Plenty of space, but no room to grow for small companies in the Twin Cities

BKB Floral Foam, a startup that makes compostable foam for floral arrangements, was riding high on momentum last fall after winning Minnesota's largest innovation competition and the accompanying $85,000 in prize money.

In addition to hiring people and buying equipment, BKB leaders planned to use the award funds from the MN Cup, along with capital from investors, to begin producing the nontoxic foam bricks.

Executives, touring as many as five commercial spaces a day, kept getting rejected on the spot. Landlords were asking for five years' worth of financial statements – an impossible ask for the brand-new company that had not yet begun full production.

"No landlord would give us space," David Goldfeld, the company's chief technology officer, said.

Despite plenty of vacant commercial real estate in the Twin Cities, many of the region's small businesses say affordable leases are hard to find, reflecting a mismatch in the types of space available and types of space being sought.

Small, but fast-growing, companies often need combination space for both offices and labs or production. The space can't be too big that a small business can't afford it nor too small that it will immediately outgrow it.

It's a Goldilocks dilemma further complicated by the current realities of the commercial real estate market, which is often controlled by institutional investors that demand certain returns.

Leaders of these small businesses say landlords aren't willing to take risks on early-stage tenants that have not yet produced sustainable revenue over multiple years. Meanwhile, landlords say they're beholden to the investors' demands for returns, which often prevents them from lowering the price or shortening lease terms to make it financially feasible for smaller companies.

It's an impediment to growth for companies with annual revenue between $1 million and $5 million, said Stine Aasland, founder of Shakopee-based Nordic Waffle. "It's unfortunate there isn't a solution for companies like us."

There's a dearth of small-sized production and manufacturing facilities for growing food companies like Nordic, which makes frozen waffle sandwiches sold in nearly 1,200 stores, Aasland said. Tech and device company leaders say the same.

"The ability to be in person and have a vibe, it's more productive and there's more effort," said Sean Higgins, founder and chief executive of St. Paul tech company BetterYou, which recently expanded in the city's Obsorn370 building. "The grind, it's easier to do that together in the office."

Growth, at a steep cost

After months of searching, Goldfeld found a suitable location for BKB in Eden Prairie: a 3,500 square-foot concrete bay. There was an adjoining bay of the same size. The landlord said take both, or no deal.

They took it.

For medical device makers, there's not only a need for cubicles, but machining rooms, labs and clean rooms to block out possible contaminations.

Mark Strong, founder and chief executive of Heart Failure Solutions Inc., which makes a device to assist heart failure patients, was searching for between 1,500 and 2,000 square feet of industrial space with some office space.

"Nobody wants to rent [out] that space," he said. "They want someone to take 40,000 or 50,000 square feet."

Ramji Iyer's company also makes a heart valve, one that's deployed through a catheter. Iyer was looking to bring together his roughly dozen employees under one roof rather than scattershot meetings at coffee shops or online.

Both companies had raised substantial capital from investors, friends and family, but that money was earmarked for research and development, not rent.

"You're talking a $100,000 commitment and we don't have any [extra] money," Strong said. "And they want us to show revenue and that we can pay the bills."

After touring at least 20 office suites, Strong decided to partner with another medical device startup and share the cost of a 3,500 square-foot suite in Maple Grove, one that included a clean room. They paid a large sum up front to get a shorter lease and moved in two months ago.

Shortly after launching his company, Laplace Interventional, Iyer occupied a lab inside a contract manufacturer's building. After raising $7.9 million from investors, though, Iyer was ready to find his own lab only to learn his ideal location was pretty much nonexistent in the market.

"If you needed cubicles and offices, those places were available," he said. "I could not find warehouse and lab space that we needed."

In December 2021, Iyer signed a three-year lease for a 5,000 square-foot office in Plymouth previously used by a communications business. He had to go deeper into his bank account to pay for construction of a clean room, lab area, engineering cubicles and a machine shop, he said.

Laplace Interventional employs 11 people but, when the lease expires in 2024, may need to find a larger office to accommodate more people. "That's something I keep thinking and worrying about," Iyer said.

Similar to device companies, food startups require a nontraditional office setup with a kitchen, storage, refrigerators and mixing equipment, as well as an area to do administrative work.

When launching Grlk, founder Peter Chehadeh floated from one kitchen to another, cooking in restaurants before customers arrived or in churches.

Trying to grow his garlic sauce business from shared kitchens was difficult, he said, with time wasted cleaning other entrepreneurs' messes and only cooking during designated time slots. He considered a co-manufacturer, but worried the ingredients wouldn't be consistent or mixed properly.

In 2021, he and two other food entrepreneurs spent nearly $200,000 on a building in the Midway area of St. Paul. The three companies share 2,500 square feet, but Chehadeh has his own equipment that he purchased and about 400 square feet to call his own.

"I've doubled my capacity and I have room to double it again in the next few years," he said.

A market in flux

Amid the growth in work-from-home or hybrid life, larger companies across the metro downsized, freeing up office space. Vacancies increased to 13% during the last three months of 2022 for all property types, but for premier locations labeled Class A, vacancies rose nearly 33%, according to a recent Colliers report.

Simultaneously, lease transactions fell from 1,200 in 2021 to 600 last year.

There's obviously room for small companies to grow, but profit-focused landlords and property owners aren't likely to negotiate with cash-tight business owners. Traditional lease terms in the Twin Cities are five to seven years, said Laura Moore, a vice president at Colliers' Twin Cities office brokerage team.

Iyer said most startup founders want three-year leases, at the most.

"You're not going to find many landlords who are going to commit to anything lower than three-year terms," said Adam Barrett, Colliers' downtown Minneapolis vice president and occupier advisory specialist.

Cash is also an issue.

Some small businesses don't want to spend more than $4,000 a month on rent, Barrett said. That's about $2 per square foot. The rental rate for Class A properties downtown at the end of 2022 was $28.68 per square foot.

While failure rate is high for new companies, if a small percentage succeeds, space in the metro's real estate market is still a concern.

In Barrett's opinion, the market is ready. There's an abundance of sublease space available, and property owners are aware demand among startups is not being met. There's also plenty of move-in ready locations, mostly in downtown Minneapolis. And remodeling a previously used office is an option for companies able to build construction costs into their rent.

Moore of Colliers is skeptical.

"It'll be a challenge to meet demand of scaling small businesses moving forward," she said.

Rising interest rates have surprised some property owners, she said, and some are having to give their buildings back to banks because they can't refinance and don't have the cash flow.

"The bank is controlling all these lease terms and they're saying, 'Hey, property owners, you're past due on your mortgage by the way'," Moore said.

The good news, she said, is some buildings that are debt-free tend to be more flexible on lease agreements. A few buildings downtown have zero debt and are being aggressive in their offer terms.

"They don't have an equity partner or lender and underwriters to look over deal terms," she said.