CREJ - Office Properties Quarterly - September 2017
Our Denver outpost covers the office market day in and day out. We study properties that run north from Longmont and south to Lone Tree, spanning nearly 1,200 individual buildings and encompassing 110 million square feet. In fact, the Mile High City is the nation’s 10th largest office market – one of only 10 to surpass the 100 million sf threshold. In other words, and in simpler terms, there’s a lot of office space all around us and the supply stock only grows. Through mid-2017, how many markets boast more office inventory under construction than Denver? The answer: Only seven. Regardless the size of any metro’s office market, there exists that niche of core, urban-area crème-dela-crème product – an exclusive set of buildings that can brand its city. Herein lies the collection that often first represents the cross-section of an office market, signaling a general sense of strength or lethargy. Typically speaking, from cycle to cycle, this collection of prized properties leads recoveries and downturns apropos to investment and leasing fundamentals. We call this our “skyline” – the urbanized micromarket comprised of trophy and Class A assets that serve as true drivers for developers, owners and occupiers alike. Here at home, what makes up the aforementioned market? The Denver skyline market is trophy and Class A product spanning the entirety of the central business district, from Wells Fargo Center across town to the Union Station wings, from a high-rise tower being built (i.e., 1144 15th St.) to the newly built, low-rise office component of the transformative Dairy Block project. In all, our skyline claims 35 existing or under construction buildings totaling 16 million sf. In our seventh annual examination of the Denver skyline, some statistical highlights included: • Skyline direct vacancy, at 14.9 percent, remains above the national average and is statistically the highest it’s been since 2009. • Tenant demand has rebounded, driving annual net absorption back into the black after a one-year hiatus and posting in positive territory for the fourth time in the last five years. • Asking rents, measured nominally, are at a record high ($39.78 per sf). • After adding more than 1.1 million sf from 2014 to 2016, development continues to hum along; two projects under construction will add another 1.1 million sf of trophy space upon completion. During the last six to nine months, our skyline occupancy rate fell to its lowest level in some eight years – a cyclical low at just around 82 percent. It’s not necessarily surprising when you consider the general dynamics taking shape within the overall Denver office set: Market momentum continues to shift more toward tenants’ favor, thanks, in no small part, to the introduction of new inventory. Nearly every square foot presently under construction or delivered so far this year is skyline-quality product and, for the third consecutive year, we’re north of 1 million sf being built right now. Three straight years of more than 1 million sf being built – that’s unprecedented since we started tracking skyline. In other words, tenants who still want that skyline caché (and who, of course, are willing to pay) have more options in Denver’s best office buildings than ever before. We believe our skyline to be at an inflection point. Given the significant increase in new supply, landlords are making concessions, even if they’re not lowering face asking rates. Work allowances and free rent offerings remain elevated while vacancy has ticked up. Our figures suggest that on a 10-year new lease transaction, occupiers can negotiate, on average, for a $50 to $55 per sf tenant improvement allowance and 10 months of free rent. It’s why we’re calling 2017 “neutral” in terms of market leverage, but that pendulum swings more toward tenants with each passing quarter. Still, we’re not projecting a skyline oversupply risk. Despite the lofty-seeming number, direct asking rents within skyline-quality product haven’t moved much. A note to occupiers: Believe it or not, adjust for inflation, and today’s average asking rent is only about 5 percent more than a full decade ago. Across 50 skyline markets nationwide, Denver’s $39.78 per sf asking price ranks as the 20th most expensive. Investors are increasingly looking to secondary markets, Denver included, for skyline acquisitions. Furthermore, owners and investors already know that occupiers continue to gravitate to buildings with the latest and greatest amenities. It’s why we’ve seen a slew of capital improvements made to properties throughout the entire CBD during the past several years. Capital’s focus will firmly remain on skyline properties; their ability to provide stable value places them atop the list of “most attractive assets.” Business’ desire to attract and retain the best possible talent has a high correlation with best-in-class and top-tier office space. For years, that’s benefited skyline-quality product with consistent leasing activity. Outperforming its suburban counterparts, new construction is attracting foreign capital at aggressive yields and record prices per sf. Finally, what about our house view looking forward? Our analysis suggests that construction will continue at a more muted pace in 2018. Skyline-quality leasing volume, along with investment trades, will remain subdued during the next 12 to 18 months as the market enters the latter innings of the real estate cycle. And though tenants will pay more for the prestige of a skyline address, rents should plateau as vacancy bumps up thanks to new deliveries.