MARKET HIGHLIGHT, MARCH 2007

MILE HIGH MARKET HIGHLIGHT
Bradley Rice, R.C. Myles, Pat Henry and Cary Clark

Vacancies have fallen in Denver’s office, industrial and multifamily sectors while retail development activity abounds.  

Office

In 2006, the Denver market experienced a dramatic decrease in vacancy due to strong positive net absorption. The 100 million-square-foot Denver metropolitan office market experienced nearly 2 million square feet of positive absorption as vacancy fell from 15 percent at year-end 2005 to less than 13 percent at year-end 2006.

The brightest area of the office market was clearly the central business district (CBD), where there was approximated 900,000 square feet of positive absorption, causing rental rates to increase nearly 15 percent. This rental increase has led two developers, Opus and Hines, to break ground on new office developments this year with delivery slated for third quarter 2008. The sale and renovation of 1001 17th Ave, the former Qwest building, will add an additional 675,000 square feet of multi-tenant space to the CBD in late 2007. The decrease in vacancy and correlating increase in rental rates and new construction are imminent.

Other submarkets, like southeast suburban and northwest, achieved significant positive absorption as well as increases in rental rates of 15 to 20 percent. In the southeast suburban submarket, there are a handful of new developments planned for delivery in mid-2008. The new construction demonstrates the confidence developers have in this area with sustained rental growth and positive absorption on the horizon.

Even with the many positive signs in the Denver office market, including the increased job growth, not all submarkets have faired as well as mentioned above. Both the west and southwest areas actually experienced an increase in vacancy, while the rental rates in these markets remained flat throughout 2006.

Projections for 2007 are encouraging for the Mile High City’s office market with the recovery occurring faster than most had predicted. With Denver’s diverse base of employment and a continuing infusion of new jobs, the future of the office market is a bright one.

— Bradley Rice is vice president of NAI Fuller in Denver.

Industrial

The Denver industrial market demonstrated one of the strongest years in more than a decade with a decline in the overall vacancy from 8.1 percent at year-end 2005 to 7.3 percent at the end of last year. Activity was broad based across numerous industry sectors, with the strongest performance by smaller and medium-sized companies expanding and relocating to the Denver market. The top five largest lease transactions were Staples (300,300 square feet), Crocs Footwear (264,431 square feet), Whole Foods (142,788 square feet), The Home Depot (136,400 square feet) and American Building Supply (133,732 square feet). Overall gross absorption for the Denver market totaled more than 6.7 million square feet in 2006.

The total industrial market now consists of approximately 221 million square feet, and developers are active with approximately 1.7 million square feet of new buildings in construction. The largest speculative developments to break ground in Denver included Majestic (415,000 square feet), Loft Properties (408,058 square feet), Prologis (370,000 square feet) and The Pauls Corporation (206,000 square feet). Investors continued to buy up industrial projects in Denver with cap rates maintaining averages in the 6.5-percent range.

The market is characterized by very little sublease space, upward pressure on rental rates, continued interest by users in building purchases and overall strengthening. These trends should continue this year, with the overall industrial vacancy projected to fall below 7 percent, lease rates to rise by an estimated 10 percent and speculative development to total nearly 2 million square feet.

— R.C. Myles is vice president of NAI Fuller in Denver.

Multifamily

Denver’s multifamily sector continues to steadily improve. The past 24 months have shown continued quarter-by-quarter increases in both rental rates and occupancy levels. Although the rental increases are modest, the overall outlook is extremely positive.

Economic vacancy is down from 25.25 percent in first quarter 2005 to 16.58 percent currently, according to Apartment Appraisers & Consultants. Many submarkets close to the CBD have seen 5 percent or lower vacancy levels. Average net rents are $765 per month or $0.89 per square foot. This is approximately $30 higher than 1 year ago, and rents should continue to rise. Construction has all but come to a halt after 5 years of excessive building. Nearly 2,300 new units were completed during that timeframe, and there are an estimated 10,000 additional units in various planning stages in the 7-county metro area. Most new construction completed in 2006 was affordable and student-housing projects.

Merchant builders are back scouring the market looking for land opportunities, with hopes of starting construction in 2009. There is little land product available; excessive entitlement fees will have a significant impact on future projects. Such hurdles should keep construction in check, with the limited number of units being built keeping pace with absorption.

Last year’s investment sector set a record in sales volume of more than $1.8 billion — $400 million higher than the previous year. Two record-selling transactions were made in 2006: 4550 Cherry Creek sold for $271,000 per unit and The Boulevard sold for $260,345 per unit. This price per unit is an all-time high for multifamily product in Denver. These new properties were sold during the lease-up phase. The total number of units sold in 2006 was in excess of 18,000, which is 30 percent above 2005’s totals.

The Denver market is attractive to investors due to the consensus that rents will continue to rise and that Colorado is steadily rebounding with job growth and a strong economic recovery. Colorado continues to draw significant interest from out-of-state investors, with California investors being the largest percentage of new buyers. The relatively stable economy and rental market in Colorado (versus California) spurs out-of-state buyers to continue to purchase in Colorado. This trend should continue as the financial returns in Colorado compare favorably to other markets around the country.

— Pat Henry is a senior vice president at NAI Fuller in Denver.

Retail

Nationally, the retail sector was ranked as the top performing real estate sector from 2002 through 2004 with annual returns of 17.9 percent versus 10.1 percent for all commercial real estate. But while the 12-month return for retail through October 2006 was still a healthy 16.2 percent, it has now become the lowest performing of the five core real estate categories. The recent surge in the performance of other sectors has made retail investing the least attractive for the ever-fickle institutional investor community.

As the volume of retail property transactions dropped for four straight quarters, the historically low cap rates that were prevalent throughout 2005 began to rise somewhat in 2006. And now, without the presence of the aggressive institutional buyers, the inventory of available retail properties for sale is actually rising, with the inventory higher by 50 percent in third quarter 2006 compared to the same quarter in 2005.

In the Denver market, just as nationwide, the strength of the retail sector resulted in the completion of significant new retail space during the period from first quarter 2005 through the end of 2006. As might be expected, this dramatic increase in supply eventually led to an increase in retail vacancy rates. After remaining less than 10 percent overall for more than 1 year, retail vacancies began rising in third quarter 2005 so that, by the end of 2006, the vacancy rate had risen to around 16 percent.

While the large amount of new inventory from active development obviously helped to increase the vacancy rate, owners also decided that they would prefer to endure higher vacancy rates rather than do without higher lease rates. From fourth quarter 2005 through the end of 2006, owners and landlords increased rental rates steadily from less than $15 per square foot on average to around $16.50 per square foot. This was, of course, another contributing factor to the increase in vacancies.

The real question, though, is not what has happened in the past, but what can we anticipate for the retail sector in the future. For potential buyers, the slower activity on the part of institutional buyers in the retail sector should create a market with increasingly better investment opportunities for other investors. And while additional space will become available in first half 2007, the balance of the year should slow dramatically in terms of new retail space coming to the market.

The slowdown in new product coming into the Denver marketplace should cause vacancy rates to trend lower for a couple of years beginning in mid-year 2007, and the continued slowdown in institutional activity in the city’s retail sector should lead to slightly higher cap rates in the short term. Combine these two factors and retail investments should provide some excellent opportunities for buyers in 2007.

— Cary Clark is a senior vice president at NAI Fuller in Denver.

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