Colorado Real Estate Journal - July 6, 2016
With Denver’s commercial real estate markets basking in a sweet spot after six years of consistent and broad-based strengthening, we’re turning our focus to the market outlook and specifically the timing of the next recession. After all, the cyclical nature of the industry is no secret to real estate enthusiasts and is a “top-of-mind” question at this stage in the game. At the national level, real estate cycles closely mirror economic cycles as represented by the unemployment rate trend, particularly for the office, industrial and apartment sectors (See Figure 1). A recent forecast based on unemployment rate cycles by Richard Barkham, CBRE’s global chief economist, projects a mild U.S. recession beginning in either late 2018 or early 2019 with a corresponding rise in commercial vacancy rates. This timeline allows investors, owners and occupiers ample time to prepare for the market shift while still deploying capital as opportunities arise. Because real estate is local, it’s important to consider market-specific dynamics, including demand and supply relationships, when assessing the outlook for Denver’s property markets. The correlation between an individual market’s unemployment rate and vacancy rate trends may appear more variable at the local level than for an aggregation of markets. Per Figure 2, the correlation between Denver’s unemployment rate and office vacancy rate is the strongest but still valid among the other property sectors. If real estate cycles (both national and local) are tied to economic cycles, let’s review Denver’s economic cycle position to help gauge when commercial vacancy rates might increase. On the job market front, Denver reached full employment (typically considered 5 percent unemployment) more than two years ago, and current unemployment stands at 3.3 percent (March preliminary), according to the U.S. Bureau of Labor Statistics. The region’s tight labor market may in fact be restricting hiring activity in certain industries because it can take longer than expected to hire the right candidate before that candidate is snapped up by another firm. An increase in the unemployment rate should not imply a fundamental market shift locally until unemployment approaches 5 percent, which is not anticipated in the near term because ongoing job growth has yet to subside. For the last three years, the region’s employment base has expanded by 50,000 or more jobs annually. Underscoring this impressive expansion, the only other consecutive period of job growth exceeding 50,000 jobs annually was in 1999-2000. As of April 2016 (preliminary), year-to-date job growth is up 2.8 percent for the Denver Boulder region, and the region is on pace to add 43,300 jobs this year. While the pace of expansion has slowed since last year, the total number of new jobs in the market remains meaningful. Office-using jobs are up 2.8 percent so far this year compared to a more modest 1.7 percent year-to-date gain for industrial-using jobs. Retail- and hotel-related job growth is up 3.7 percent year to date (April 2016). Paralleling impressive job growth, commercial vacancy rates in Denver are at either their lowest position of the current cycle or near the bottom, with the exception of apartment vacancy, which has ticked up for the past three quarters to a still-tight 5.4 percent. Any softening in commercial vacancy in the near term does not indicate a slowdown in demand for commercial real estate. Instead, the culprit is the addition of new supply. Construction activity is generally at healthy levels and will be absorbed in reasonable time. According to CBRE Research, $4.2 billion of commercial construction is underway in the Denver market and about half of the total is tied up in hotel and multifamily projects. • About 2.8 million square feet of mostly speculative office development is underway and scheduled to deliver over the next 18 months. For comparison purposes, today’s pipeline of office development is less than the prior-cycle peak of 3.4 million sf (2008). • Industrial construction is at the highest level since 2001 with 4.4 million sf underway, but the sector’s tight vacancy rate of 4.7 percent and 24 quarters of consecutive positive absorption suggest the new supply is warranted. • Less than 700,000 sf of retail is being developed, which is well below prior cycle highs by a few million sf. E-commerce headwinds are contributing to the modest level of retail development in the market. • Concerns about the pipeline of multifamily units under construction are understandable given the 26,000 units that delivered in the past five years, according to CBRE Econometric Advisors. The addition of new multifamily units in the market is already increasing concessions and slowing rental rate appreciation; further deliveries will improve affordability to some extent. Overall, the outlook for commercial real estate market fundamentals through the lens of job growth and vacancy rates reveals a couple of key insights. First, given Denver’s below-natural unemployment rate and ongoing job growth (70 consecutive months), there are no indications that the local economic cycle exhibited by the unemployment rate will begin contracting anytime soon. Second, although we anticipate modest near-term softening in Denver’s commercial real estate vacancy rates, this will not be the result of a slowdown in demand but rather prompted by new supply across all property sectors. New supply is a critical component in meeting the needs of both in- and out-of-market tenants looking for office, industrial and retail space as well as residents migrating to the region and organic household creation. Vacancy rates may tick up in the near term, but it is not a signal of decline in Denver’s real estate market – rather it is a sign that the market is poised for continued expansion.