WESTERN SNAPSHOT, NOVEMBER 2006

Salt Lake City Office Market

Until last year, Salt Lake City area office space was the perennial laggard in the commercial real estate market. Most investors avoided it because of high vacancies and lease rates that weren’t keeping up with other investments. But 2005 and the first half of this year changed all that. The city’s office space did more than realize its potential, it blew away every previous record.

So, what happened? First, the rise in prices of apartment and retail property finally made office space a reasonable risk. Second, office lease rates started to rise, making this market more attractive. And third, and most importantly, the vacancy rate plunged 35 percent, from 16.69 percent at the end of 2003 to 10.92 percent by the middle of this year.

Institutional investors noticed, and they returned to this market for the first time in a long time. The $110 million purchase of the 471,000-square-foot Cottonwood Corporate Center by Hines was first. In Salt Lake City, a $20 million sale is major, which made the Hines purchase extraordinary.

Another factor is the escalating costs in California and other West Coast markets, which have propelled out-of-state investors to check out secondary markets such as Reno, Nevada; Boise, Idaho; Albuquerque; and Utah’s capital city. The market is also seeing more tenant-in-common (TIC) transactions in which investors buy smaller, fee-simple parcels of a large property and then turn around and resell them to smaller investors. The tax benefits seem to outweigh the drawbacks of such deals, because more investors are buying in.

These additional trends should continue, supporting ongoing growth in the Salt Lake office market:

Low Vacancies in Class A

Investing in Class A office space will remain strong because by mid-2006 downtown vacancy rates had dropped to 1.9 percent, a big decline from 11.25 percent in 2003. Rates for suburban Class A space were cut in half by mid-year, from 18.26 percent in 2003 to 9.03 percent this year. As the cost of new construction continues to rise, from $150 per square foot for new suburban space last year to about $180 per square foot today, new construction will maintain a modest pace, which will allow vacancy rates to remain low and lease rates to continue to rise.

Downtown Refurbishing on the Rise

A developing trend this year and next is the refurbishing of Class C properties. Now that new construction is becoming less affordable, investors are viewing these buildings as a more cost-effective way to own real estate.

In the downtown central business district (CBD), Class C buildings typically are historic, older structures that haven’t been well maintained and, consequently, aren’t in demand. New owners will typically replace the mechanical and electrical systems and redo the exterior to create a desirable building. The former Auerbach department store building and the Walker Center are both examples of CBD rehab projects. When refurbished, these buildings will be offered as new office space.

More than Rehab Downtown

There are more than just rehab projects happening downtown. Six major office properties have traded already this year, which far exceeds the total for any other year in the submarket. Several other buildings in the heart of the city will be closed and razed to make way for other development, contributing to an even tighter supply in the market.

Also, due to high lease rates, there are more owner-occupied buildings, instead of straight property investment. As the cost to lease office space increases, more users of such space will recognize the benefits of outright ownership of real estate, including condominium-type office properties. Investors may be able to maximize value by purchasing a property and converting it to the condo model. There are examples of this in smaller projects located on the east edge of the downtown area, as well as in a suburban office park.

Overall, expect the office market to remain very active for the rest of this year and into 2007. Higher lease rates should keep values climbing, creating profitable opportunities for all investors, large and small.

Mike Richmond is a commercial real estate agent for Salt Lake City-based Commerce CRG.

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