May 2020, Now it’s Plummeting?
In a matter of only a few weeks, the COVID-19 stay at home orders saw commercial real estate activity decrease by 90% as governments prevented touring of for sale and lease properties and companies looked through clouded eyes to try and see what the future holds for their business. At the same time, investors, who have been sitting on the side lines with a lot of cash, in markets they felt were overpriced, are now on the hunt for “deals”! In the beginning of the year we predicted that 2020 was a decelerating year for commercial real estate, but now it looks like it may be a plummeting year. The longest ever waive of economic expansion that Denver has been riding has come to an end as the U.S. appears to be entering a recession.
For the office, retail and hospitality markets, there is a deep sense of uncertainty in the industry. Big box and mall retail locations will see vacancies increase as larger retailers fail to weather the storm. Hospitality properties such as hotels and restaurants will have a very long recovery time and some of them may never reopen. With office space, we are in the midst of the largest work-from home experiment ever! Different companies could be seeing different messages. Some may decide they need less space because they have learned that employees can function by working at home. Other companies may find they need to increase their square footage to facilitate a decrease in density to obtain necessary social distancing. Some companies may send 50% of their employee’s home, leaving them with enough current space to redesign their layout for social distancing. These same companies may also decide to move from the highest price Class A properties to lower cost B and C properties. With employees only being in the office 50% of the time, and little interest in using publicly accessible facilities, companies may find they can forgo all of the amenities of higher class office properties in favor of more attractive lease rates in lower quality properties.
What will the overall effect of the COVID-19 virus be on the commercial real estate market? The truthful answer is, no one knows. It’s too early to predict the impact and there are very few post COVID completed transactions to measure what direction property values and lease rates may be going. The COVID-19 issue may be the least of Denver’s problems. With a high percentage of downtown Denver’s office market occupied by energy sector tenants, and oil prices dropping, some are concerned Denver and Colorado could see a downturn like that of the 1980s as these tenants consider smaller or zero footprints.
Denver’s office vacancy at the end of first quarter 2020 increased to 10.5% up from 10.1% one year ago. Net absorption during 1st quarter of 2020 was a negative 483,696 square feet of space. Average asking lease rates for all metro Denver office space continued to increase to $28.61 per Rentable square foot on a full service lease. Office space availability is expected to rise for the balance of 2020 which will cause downward pressure on asking lease rates. 1st quarter 2020 ended with Denver having over 3.1 million square feet of office space under construction, which consisted of 32 properties that were 41.5% preleased. The construction pipeline is the smallest it has been in 4 years, and fewer construction starts are expected in the near future.
Many tenants could need rent relief way beyond the length that their PPP loan will last. There are a number of options a tenant can employ to reduce their occupancy costs, such as recasting leases–what we call “blend and extend”, rent holidays, lease buyouts from existing or new landlords, or subleasing all or part of your existing space.
Expectations are for the office market to move more strongly to a tenants market. Tenants of all sizes should be able to command lower lease rates and stronger incentives, such as more free rent, increased tenant finish allowances, moving and cabling allowances, and discounted or free covered parking. Landlords will be looking closer at tenant credit and ability to withstand another round of stay at home orders.
Tenants with lease renewal options should make sure they have expert advice on market lease rates and not just accept a lease renewal rate proposed by their landlord. For companies that wish to relocate or build out new space, significant time will be needed to accomplish design, obtain construction permits and complete construction. For most tenants, starting the process 9 to 12 months in advance of your lease expiration is appropriate. For large tenants, starting 1 to 2 years in advance is necessary. Identifying upcoming space options, gaining market knowledge on other tenants negotiated lease rates, tenant finish allowances, free rent, and other incentives is necessary to achieve the best economics on your next lease decision. Retaining an experienced commercial real estate consultant to represent your company is imperative to navigating our “new normal”, accomplishing your goals, and keeping your companies occupancy costs as low as possible.