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This paper identifies the cyclical patterns of an office market under potential terrorism threat by comparing vacancy rates and rent per square foot trends before and after September 11, 2001. This study goes beyond identifying general market trends and focuses specifically on office trends among trophy, Class A, and Class B buildings in Chicago. The findings indicate that trophy buildings were severely impacted by 9/11 and did not recover until the end of 2005. Class A buildings were also significantly impacted, although less than the trophy buildings, while Class B experienced even less of an impact. In general, the Chicago office market cycles were estimated to be between 6.4 (sublease vacancy of Class B buildings) and 13 years (total vacancy of Class A buildings). [PUBLICATION ABSTRACT]

This study aims to identify the extent to which terrorism fears and the resulting economic recession after September 11, 2001 (9/11) impacted the Chicago downtown office market cycles of vacancy rate and rents (per square foot). The office market impact is estimated by using building-specific data that distinguish between classes (A and B) and trophy status, with a time horizon from 1997 through 2005. This study diversifies for the first time the effect of a severe external market shock (9/11) between "trophy," Class A, and Class B buildings in a very precise geographic area providing insight on the market tolerance by building class. Acknowledging that real estate markets are part of the economic system, there is a brief review of general economic cycle theories, as well as the interrelationship between real estate cycles and the economy.

The tools used to accomplish the aim of the study include statistical testing and a non-linear optimization model of Fourier spectrum analysis. The statistical tests indicated a significant difference between vacancies experienced before versus after 9/11 in contrast to rents. The Fourier results indicate that the Chicago downtown office market cycles span from 6.4 (sublease vacancy of Class B buildings) to 13 years (total vacancy of Class A buildings), depending on the market variable studied and building class. Trophy buildings seem to experience longer vacancy cycles (total and sublease) compared to Class B buildings and shorter rent cycles.

Literature Review

Economic, Real Estate, and Terrorism Cycles

Economists recognize four major cycles based on the study of a number of financial/economic indicators and international relations (Kondratieff, 1935; Modelski, 1987; Tylecote, 1994; Tvede, 1997; and Fekete, 2005): (1) short-wave cycles: a. Juglar's cycle with average duration of 7 to 11 years; b. Kitchin's cycle with average duration of 3 to 5 years; (2) medium-wave cycles: Kuznets' cycle of 15 to 25 years; (3) long-wave cycles: Kondratieff's cycle, which is approximately 47 to 60 years; and (4) extremely long-wave cycles: These cycles are based on international relations and span 100-120 years.

Acknowledging the existence of various length economic cycles, real estate researchers have directed their efforts to the study of two main areas: (1) the identification of real estate cycle lengths and (2) the relationship between real estate cycles and the national economy/business trends. In the first area, Wheaton's (1987) review of office construction activity in the United States between 1967 and 1986 revealed the existence of 10- to 12-year cycles. Earlier studies by Barras' (1983) on office-development cycles identified 10-year property oversupply cycles; the Grebler and Burns (1982) study of the non-residential construction activity in the U.S. identified four cycles, between 1950 and 1978. In addition in the first area, Brown and Liow's (2001) study of the commercial real estate and property stock prices in Singapore from 1975 to 1998 identified 8-year cycles for both markets. Another study, focusing on the values of commercial properties in the United Kingdom between 1956 and 1996, identified a fairly regular cyclical pattern of 7.8 years (Scott and Judge, 2000). In addition, Wilson and Okunev (1999) identified 7-year cycles in the U.S. securitized property market, while Irwin and Landa (1987) identified 8-year cycles in unleveraged property returns. In the second area of study, the relationship between real estate cycles and the national economy/business trends,1 researchers have argued for and against the existence of direct links between real estate markets and the economy.

Beyond economic-real estate cycles and their interrelationship, cycles are also identifiable in transnational terrorism events (Sandler and Enders, 2004) with researchers providing a number of causes for this phenomenon, such as copycat effects (Alexander and Pluchinsky, 1992), "attackcounter attack cycles" (Faria, 2003), "pressure by public-opinion" after an attack (Chalk, 1995), lagpreparation time required for "logistically complex events" versus other less complex events (Im, Cauley, and Sandier, 1987; Enders, Parise, and Sandier, 1992; and Enders and Sandier, 1999). The existence of a cyclical pattern of terrorism, along with the continuous adjustment of terrorism attack techniques and the terrorists' efforts to increase the number of casualties should be a point of concern for downtown areas in the future. Going beyond terrorism cycles, researchers also focused on the impact of terrorism on a number of economic indicators, such as Gross Domestic Product, investment, consumer spending etc. where they found statistically significant effects (Grain and Grain, 2006). Eckstein and Tsiddon (2004) studied the effect of terrorism on business cycles in the Israeli economy and found that "terror has a large impact on the aggregate economy," especially when the events are not isolated.

Overview of Impacts of September 11, 2001 on Real Estate Markets

Sandler and Enders (2004) study of all transnational terrorist attacks from 1968 to 2003 found that 40% were against U.S. interests. Although this percentage is significant and only one major transnational terrorist attack took place in the U.S. (9/11), this fact should not be reassuring, considering the existence of terrorism cycles and the concentration of people in downtown areas. The events of September 11, 2001 led to the death of 2,749 people in New York City; "the total destruction of 13 million square feet of Class A office space in the World Trade Center Complex and the damage in various degrees of 17 more million square feet," (Dermisi and Baen, 2005). Both "the destroyed and damaged office space represent 11% of the Manhattan Class A space and 44% of the downtown Class A space," but only 6%-7% of the total Manhattan office space (The City of New York, 2001).

The fears of potential secondary attacks2 in densely populated downtown areas led office owners and managers to deploy a number of new security procedures (Dermisi, 2006) based on the significance of the building and tenant requests, in an effort to maintain their tenant base. Although the security costs per square foot for both government and private office buildings in some cases rose more than 60% after 9/11, the market has now stabilized (Chapman 2004; BOMA, 2005; and Kinum, 2005). The cost of the additional security measures was not passed on to the tenants immediately because of the continuous adjustment of these measures and the need to maintain tenants during an economic recession. The difficulty in accessing exact security cost increase on a building-specific basis has led researchers to focus on the impact on vacancies or rent levels especially for tall or trophy buildings. Dermisi's (2006) comparison of three downtown Chicago trophy buildings, their immediate (shadow) areas, and the rest of the Class A office buildings indicated significant increases in direct and sublease vacancies after 9/11 and a lack of recovery until the end of 2005. A more expanded study of both Class A and B buildings in downtown Chicago until the end of 2006 and with the implementation of other techniques further reinforces the results of the previous study (Abadie and Dermisi, 2006). Fuerst's (2005) study of the Manhattan office market found that the devastation caused by 9/11 was absorbed by the market through time, even for tall buildings, although challenges still exist in the Lower Manhattan area. Fuerst also found that the majority of displaced tenants remained in Midtown and Downtown Manhattan, reinforcing a previous study by Dermisi and Baen (2005). An earlier study by Miller et al. (2003) indicated that a "small subset of trophy buildings in Chicago and New York seemed to suffer from significant losses in rental and value." Their survey of property managers in the U.S. did not indicate significant tenant flight from tall buildings at the time. Earlier, Mills (2001) had argued that the tallest buildings will suffer because of their high densities and Central Business District land values would suffer if there is an increased perception of fear of terrorist attacks.

Methodology and Data

This paper focuses on the impact of terrorism fears on the downtown Chicago office market using statistical testing and Fourier spectrum analysis. Chicago was chosen as the area of study due to the following reasons: (1) concentration of the tallest office buildings in the U.S. less than two miles from each other-Sears Tower (tallest building), Aon Center (third tallest), and John Hancock Center (fourth tallest); (2) concentration of key financial and economic functions in one area (Chicago downtown) with numerous high-rises; and (3) increase in vacancy rates after 9/11, especially in Class A office space.

This study analyzes total, sublease vacancy rates, and rent3 levels for both Class A and B office space in the downtown Chicago office market area using data from the CoStar Group. The CoStar Group data were provided by BOMA/Chicago as part of BOMA/Chicago's study of downtown Chicago office market conditions. Exhibits 1 and 2 show the area coverage of the study, based on the CoStar Group sub-markets. The study includes three "trophy" buildings (Aon, Hancock, and Sears), 85 Class A, and 279 Class B office buildings in the downtown area. The time series used include aggregate data of the variables studied from the first quarter of 1997 until the fourth quarter of 2005 (36 data points).

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The extent of the data set size (36 points) led to "zero padding"8 allowing the addition of zeros to the time-domain sequence, which increases the sampling rate in the time domain (and increases the number of frequency channels in the frequency domain). In this study, the same sampling rate was used for all types of buildings (trophy, Class A, and Class B) within each of the variables for comparison purposes. Detrending was also used for both vacancy rates (total and sublease) and rents per square foot, which allowed a lowering of the transformation of the sawtooth variation of a slow trend generated by the Fourier analysis. Based on the data set structure, the constant detrending was used to remove the constant trend.

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Results and Discussion

The two-tailed t-tests of the total and sublease vacancy rates, before and after 9/11, of trophy buildings as well as Class A and B office buildings, indicate a statistically significant difference between the two groups of observations at a 5% level of significance (Exhibits 3-5). The Mann-Whitney test also shows a significant difference between vacancy rate medians for all three cases. The increase in vacancy rates in downtown Chicago after 9/11 was caused by a combination of factors, among which are fear by certain companies to locate in trophy buildings [similar to Stoken's (1993) and Miller et al.'s (2003) observations], the new office stock, the sluggish economy, and the lack of inflow of significant numbers of tenants in the downtown area. Focusing on the new office stock additions, at the same time the downtown market was experiencing increasing vacancy rates, eleven new Class A office buildings were delivered from 2001 until 2005 in the area of study (representing 12.7% of the area's overall Class A space). Although their amenities, location, and preconstruction lease agreements made them attractive to high-end firms in the downtown area, they led to an increase in vacancy rate levels in the older Class A office stock.

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Average rents for both Class A and B office buildings do not seem to present a statistically significant difference before and after 9/11, although they do for "trophy" buildings (in deflated 2005 values) (Exhibits 3-5). The similar trends before and after 9/11 for Class B office buildings were expected because rent levels of these types of buildings historically do not fluctuate significantly through time due to their quality compared to Class A space. Only a significant market shortage may push their rents to higher levels. Class A properties' lack of significant statistical difference before and after 9/11 is mainly caused by the addition of eleven new office buildings in the West Loop, and even with higher rent levels, were able to attract tenants from the existing Class A office stock. These increased rents of the newly added office stock were able to balance rent decreases caused by other Class A office buildings. Trophy building rents, however, show a statistically significant difference before and after 9/11. More specifically, the average rent presents a 12% decrease after 9/11 compared to the before 9/11 trends, using the full extent of the dataset. The main reason for this significant decrease is the higher vacancy rate levels these buildings sustained after 9/11 compared to the rest of the office market, especially in their upper floors. In an effort to mitigate the continuous vacancy rates, the only available solution by owners was to both decrease rent levels and provide additional concessions. This result reaffirms Miller et al.'s (2003) observation for the significant impact of 9/11 on certain truly famous building rents. Unfortunately, the trophy buildings do not seem to have recovered almost five years after 9/11. Average Class A market rents were not significantly affected overall because the addition of new office space in high demand balanced the rent decreases of older Class A stock. The higher rents of the newer office space were sparked by the increased demand due to the location of these buildings (close to a major train station and expressway of Chicago), floor efficiency, and nontrophy status. These property elements led highend tenants, such as international law firms and finance/investment companies, to relocate to these newer buildings although they are paying a higher premium than for their previous trophy or non-trophy Class A space.

In addition to the ß-test results, the Fourier analysis provides additional insight on the vacancy rates and rents per square foot cyclicality of the Chicago downtown market before and after the external shock of 9/11. Exhibit 6 identifies the model best fitted to the dataset using zero-padding and constant detrending. The high R^sup 2^ values and the generally low standard errors indicate an increased accuracy in the identification of the vacancy rates and rents per square foot cycles for the various types of buildings. As presented in Equation 1 and Exhibits 6-9, the regression models include three key indicators: the amplitude, frequency or period, and phase. Particularly, Exhibits 7-9 present geographical evidence of the vacancy rates and rents per square foot cyclicality among the trophy, Class A, and Class B buildings.

Note that the waves' theory is used only for the cyclicality and not for the symmetry (length in time and amplitude). Each exhibit (Exhibits 7-9) includes two graphs, with the upper graph reporting the transformed data (after detrending) and the predicted model sum wave. The lower graph presents the sinusoidal wave with the largest explanatory data power and three other sine waves with some contribution. The almost non significant explanatory power of the three sine waves is evident in the very small amplitude and phase compared to the main sine wave (see the Appendix).

Analysis of Amplitude Trends

The amplitude, in this study, represents the extent to which vacancy rates and the rent per square foot levels were differentiated before and after 9/11. The analysis indicates that trophy buildings sustained a larger differentiation between the two periods (before vs. after 9/11) in vacancy rate levels (total and sublease) and average rent per square foot compared to Class A and B buildings. This maximum differentiation9 for trophy buildings is estimated for total vacancy rates at 16%, sublease vacancy rates at 6%, and for rents at $12.5/square foot (Exhibit 6). The maximum differentiation for Class A buildings is 10% for total vacancy rates, 3% for sublease vacancy rates, and $8.6/square foot for rents (Exhibit 6). Finally, for Class B the differentiation is 7% for total vacancy rates, 1% for sublease vacancy rates, and $5.8/square foot for rents (Exhibit 6).

Analysis of the Cyclicality Trends

The second and most crucial indicator in the regression model (Equation 1) is period T (or frequency), which represents the time under which the same vacancy rate or rent per square foot is repeated (cyclicality). Using period T, the vacancy rate and rent time length cycle among the three building types can be determined. Without the benefit of results from another study on the Chicago office market, the general literature is used for comparison purposes. The literature highlights that U.S. real estate property cycles range from eight to twelve years (Wheaton, 1987; Pyhrr, Roulac, and Born, 1999; and Scott and Judge, 2000), which is fairly comparable with the 6.4 to 13 years Chicago experiences (Exhibit 6). Focusing on the total vacancy rates cycles, trophy buildings (12.8 years) and Class A buildings (13 years) have comparable time lengths in contrast to Class B buildings (9.6 years) (Exhibit 6). Some causes of this difference between Class A (trophy and nontrophy) and Class B buildings are outlined below, although additional research needs to be conducted through tenant targeting surveys:

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* Tenant Image or Needs: Certain financial and other institutions prefer to locate in trophy and Class A downtown buildings, with a certain image or qualities, and therefore are motivated to sign long-term leases (10-20 years). The long-term leases prevent significant short-term tenant turnover among Class A properties because companies are reluctant to move before the end of their lease with the exception of significant company downsizing. The lack of shorter-term tenant turnover is therefore prolonging the direct vacancy rate of Class A properties, especially if there is not significant tenant expansion or tenant inflow in the area among tenants who are willing to pay the premium of being located in Class A versus Class B properties.

* Post 9/11 Terrorism Concerns: After 9/ 11 the Chicago Joint Terrorism Task Force assigned threat levels to each high-rise building based on the likelihood of a terrorist attack occurring at the building. The higher risk that trophy and certain other Class A buildings face due to their location, tenant base, or other security-related challenges prolongs their total vacancy rates.

* Class A Office Stock: Wheaton (1987) argued that over the last twenty years the "stock of office space increased almost 200%, with average length of lease shortening." All new office space added after 2001 in Chicago was identified as Class A, which in combination with the sluggish economy could not generate significant demand to lower the vacancy rates for such properties, therefore prolonging the Class A vacancy rate cycle. This trend seems to be consistent with Roulac's (1996), Wang's (2003), and Pyhrr and Horn's (2005) arguments on the link between real estate and the economy. The extent of the sluggish economy is evident from labor force data of World Business Chicago that which showed an unemployment increase in 2002 by 44% (8.5%) compared to the 1998-2000 period within the city of Chicago. Although unemployment had decreased by the end of 2005 to 7%, companies were still not expanding significantly. The same organization highlights that the total number of employed individuals decreased by more than 20% after 2001 as compared to 1990. This decreasing labor force trend had an obviously a negative effect on the need for office space, therefore decreasing demand.

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* Class B tenants: Class B tenants usually sign shorter leases because their companies might not be as well established as companies in Class A space and they have an increased probability of expansion or contraction based on market conditions. Therefore, a short-term lease provides these companies with the flexibility of occupying the space they need immediately, allowing them the option to expand or contract in the future depending on their business performance in the market. In addition, certain tenants aspire to move to Class A office space and prefer to sign shorter leases.

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The sublease vacancy rates cycle is significantly larger in trophy buildings (11.6 years) compared to Class A (7.1 years) and Class B buildings (6.4 years) (Exhibit 6). This significant difference between trophy and Class A buildings (Class A and Class B building cycles are comparable) is the result of a combination of the following:

* Tenant Stability: Sublease vacancy rate is usually caused by the significant contraction of a building tenant and the need to find a subleasee for the non-needed space. This contraction might be caused by either external economic conditions (e.g., recession) or internal conditions (e.g., company performance in the market). Unfortunately, the events of 9/11 led both causes to materialize even more for trophy buildings due to terrorism fears.

* Terrorism Fears (trophy buildings): After 9/11, the fears of other terrorist attacks targeting trophy buildings increased. The data set indicates larger amounts of space being placed in the sublease market compared to Class A and B properties, but more significantly an increasing exodus of tenants with expiring leases.

* Floor Layout: All three of the trophy buildings in this study were built in the early 1970s and their floor layouts might be inefficient for sublease compared to newer properties, therefore prolonging the sublease vacancy rate cycles of these buildings. Companies in search of space with specific requirements and without significant economic constraints are more likely to select space available on the direct rather than the sublease market, therefore prolonging the sublease vacancy rates of older trophy buildings.

Finally, rent cycles indicate for the first time that trophy buildings (7.7 years) present the shortest cycle compared to Class A buildings (10.1 years) and Class B buildings (9.2 years) (Exhibit 6).

Some causes of the trophy building shorter cycles are:

* Terrorism Fears: The most severe impact of 9/11 was on trophy building rents, which was caused by fleeing tenants who opted not to renew their terminating leases and moved to other less high profile buildings. In addition to these types of tenants, the available space in trophy buildings, especially in the upper floors, was much harder to lease triggering the lowering of rent levels. Although specific rent levels among the upper floors of trophy buildings are not available, a search in the CoStar Group database indicates that among Chicago's three trophy buildings (Sears Tower, Aon Center, and Hancock Tower), the majority of available space even by the end of 2005 was located above the 20th floor (84%) and the 30th floor (65%).

* New Office Supply: In order for trophy buildings to maintain their competitiveness, in a market within mushrooming new office buildings in highly attractive downtown areas and in a post 9/11 world, the owners/managers of these buildings need to adjust rent levels more frequently than other buildings.

Analysis of Angle Phase Trends

Taking as horizontal axis the axis of phase angle &, Exhibits 6-9 indicate that the maximum or minimum Y^sub ti^ did not occur for the same $. Therefore, the sinusoidal wave with the largest explanatory power does not have the same phase (staring point) as the other waves (of less significant contribution).

Conclusion

The study of the Chicago downtown office market (trophy, Class A, and Class B buildings) before and after September 11, 2001 indicates a lack of significant recovery almost five years after 9/11 mainly for trophy and less for Class A buildings although some positive signs are clearly evident. More specifically, the statistical analyses indicate that total and sublease vacancy rates increased on average significantly for all building types (trophy, Class A, and Class B buildings) after 9/11, but rents decreased on average significantly after 9/11 only for trophy buildings. A few factors triggering this increase include terrorism fears, addition of new office stock, and a slow economy.

The vacancy rates cycles of the Chicago office market spans from 6.4 (sublease vacancy of Class B buildings) to 13 years (total vacancy of Class A buildings) among trophy, Class A, and Class B buildings, using 9/11 as a point of reference. The rent per square foot cycles of the Chicago office market spans from 7.7 (trophy buildings) to 10.1 years (Class A buildings) among trophy, Class A, and Class B buildings using 9/11 as a point of reference. Comparing the Chicago office market cycles with those from the real estate cycle literature review (spanning 7.8-12 years), the Chicago market does not seem to be significantly different. The analysis, however, indicates that Chicago trophy buildings and Class A buildings seem to be more susceptible to external shocks (9/11) with longer total vacancy rates cycles compared to sublease vacancy rates and rent per square foot cycles. In addition, the magnitude of the waveform (amplitude) of trophy building vacancy rates (total and sublease) and rent per square foot is significantly larger than Class A and Class B buildings.

This paper has a threefold contribution: the first consists of the use of Fourier analysis in the analysis of cycles, which is an approach not well represented in the existing literature. The second is the depth of analysis within a market by analyzing market reactions to 9/11 not only by building class (A and B) but also between trophy and non-trophy Class A buildings. Finally, the study examines the psychological effect of terrorism (through vacancy rates and rent per square foot fluctuations) in a downtown area with a high terrorism risk factor, due to building stature, corporate-people concentration, etc. With the data sources now available in commercial real estate, additional research needs to be done based on individual building trends and their affects on the overall market trends under various conditions. This research will allow owners and investors to be prepared in the future for both terrorist and natural disaster events.

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