MARKET HIGHLIGHT, JULY 2005

DENVER: AIMING FOR HIGHER GROUND
Sherman Miller, Carter Sales and Larry Thiel, Jr.

Denver’s commercial real estate market has remained relatively flat, with the exception of retail. This perceived bottom of the cycle has investors eager to get in on the ground floor for the ride to recovery. Job growth and infrastructure improvements, coupled with a major acquisition in the industrial market, will help to perk up the Mile High City’s momentum.

Industrial

Whoever coined the phrase, “you are making a mountain out of a molehill,” must have had a crystal ball on the 2005 Denver industrial market. The recent purchase of Catellus Development Corp. by Denver-based ProLogis forms the largest network of warehouses and distribution services in the world. How much of an impact the new-look mega-industrial development company will have on the local market remains to be seen. But it could help provide a much-needed spark to an otherwise flat industrial real estate market.

Denver’s industrial segment appeared slightly weaker in first quarter 2005 than it did during the second half of 2004, with overall absorption increasing by slightly more than 100,000 square feet. A shift of users that were occupying flex space as a low-cost office solution back to more traditional office product has created some of the increased industrial vacancy, especially in the southeast sector where high-tech flex space has become the product of choice. The change in attitude could be a good news/bad news situation though, as these users apparently realize the overall market has reached the bottom of the cycle and a move back to office product in the near future in Denver should come at a premium.

The northeast sector, on the other hand, has already begun to experience some positive growth. ProLogis has its major presence in this portion of the Denver metropolitan area, with its new ProLogis Park 70 continuing to add product, including a 283,666-square-foot development nearing completion. Along with other projects in the area, the new construction may threaten the Denver metro area’s current streak of four consecutive quarters with positive absorption. But the general tone of the region’s growth indicates the market is ready to climb the peak of new product.

With overall lease rates remaining relatively flat, recording direct weighted average rates of $3.99 per square foot NNN, the industrial market in Denver has shown some increase in activity. Over the past 6 months, most of the activity has been the “tire-kicking” variety with only a minimal amount translating into signed leases.

Signing on the dotted line has not been a problem in the industrial investment market. Denver has become a “go-to” market for virtually every institution. An increased commitment to the freeways, a decrease in unemployment and a variety of other infrastructure improvements throughout the Denver metro area have combined with record low cap rates to return Denver to the middle of the national investment frenzy.

Industrial real estate fundamentals continue to remain stable in Denver with minimal improvements. But with an increase in activity and the excitement created by ProLogis, the industrial market may indeed soon become another mountain on the Colorado horizon.

— Sherman Miller is area leader in Cushman & Wakefield’s Denver office.

Office

Recovery brought by the melting of an ice-cold national economy is beginning to trickle down to the Denver office market. Although historically the overall process has taken longer than the thawing of a Rocky Mountain glacier, the current cycle could be the exception.

While many primary markets throughout the country are experiencing dramatic turnarounds, Denver’s pattern over the past 25 years has been similar to other secondary markets, trailing the recovery by more than a year. This time, however, the warming trend has already reached the Mile High City. Denver’s unemployment rate has dropped, with job growth in positive numbers for back-to-back years after a streak of three straight negative reports for the area’s workforce.

An increase in user activity has been felt in the overall office market during the first 6 months of 2005, primarily in the southeast suburban area, which has experienced a moderate rebound in the tech sector as indicated by a positive absorption of more than 460,000 square feet through the end of the first quarter. EchoStar Communications Corp., for example, recently purchased and will occupy the 600,000-square-foot campus formerly owned by Merrill Lynch.

Active prospects in downtown Denver continue to be energy-related companies. Current energy prices have forced many of those businesses to reevaluate their respective positions in the marketplace, with mergers and acquisitions, consolidations and extensions making up the majority of the central business district (CBD) activity. Direct vacancy for all classes of office space was 15 percent at the end of the first quarter, while Class A product experienced a slight decline in vacancy from fourth quarter 2004, moving from 13.9 to 13.5 percent.

The increase in activity has translated into a relatively flat leasing rate, recording a direct weighted average for Class A office space of $21.35 for CBD and $18.43 for non-CBD. In addition, owners are holding firm with fewer concessions. It is the first significant change in the market over the last 9 months and should signal the bottom of the cycle.

Echoing the national trend, office investment activity remains the summer’s hottest sector in Denver. Currently, many properties are receiving multiple bids in what has been nothing short of the biggest buyer frenzy in the last 25 years.

Improvements in Denver’s infrastructure, led by the recent vote in favor of FasTracks, a $4.7 billion, 12-year tax commitment to build 119 miles of light rail throughout the city, as well as new light rail stations, expanded suburban bus service and freeway expansions have added to the momentum created by record passenger traffic through Denver International Airport. Three of the newest sports and entertainment venues in the nation have also helped. While not quite ready to boast an avalanche of activity, the temperature of Denver’s office market is definitely heating up.

— Sherman Miller is area leader in Cushman & Wakefield’s Denver office.

Multifamily

The apartment market in the Denver/Boulder metro area has reached the bottom trough of the real estate cycle. Job growth and limited new supply will fuel the recovery to take place in the next 18 to 24 months.

Current overall vacancy stands at 9.3 percent, but the larger factor is rent concessions, which range from 15 percent to 20 percent of gross potential rents. The highest concessions are being offered at newer properties, although landlords are requiring longer lease terms for these high concessions. The market reflects that concessions have begun to slow and will continue to evaporate as rental demand is fueled by economic growth and job creation.

The Denver/Boulder metropolitan area created 12,600 new jobs in 2004 which represented an increase of 1 percent over 2003. This job increase is welcome news after 2 consecutive years of net job losses in 2002 and 2003, representing 62,000 jobs lost. The forecast is for continued job growth of 2.5 to 3 percent for 2005. Job growth coupled with rising interest rates will encourage the formation of more rental households in the Denver market.

Development of new apartment product in the market has slowed to an expected 2,500 new units in 2005, well below the peak of 9,000 new units that were added to the market in 2002. Typically, Denver has absorbed an average of 4,500 new units annually; therefore, the 2,500 new units expected in the market is well below the historical average absorption rate.

The hot market for new development is Transit Oriented Development (TOD) sites along the southeast corridor of Denver. Developers are planning new product in close proximity to eight new light-rail transit stops that are currently under construction along the $1.6 billion Interstate 25 Transportation Expansion Project scheduled for completion in 2006.

Investors remain bullish on the long term outlook for Denver and the intermountain region as a safe haven for real estate investment and an alternative to the stock market. Buyers are accepting lower initial returns on equity in exchange for well-located, quality apartment investments now that the economy is creating positive job growth and the supply of new product has slowed to a reasonable level. In addition, the prospect of rising interest rates will help to fuel apartment demand as fewer renters will be able to qualify for loans to purchase homes.

For the remainder of 2005, look for rental rates to remain flat. Owners will realize subtle growth in net operating income as they are able to reduce concessions with the recovery.

— Carter Sales is an associate for Grubb & Ellis in Denver.

Retail

The Colorado market has remained relatively strong over the past 24 to 36 months, especially in the retail investment sector. The primary reason for the prolonged bullish activity has been the low interest rate environment and the perceived stable investment returns, particularly when compared to the stock market. As more new equity flows into the retail investment arena, many owners are taking advantage of the pent-up demand and selling their real estate assets. Buyers continue to purchase these investments due to low interest rates by which debt can be obtained. And in turn, these sellers ultimately trade their equity position for newer or larger assets in order to avoid any potential capital gain taxation. This trading frenzy appears to be in full swing and could keep the retail investment market relatively strong for the next 12 months, as long as long-term financing remains at its current pricing level.

While investment activity is extremely high, caution has been exhibited when discussing the issue of the “Wal-Mart” effect in Colorado. The fear factor with many retail investors is that as Wal-Mart continues its consumption of marketshare in both manufactured goods and grocery products, some grocers may be forced to exit the state leaving large blocks of vacant space. This pattern has been more prevalent in smaller towns and communities. With more than 33 Wal-Mart Supercenters in Colorado, smaller supermarkets could be forced to close their doors as the retail giant moves in. The loss of a grocery “anchor tenant” threatens the economic health of all the other retailers in a retail center. Often times, the smaller retailers rely heavily on the anchor tenant to bring in traffic to the center. Not only is the economic health of the center threatened, it is often difficult to re-lease this type of anchor tenant space as the user pool for 40,000- to 65,000-square-foot tenants is quite limited in secondary and tertiary markets.

Although there are some concerns regarding the retail market, buyers, tenants and developers alike view Colorado extremely favorable. In fact, newly constructed retail projects, with credit-worthy tenants willing to sign long-term leases, are commanding cap rates well below the historical averages across the board. This type of aggressive pricing is not limited to the Denver metropolitan area, but is consistent throughout the state. Similar projects in markets such as Boulder, Colorado Springs, Loveland, Longmont, Greeley, Fort Collins, and Grand Junction are commanding cap rates similar to those found in the Denver metro area.

There are currently a number of new projects being planned, built or completed in Colorado, which will add to the total inventory by the end 2005. This is evidence of the strength and confidence of the mountain states’ consumer, with a confidence index exceeding 100 since early 2004 (and continuing to climb on a month-by-month basis). Retail vacancy in the Denver metro area stands at 9.2 percent while the median rental rate hovers around $15 per square foot per year. As long as the market fundamentals remain as they are with low interest rates, aggressive pricing levels and limited alternative investment vehicles, the retail segment of the real estate arena will continue to keep pace and the overall activity level will be extremely high.

— Larry Thiel, Jr. is a senior associate for Grubb & Ellis in Denver.

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