CREJ - Office Properties Quarterly - September 2017
Earlier this year, I was speaking with a client who owns extensive commercial real estate holdings in Colorado, including two large office buildings, and he said he would be nervous to buy another office property today. He was voicing a concern about the office investment sector that I have been hearing often lately: The evolution of technology has allowed machines to fill the roles of people (requiring businesses to lease less office space) and prompted many employees to work remotely by phone, video and internet (which, again, requires less office space). The result is that office properties, similar to big-box retail, as a long-term investment have become stigmatized as lacking in relevancy. Consequently, many former office investors have shifted their attention to multifamily properties (everyone still needs a place to live) and industrial properties (goods come from shipping distribution hubs instead of retail locations in the age of online shopping). Don’t get me wrong, the logic behind investing in multifamily and industrial makes sense. But, as we have seen that retail is still important (exemplified by, for example, Amazon’s acquisition of Whole Foods), I argue that the office sector is here to stay and presents, perhaps, the best value for investor capital in Colorado today. Following are three reasons why. First, the office remains a crucial component to successfully running most businesses. While we have all witnessed the rise in the remote workforce, companies large and small are reversing work-from-home policies because there is no substitute for the benefits of in-person collaboration. Furthermore, the increasingly competitive job market is prompting decision makers to further define their company image through its office space. This is beneficial not only for clients who visit but also for recruiting and retaining the best talent. Nearly 100 percent of my office lease tours start with a client-led conversation about the image the company wishes to achieve in its new office, because the client wants his employees and recruits to be excited about coming to work. And offices are cool again! Collaborative office concepts are popping up everywhere – even in “regular” office buildings – and existing operations like WeWork are expanding into more office space at greater velocity than ever. Although individual offices in these co-working facilities are efficient, consider the massive common areas that tips the scale back toward more old-fashioned square-foot-per-employee figures.
Next, consider office properties’ relatively high return on investment. Margins are thinning for commercial real estate investments across the board in Colorado, but my perception is the nonoffice asset classes are doing so more rapidly. These days it is nearly a guarantee that on-market multifamily investments are offered at sub-6 percent or even sub-5 percent cap rates. Industrial and retail investment properties often are offered at sub-7 percent rates. Compare these figures to the 28 Denver County office buildings over 10,000 sf listed for sale on Costar in late August, of which 78 percent had a cap rate advertised at 7 percent or higher. Whereas five years ago, when full-service office leases without expense reconciliation provisions were prevalent, office landlords more frequently are switching to a triple-net platform or requiring a hard-line expense reconciliation policy for full-service leases. The result is the landlord’s lack of responsibility to eat rising tax and common area maintenance expenses – and a clearer path to profitability. And lastly, consider Denver office leasing trends in recent years. Office rates exceeding $50 per sf in Union Station and Cherry Creek have pushed tenant demand to the east side of downtown, Glendale and the Denver Technological Center, where you would be hard pressed to find a full-service Class B offering for less than the high $20s (downtown) and mid $20s (in Glendale and Cherry Creek) – representing a double-digit increase in just the last few years. In the first two quarters, leasing absorption is positive despite nearly 1 million sf of deliveries per quarter, while the vacancy rate has decreased by over 5 percent since 2009. Average rental rates and cap rates each have increased by 1 percent in the second quarter over first quarter. Factor in Colorado’s expected population growth and the increasing strength of the entrepreneurial and tech scenes, and it would appear the Denver investment office market is on solid ground. In summary, while the office market is evolving, it is not dying. The office place will maintain its importance in American commerce; higher returns are readily available for office investors; and the office market remains healthy in Denver. A quality I admire most in my clients is their motivation to go where the profits are, regardless of their asset type comfort, and what I have noticed is those willing to keep an open mind or, better yet, buck the current trend often enjoy the most success.