the golden age of the mortgage banking business and learned the trade from his father, Walter C. Nelson, who bought Eberhardt in 1951. Both Nelsons have served as president of the Mortgage Bankers Association of America: the father in 1959, the son in 1991. Nelson, now 51, has obviously mulled over the direction of the industry and of his company.

"Is the company here just to serve us old guys?" he says he asked himself years ago. "Will we, and how will we, build |for~ our successors? We have that obligation," he pauses, "and that interest." His son Tom is now at Eberhardt, creating possibly another generation in the industry.

Nelson saw the crunch coming. "Six years ago I was worried about what's happening now," he says. "But we are market driven, not drivers of the market. A lot of people create their own destiny. In the business we're in, we are reacting to market conditions all the time. We could spend months doing 10-year projections, but it would be a total waste of time because the market conditions have so much to do with what generates business for us. Our primary job is to react to market changes."

And therein lies one secret to his success, he thinks. "A lot of companies have problems doing that." He continues. "Never confuse success with a good market, or failure with a bad market."

Nelson sold off the residential side of his business in the mid-1980s and moved headquarters downtown in 1988. But while dropping the residential division and more recently winnowing down the size of the staff in the Minneapolis office, Eberhardt also opened a Phoenix office in 1988 and an office in Milwaukee on December 1. It is in these medium-sized cities that Nelson thinks there is room for Eberhardt to grow, and called it an "option" for the company to become more of a regional firm.

"Milwaukee as a real estate market was not hit as hard," Nelson says of his decision to set up a two-person Eberhardt office there. "A number of life insurance lenders say they'd be interested in the market, and there's not a lot of competition for our services. Chicago is not supplying |the mortgage banking services to the Milwaukee market~." But Nelson is realistic about expansion. "We'd never make it in New York City or Newark, New Jersey, or California or Texas. We are very Midwestern in outlook and attitudes."

And the Midwest has a number of cities that fit the bill. Des Moines, Omaha, Kansas City, St. Louis and Sioux Falls are all dominant cities in their states. Nelson would not specify where Eberhardt is considering expanding. And the tenet that shaped earlier decisions, "Let's be what we can be and do a good job of it," will surely follow with the company as it tackles expansion into any new markets.

Nelson's downtown office is a reflection of that commitment to quality. White-gloved elevator operators deposit guests at Eberhardt's fourth-floor office. Ceiling-to-floor glass walls serve as a front door. The receiving area is spacious and homey, more like a living room than an office. An Illustrated History of Minneapolis, a thick glossy book, rests on the coffee table. Nelson's office is right in front, in plain sight to viewers thanks to glass walls. Off to one side, behind the receptionist's desk, the wall is a collage of black-and-white photos, a tribute to the buildings of Eberhardt. The furniture is nice, polished. Even the plants shine.

The scene is more pragmatic less than a mile away at the Towle Building. Instead of gloved elevator operators, guests share a more utilitarian ride up to Towle's eighth-floor headquarters. A receptionist's desk regulates the flow of visitors to the offices, and the waiting area is small. Reiling's office lies at the far end of the floor through a narrow trail of cubicles. A framed poem titled "Attitude" hangs prominently on his office wall.

"I am convinced that life is 10 percent what happens to me and 90 percent how I react to it," the words by Charles Swindoll read.

It is obviously Reiling's attitude that has spurred Towle's continued growth in the face of such tough market conditions. The 60-year-old man looks closer to 45 and keeps in shape by running 1,000 miles per year. His reference to a yearly number of miles run instead of daily miles logged seems appropriate from Reiling, who speaks in metaphors and can't sit still for more than a few minutes at a time.

When asked about Towle's reaction to the dwindling commercial real estate market, Reiling spoke of cutting the finance department budget by one-third at the end of 1989. He then jumps up and imitates a golfer who missed a putt by a number of feet and says, "Other than the direction and the distance it was perfect." He concedes that the 1989 cuts were too late and not deep enough, "We couldn't cut overhead fast enough." So they plucked another 20 percent from the budget the next year. But "it was still not enough," Reiling says, sitting back in his chair. In 1991-92, the finance division finally turned a profit. Mortgages were half the size and took twice as long, but Reiling was happy.

Meanwhile the property management division has grown, the sales and leasing division has grown, the aforementioned research department has earned respect for its market reports and other surveys and the company itself continues to grow. In 1990, revenues were $12.5 million; in 1993 Reiling estimates that number will be closer to $16 million.

In late May, Towle signed a letter of intent to pursue the transfer of its property-management and appraisal/consulting divisions to a new venture called Marquette/Towle. Reiling will be a consultant to Marquette/Towle and serve as co-chairman of the new venture with Michael F. Kelly, chairman of Marquette Partners, Inc., Minneapolis.

"If this state had its tax act together," Reiling says, "this city would be dynamite; it would be growing like a weed. If we got real estate taxes in order, and state spending in some sort of rational balance, it would be unbelievable. We would grow twice as fast. We're already growing, we can't stop the growth, even with all our stupidity. It's so nice here."

The tourist office once billed Minneapolis as the Mini-apple, a smaller, more-livable New York with all the cultural advantages. But the differences are obvious. Bus drivers are friendly, a cab ride is relaxing, homes have yards, and the people, if you can get past their nasal drawl, are just plain nice.

"It's something about the mothers in this region," Reiling surmises. "People are psychologically secure. They know how good they are and they know how good they are not. It's very healthy." For Reiling, the people are a major selling point of the city. Another is the skywalk system connecting downtown Minneapolis. "We've got 20 million square feet under one roof," he cries, jumping out of his chair to grab another Towle Report. "You don't even need a coat. It's the dead of winter and where's my coat? In my car." But, he claims, he doesn't even need it there, with a heated garage connected to his home, and a heated parking lot connected to his office.

Yet, selling the Twin Cities to investors will continue to be a chore for a few more years. Four new towers finished in the early 1990s have added a combined 156 stories' worth of office space, much of which is still vacant. The motto recited through the recent lean years in the finance division still falls knowingly from Reiling's lips: "Survive till '95." He, too, has been in the business all his life, since 1958 when he started at Eberhardt, and worked as a mortgage banker on up to executive vice president. In 1973 he moved to Towle. And as a career mortgage banker, he is the first to admit he can't predict the direction of the industry.

"I don't think there are very many people who know the future of the commercial mortgage business. I don't know that we're going to be making mortgages and servicing as we have in the past. I don't think there's anybody who really knows. Are we going to be servicing securitized mortgages that are sold on Wall Street? Are we just going to be doing portfolio money reviews and not collecting money? I don't know. I just don't know.

"I think there's a future, don't get me wrong. I think there's a future for us because real estate is parochial. Real estate is local. Real estate needs trained professionals, trained ethical professionals on the local scene. And I think it's an exciting future."

Both seasoned mortgage bankers see the market slowly improving over the next few years. Nelson says such recoveries generally take about 10 years, and most of the country, including the Twin Cities, is at the five-year midpoint. Reiling says it has to get better because "we're at the bottom. We're at the bottom as far as rents. We're at the top as far as vacancies." Southern California and the northeastern United States are exempt from his predictions.

Ever ready with the metaphor, Reiling adds, "I'm staying loose in the saddle. I'm ready for anything."

Karen M. Lundegaard is a reporter with the Cincinnati Business Courier. She grew up in the Twin Cities.
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Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Minneapolis-St.Paul commercial real estate market copes with recession
Author:Lundegaard, Karen M.
Publication:Mortgage Banking
Article Type:Industry Overview
Date:Jul 1, 1993
Previous Article:Signs of a rebound.
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