While a lot of water-cooler talk currently focuses on recession fears and slumping home sales, much of the Inland Northwest commercial real estate sector is flying high.

One factor that’s causing the market to soar is a flight to quality.

The term flight to quality refers to a trend in which tenants who historically have occupied less-expensive space move into nicer digs.

“People are looking to upgrade, moving from Class C space to Class B and from Class B to Class A,” says Mark McLees, a real estate agent with NAI Black. “Some also are looking for the historical look, and a number of tenants are willing to put in money for tenant improvements.”

In downtown Spokane, large spaces—those with 10,000 square feet of floor space or more—are difficult to find, says Craig Soehren, sales associate at Kiemle & Hagood Co., of Spokane. Also, the inventory of buildings available for owner-occupants to buy is small, limiting options for some companies, he says.

A spring 2008 commercial space vacancy survey is expected to be completed this month. The survey is conducted twice yearly by Auble, Jolicoeur & Gentry appraisal firm in conjunction with NAI Black, Kiemle & Hagood and Goodale & Barbieri Co.

In the most recent vacancy survey, from last fall, the total office-vacancy rate in the Central Business District was 13 percent. McLees says the vacancy rate likely will stay in double digits through 2008 but it likely will be close to 10 percent later this year.

The current conditions are causing rental rates to escalate.

“Rents are definitely going up,” Soehren says. “There’s a lot of pricing shock in the marketplace. For tenants who are used to paying low rents, there aren’t that many options anymore.”

As of last fall, the average annual rental rate for recently leased Class A space downtown was $20.28 per square foot, comparable to what it has been for four years. Experts say, though, those rates are going up this year, and they expect them to continue to increase.

Currently, Black says, rental rates are substantially lower than the per-square-foot cost of new construction. He says the inventory of available office space will continue to constrict with little new development until rental rates rise and come more in line with the cost of new construction.

That dynamic is perhaps most apparent in Spokane Valley. There, tenants have absorbed a lot of the vacant office space in recent years, and a relatively small amount of new space has come on the market, Soehren says. Consequently, vacancy rates continue to fall in that market.

The most recent survey shows a 12.5 percent vacancy rate in the Valley, down considerably from a vacancy rate of 21 percent a year earlier.

One project that currently is under way, however, will add a large amount of office space to the Valley. Spokane developer Walt Worthy has started work on a 250,000-square-foot office structure just east of the Interstate 90-Sullivan Road interchange. That structure is expected to be completed later this year, and when it comes on line, it will add 10 percent to the total inventory of office space in the Valley.

In Coeur d’Alene, the office market remains tight, with little inventory of space for larger prospective tenants, says Mike King, associate broker at Coldwell Banker Schneidmiller Real Estate.

“At times, it can be difficult to find the right configuration for tenants,” he says. “If we work with a large corporation, it’s usually a build-to-suit.”

Coldwell Banker Schneidmiller Real Estate teamed up with Auble, Jolicoeur & Gentry for the first time last fall to conduct a commercial-space vacancy survey for Kootenai County.

That survey showed an office-vacancy rate of slightly more than 2 percent. King says he expects the vacancy rate to remain that low through this year. Many of the office developers in that market wait until they have tenants committed to the planned space before breaking ground on a building.

Northwest Place, a three-story commercial building at 1450 Northwest Blvd., recently was completed, and all of the second-floor and third-floor office space is leased out already. Some retail space on the ground floor is still unspoken for, King says.

Retail activity varies depending on the part of the region.

“If there is one part of the market we’d be concerned about, it’s retail,” King says. “That’s something that people are being cautious about.”

He says some national tenants are slowing their expansion pace, but developers are “being smart about it” and scaling back their development plans.

Last fall’s survey showed a retail-vacancy rate of 8 percent in Kootenai County.

While the retail market has cooled in general, some pockets in Kootenai County remain hot. King says rumors persist that some huge retailers will announce plans later this year for new superstores near the new Cabela’s store in Post Falls. Rumors involve companies like Wal-Mart Stores Inc. and Lowe’s.

In Spokane County, retail activity remains strong in downtown, though some say interest in other parts of the market has slowed.

The vacancy rate in downtown retail last fall was almost 7 percent.

McLees says, “That keeps declining rapidly, and I wouldn’t be surprised if that’s at 4 or 4.5 percent by the end of the year.”

While some say retail-space interest has tapered off in parts of Spokane, there still are some big players looking for a presence here, Black says.

“The tenants that aren’t here want to be here,” he says.

The retail vacancy rate remains low on Spokane’s North Side. As of last fall, only 200,000 square feet of space out of almost 4.4 million square feet was available, giving it a vacancy rate of 4.5 percent.

The similar-sized Valley retail market had a higher vacancy rate. Of its 4.4 million square feet of retail space, about 600,000 square feet was empty, giving the Valley a vacancy rate of 13.6 percent.

The North Side’s average annual rental rate for recently leased retail space was $18 per square foot, substantially higher than recent annual rate of $13.74 per square foot in the Valley.

On Spokane’s South Hill, which has a retail market that’s about a quarter the size of the Valley and North Side’s markets, the vacancy rate was 3.5 percent. The average rental rate for recently leased retail space on the South Hill was about $17 per square foot.

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