At first glance some of the 2023 Q1 data presented here seems contradictory: increased sales prices accompanied by declines in rent growth; higher vacancy rates alongside higher rent rates.
But if you look deeper into the data and consider the stories behind the numbers (which we’ll lay out below), there’s a logical explanation for the unique dynamics we’re seeing today in the Metro Denver commercial real estate (CRE) market.
We’re at a cusp in the CRE cycle – more specifically, we’re at the early hyper-supply phase for industrial and early recession phase for office properties. The impact seems muted on the industrial side given how strong that market has been in recent years and how it’s outperformed the office sector.
The industrial CRE vacancy rate in Metro Denver is still very low by historic standards, but it’s been inching higher since the middle of 2022. It’s up one percentage point from this time last year. The industrial market is strong, but it’s softening (not declining) for three reasons:
- The record-high demand for logistically critical warehouse space during the pandemic era is tapering off.
- General pre-recessionary business slowdowns are catching up with this sector.
- New industrial properties are increasing the product supply while massive corporate tenants/users are often reducing their footprints.
These newer industrial properties are commanding higher rent rates, as indicated by the $0.64 per sq. ft. increase in market rents compared to Q1 2022. But while market rents continue to increase, the rate of increase is slowing, as seen in the 2.3 percentage point drop in annual rent growth compared to Q1 2022.
In Q2 we believe the industrial CRE vacancy rate will remain steady given the new properties coming on the market. Rents and sales prices will increase, but rates of growth in both will continue to decline. In the coming year, the industrial CRE sector will soften but remain solid (especially smaller industrial properties catering to smaller tenants/users). It will weather the recession better than the office sector.
The Denver Metro office market is struggling, and if it weren’t for the relative strength of the office CRE outside of downtown Denver the picture would be even worse.
At 15.3%, vacancy rates are well above historic equilibrium rates of around 10%. Market rents are essentially the same as in Q1 2022. The modest 4% increase in market sale prices from a year ago to $257 per sq. ft. is explained in part by the fact that certain economically insulated businesses are relocating to higher-end, Class A buildings (a “flight to quality” phenomenon) to entice employees back to the office.
One major story in the office CRE market that’s not reflected in this data is the tremendous growth in available sub-lease space. The office vacancy rate of 15.3% doesn’t include roughly 6.5 million sq. ft. of available sublet space on the market. Companies are being hammered by the higher cost of capital (due to the Fed Reserve’s inflation reduction policy) and other negative inflationary economic conditions. In response, business owners and executives are scaling back their office footprints with large waves of layoffs (especially in certain sectors like tech) and subleasing their vacant space until they can renegotiate their lease agreements. It’s not an ideal situation, given that the companies are forced to rent the space out at a significant discount compared to their contract lease rate, adding to their P&L pain.
Our outlook for the office CRE market in Q2 is for vacancies to increase slightly, with market rents remaining flat or declining just a bit as sale prices fall. These anticipated falling office prices should create the first solid value-add investment opportunities in a dozen years for the patient, opportunistic, selective investor. Keep your powder dry!
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.