The most recent commercial real estate (CRE) data show that we’re in a period of slow but steady transition. Throughout the Denver Metro area, the demand for industrial space has slowed and we’re likely in early stage of emerging from the depths of a depressed office real estate market.
We’re not out of the woods, yet though. Fed action is at least partially responsible for a dramatic decline in 12-month sales volume, which decreased almost 25.75 percent for industrial properties and 21.5 percent for office properties compared to Q3 2022. The CRE market is clearly in a wait-and-see mode at this time as it relates to future Fed interest rate increases.
In our blog on CRE syndication two months ago, we referred to the four-phase, six-year CRE cycle that’s been apparent in recent decades, a concept initially presented by Terry Painter, a prominent CRE expert and Forbes Council Member.
The four phases in this cycle are:
- The Recession Phase, in which investors initially hold on to their properties too long, but then quickly unload them when values decline significantly as the recession deepens.
- The Recovery Phase, when the recession begins to turn the corner and real estate prices are relatively low.
- The Expansion Phase, a seller’s market characterized by low vacancy rates and high rental prices. In spite of expanded construction activity during this period, good deals are hard to find.
- The Hyper-Supply Phase, where the market is saturated with properties and sales prices remain stubbornly high even while rents are declining. In this phase, markets are moving toward a recession.
Let’s take a look at the data to see where we might find ourselves in this cycle as we ring in 2023.
Industrial Real Estate Data Highlights
In addition to the data points that we typically track most closely, there’s another variable that warrants attention in the industrial market at this time.
For the past eight quarters, industrial space under construction in Metro Denver has consistently been above 8 million sq. ft. It had never exceeded that level in prior years. This new supply coming on line (much of it in the east I-70 submarket) hasn’t yet impacted rents and prices, but the writing is on the wall.
The industrial availability rate (which includes existing vacancy, pre-leasing of under-construction properties, and sublease space) has been inching up slowly, from 8.9% to 9.5% over that two-year period. The last time we saw industrial availability rates this high was in 2013 when we barely avoided a looming “double-dip” recession.
When all of the industrial space under construction is fully delivered, we may find ourselves moving from the Expansion Phase to the Hyper-Supply Phase, which precedes the cyclical Recession Phase. This hypothesis is supported by the fact that the current annual rent growth rate of 7.2% is projected to quickly fall by 2-3 percentage points over the course of this year.
Office Real Estate Data Highlights
It’s very likely that the four phases for the office CRE market have been distorted recently by non-economic factors, especially the work-from-home situation during and following the pandemic. After all, it seems we’ve been in a state of Hyper-Supply in the office CRE market for two years or more and we possibly even find ourselves at this time in the Recession Phase, poised to move to Recovery as return-to-office trends accelerate.
Since Q2 of 2020, we’ve seen mostly negative 12-month net office space absorption levels. Absorption turned slightly positive in the first half of 2022 but quickly slipped back into the red in the third quarter when the Fed started hiking the funds rate. Office absorption is projected to finally shift firmly positive in the last half of this year.
Similarly, office vacancy rates climbed steadily in the past two years, but there are indications that they will peak just shy of 15% by the end of this year.
All of this is to say that the crisis appears to be abating in the office market (albeit too slowly for landlords). We’ve likely seen the worst, assuming no new headwinds begin blowing. Compared to industrial, the office market phases may be condensed, and the Recovery Phase may arrive sooner, given that: a) the office market bottomed out deeper and earlier and b) work-from-home will be phased out for more office workers in the coming year.
This opportunity to enhance worker productivity, combined with an apparent increasing willingness by landlords to provide higher tenant allowances and other rent concessions, makes 2023 a better time to be an office tenant than it has been for several years.
Individual situations can differ from the aggregates and the averages. For example, office tenants need to understand the financial situation and motivations of each individual landlord they’re negotiating with. And industrial tenants may need to be flexible to relocate to a different sub-market with more vacancies. There are solutions for nearly all situations when you plan ahead and think outside of the box.
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