Is the U.S. in a recession? Whether the correct answer ultimately proves to be “yes,” “no,” or “not yet,” it’s an academic issue that’s not keeping us up at night.
There’s no doubt, though, we’re entering a period of economic slowdown in the commercial real estate market caused by:
- Inflation’s impact on consumer demand and, therefore, business activity.
- The series of Federal Reserve rate increases that are increasing the cost of lending, diminishing buying power, and reducing the number of qualified buyers for commercial real estate.
As we’ve seen for the past several years, Denver’s industrial real estate market is outpacing the office real estate market. That kind of divergence will continue, albeit with the industrial sector slowly flattening out and the office market slowly declining. The trends are marginally better in the suburbs and other prime locations compared to Denver’s city core.
Office Workforce Issues Continue
Behind the office market data presented here are stories of companies struggling to bring employees back to the office and others who have decided to go to a fully remote or hybrid arrangement. They know all to well the tradeoffs between providing employee flexibility or enjoying significant cost savings, and potentially sacrificing company culture and productivity.
As long as a significant portion of white-collar workers prefer to work remotely and the labor market remains tight, the remote working situation won’t change significantly. A recession-induced reduction in white-collar office jobs will depress office space demand further still, although an economic slowdown may shift leverage back to the employer, who will likely seek to bring jobs back into the office.
Given the declining occupancy rates in office buildings, more and more property owners will likely find themselves in a “must sell” or “must refinance” situation, which will cause a decline in asking prices due to the cost of debt going up with the increasing interest rates. Owners with a solid equity position will hang on and make necessary financial concessions to attract and retain tenants.
Industrial Commercial Real Estate Sector – Key Data Points
The 10% annual rent growth rate in Q2 for industrial space (now at $11.44 per sq. ft.) is remarkable and much of this increase is due to the lack of newer, vacant light industrial properties currently available in Metro Denver.
Another factor driving rents is the vacancy rate of 4.9%, which has tightened over the past 12 months and has now dropped to pre-pandemic levels after drifting slightly higher during that period.
Some observers believe the market sale price, currently $183 per sq. ft., will move even higher over the next 12 months, although we believe any prognostications like that probably are not fully accounting for the looming impacts of inflation and the economic downturn. This sector might cool marginally, along with pricing pressure.
Office Commercial Real Estate Sector – Key Data Points
The relative strength of the suburban office real estate market is likely one key to the continued increase in sales prices for office space in the Denver region. The current average sale price of $254 per sq. ft. is up 5.4% over the last 12 months. Other conditions driving this figure include the fact that these office property owners simply can’t afford to discount their rental rates. There’s also the perception that office buildings still represent a reasonable investment with a market cap rate of 6.9%.
Vacancy rates will be the key indicator we’ll be watching in the office sector moving forward since the fundamental pricing principles of supply and demand can’t be ignored. The current 14.4% vacancy rate matches the rate in Q4 2021. The previous time it stood at that level in recent years was in 2005. Early indications are that the vacancy rate has plateaued, but, again, we don’t believe this estimate takes the upcoming economic upheaval fully into account.
Economic Cycles Rarely Align with Lease Expiration
In any market at any time, a seller, buyer, landlord, or tenant will be in a position of either an advantage or a disadvantage. The commercial real estate market is presently in a period of transition, and sometimes these parties have no better alternative but to act now, even though the timing might not be ideal for their purposes.
If you can’t afford to wait for markets to move in your favor and you need to make a deal (due to an active 1031 Exchange or an upcoming lease expiration, for example), just remember there may be a silver lining to take advantage of or a strategy to limit the negative impact to your bottom line.
We help our industrial and office commercial real estate clients make the best possible deal based upon the current market conditions.
If you’d like to dig deeper into this data or if you have questions about what all of this might mean for your commercial real estate investment plans or your tenancy situation, please contact us