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Page 8 — Office Properties Quarterly — June 2019 www.crej.com Market Update I t’s good to be an investor in Denver office. Office proper- ties in Denver continue to see strong demand from global and domestic capital. Denver is considered a top-tier market for several reasons, and owners of its properties are benefitting from excellent fundamentals. In truth, we are experiencing one of Den- ver’s greatest expansion periods as the population has eclipsed the three million mark and a record number of jobs are being created. Vacancy is low, lease rates are pushing new highs, new construc- tion has been relatively in check and tenant demand is very strong. Despite these strong fundamentals, there are some trends developing in Denver – and nationally – that are impacting value as we’ve fin- ished the front nine and are mak- ing the turn in this 18-year real estate cycle. Maybe that is a bit optimistic, but who can argue the momentum of this cycle? The No. 1 issue facing office investors who are buying, leasing or selling assets is the meteoric rise in tenant improvement allow- ances. A few short years ago, inves- tors could underwrite $5 to $7 per square foot for every lease year of term. Currently, they are con- sidering $9 to $12, depending on the quality of the existing space. Much of the increase is due to the higher cost of labor, but the cost of materials has risen as well. Fortu- nately, we also are experiencing an increasing lease rate environment in Denver, which is helping to offset these costs. The elevated capital expenditures and where we are perceived to be in the cycle have resulted in office no longer being the most favored asset class for investment. There is a pronounced shift toward cash-flowing assets with lower expected capital expen- ditures, such as workforce housing, industrial, self-storage, life scienc- es, medical office and more, which are viewed as having reduced exposure. Risk profiles and buyer pools are changing too. Core funds generally are overallocated in office, and the buyer pool is getting thinner. There are exceptions in Denver, as some core funds have yet to place capital in Denver. Core investors looking at Denver are weighing whether to buy at a 5% cap rate and $750 per sf or build to a 7% and $600 per sf. The stabilized office buyer pool, generally core-plus in nature, is becoming shallower as the strategy and length of cycle are perceived to be disconnected. Fortunately for buyers and sellers transacting in this segment, debt funds are help- ing to drive value with aggressive terms as they compete to deploy capital. The value-add buyer pool is the most robust part of the bell curve of buyers, especially in Den- ver. In some cases, we are seeing pricing for value-add opportunities outperform stabilized assets. At this point in the cycle, we still see plenty of opportunity and are advising capital to analyze several strategies. One of those strate- gies is identifying suburban office opportunities that are transit ori- ented and/or walkable to retail with “good bones.” These assets have a key market presence and will continue to be favored as mil- lennials push to the suburbs. We see the repositioning of former core office buildings in core loca- tions as having significant poten- tial. Although there is a need for significant capital infusion in these assets, an operator will find abun- dant sources of equity and debt capital for the right business plan. Finally, spec suites that serve the market are proving to be highly effective. Although they may be expensive to build initially, we are seeing data that suggest the sec- ond- and third-generation build- outs tend to retain their value, resulting in lower tenant improve- ment costs as space is turned over. Denver’s office market is at an interesting stage in its growth. A new brand of tenant is entering the market that is showing a clear preference for newer construc- tion or buildings that offer newer amenities, superior functionality and locations to access a talented workforce. The tenants looking for best-in-class product are willing to pay lease rates that have surpassed peak levels. Denver can meet their expectations in nearly every cat- egory; however, the vast majority of office buildings in Denver were built in the 1980s, and, in addition to requiring significant capital for major systems replacements, this vintage doesn’t match the needs of this new tenant. Opportunistic and value-add cap- ital will continue to reposition the assets and realize massive returns as replacement costs approach $600 per sf downtown and more than $370 per sf in the suburbs. There are a few other themes to consider, such as the flows of global capital, the effect of cowork- ing tenants entering the buyer pool and an asset’s value with cowork- ing tenancy. Each of these are wor- thy of their own analysis for anoth- er article. Overall, Denver presents office investors with enormous potential for value creation and cash flow. Among the major metro- politan areas, Denver ranks sixth in population growth since 2010, the labor force has grown 16% in that same time period and Denver has the fourth-highest gross domes- tic product growth in the United States. Whether we are truly on the back nine or in a three-hole playoff in this real estate cycle, Denver’s growth will continue to attract investors for the foreseeable future. V The state of Denver’s office investment market Larry Thiel Managing director, HFF