Colorado Real Estate Journal - July 6, 2016
The outlook for commercial real estate in the Denver market remains positive as population and employment growth continue to increase the demand for space. For the year ending Dec. 31, 2015, the state of Colorado ranked second in the U.S. (behind North Dakota) for annual percentage increase in population. The 1.9 percent annual increase in population in Colorado was nearly 2.7 times the 0.7 percent national average rate of population increase over the same period. Most of the increase is attributable to net migration into the state. According to the Bureau of Labor Statistics, employment growth in the Denver metropolitan area between March 2015 and March 2016 exceeded 3 percent for the year, far outpacing the 2.2 percent national average rate of employment growth over the same period for the 326 cities reported by BLS. For the state of Colorado, the industries reporting the largest percentage increases in employment are Leisure and Hospitality, 7.8 percent increase for the year ending March 2016; Construction, 7.4 percent; Real Estate, 5.9 percent; and Education and Health Services, 3.6 percent. The Business Research Division of the Leeds School of Business has forecast that Construction, Professional and Business Services, and Education and Health Services will continue to lead the growth in the Colorado economy with 2016 expected rates of growth of 6.4 percent, 3.9 percent and 3.5 percent, respectively. In terms of the number of employees added to the Colorado economy between March 2015 and March 2016, Leisure and Hospitality added 24,200 employees, with 19,300 in Accommodation and Food Services and 4,900 in Arts, Entertainment and Recreation; 11,000 employees added in Education and Health Services; 10,900 employees added in Construction; and 7,700 employees added in Retail Trade. Government, at all level, added 9,200 jobs, while the Mining industry lost 6,800 jobs over the same period. The increases in population drove apartment and retail rents up substantially, while the employment increases put upward pressure on industrial and office space rents. With cap rates relatively flat over the past year, transaction prices increased, while transaction volumes for income producing properties decreased substantially. Real Capital Analytics reports that between March 2015 and March 2016, Denver apartment prices increased 39 percent, from $149,445 per apartment to $207,254. Apartment prices increased 45 percent for garden apartments and 22 percent for mid-/high-rise apartments. While apartment prices increased dramatically, transaction volume plummeted. Apartment property transaction volume declined by 28 percent for garden apartments and by 52 percent for mid-/high-rise apartments. Denver commercial properties also experienced price increases and decreases in transaction volume over the same period. Office property prices increased 14 percent, from $159 per square foot to $182 per sf, with suburban office prices increasing 21 percent and central business district office prices increasing 7 percent. Transaction volume for office properties fell 74 percent for all office, 69 percent for suburban office and 87 percent for CBD office. Retail properties experienced a 42 percent increase in per-square-foot prices and a 19 percent decline in transaction volume, while industrial property prices increased 14 percent, from $76 to $87 per sf, while transaction volume decreased 82 percent. Real estate supply will catch up to the increase in the demand for space – it always has and it always will. As more supply becomes available, rents will stabilize, and what happens to property values will depend primarily on future cap rates. Cap rates can be viewed as a spread over yields on 10-year U.S. Treasurys. While the Fed continues to threaten to increase short-term rates, current capital markets are not expecting much movement in long-term rates (e.g. yields on 10-year U.S. Treasurys). Current market expectations for future yields on 10-year USTs can be extracted from the current yield curve. As of May 31, 2016, yields on 10-year USTs were 1.84 percent (Figure 1). Without getting into the details, the current implied yield on 10-year USTs one year from now is 2 percent; two years from now 2.13 percent; and five years from now 2.37 percent, only a 52.9 basis-point increase in the yield on 10-year USTs over the next five years! So the current 7.5 percent cap rate for Denver office properties represents a 566 bps spread over the current yield on 10-year USTs. This is very high by historical standards. Over the 2001-2015 period, the average spread between CBD office cap rates and yields on 10-year USTs nationally was about 340 bps. As the economy continues to gradually improve over the next few years, the spread between cap rates and yields on 10-year USTs will likely revert to its historical average. With little upward movement in yields on 10-year USTs over the next few years, cap rates are likely to fall slightly.