Class B office: Is it time to invest here?
Low interest rates and lackluster demand has been the general scenario since 2009 around the local real estate scene. We witnessed little flurries of activity during this period, just to have them slow, and then go. No leads for weeks. This seemed to be true for all the product types except multi-family housing.
Most all the indicators reflected this stop/start demand with decent absorption in certain quarters, and then none, and ending each year with flat or negative absorption (negative absorption=net decrease in occupancy). However 2014 appears to have changed that pattern.
Year end numbers for Denver Metro report positive absorption in industrial, office and retail. This shift in consistent demand seems to reflect the overall economy of Colorado and both appear to be on an upward track. Based on data recently presented by CU’s Leeds School of Business Associate Dean, Richard L. Wobbekind, 2014 was a good economic year for Colorado in general, and Wobbekind and his team forecast 2015 as comparable and maybe even better.
So, why Class B office?
During each economic slowdown we have survived, we have noticed that healthy office tenants have used the opportunity to improve their office space without changing their budget. This pattern has been consistent during the Great Recession also and now we have relatively low vacancy in Class A office as the healthy tenants have upgraded their digs in the soft market conditions (with lower rental rates).
In the process they have caused an increase in the vacancy in the Class B office buildings that they formally occupied and pushed Class A office rates up to a point where new supply (construction) is forthcoming. This new construction, which is expensive, has the short term effect of pushing Class A rental rates even higher, increasing the spread between Class A and B.
The next cycle, in our opinion, will begin as those office tenants facing lease renewal or expiration start shopping around. When they do so (and they do), many will choose Class B space to take advantage of the rental rate spread. The savings currently can be as high as $10 psf per year! Furthermore, as the economy continues to grow, additional office demand will follow and much of this demand will land in the better value positioned Class B product.
The final metric we see, which confirms the timing of this strategy, is the current cost to reproduce these Class B assets. The general opinion in our area is that these buildings will cost between $220-270 per square foot (psf) to reproduce in today's marketplace. Not only are current Class B rental rates too low to support this new construction, current sales of this product type in the Denver Metro area have been at $150 psf or below. This suggests quite a move in Class B metrics will be forthcoming before any new supply comes to this market segment. Pretty clear buy signal on existing product.
In case you are curious, please know we have almost 35 year of experience in buying, leasing, managing and selling this office product (all classes). We understand this product very well and have been actively identifying Class B office assets. Because of the potential gains, both from occupancy (cash flow) and cost of replacement (appreciation), it is our goal in 2015 is too grow the portfolio, for our clients and active partnerships, in this Class B office category. If this sounds like an area of investment you would like to know more about, please feel free to call or write me.
Serving the Boulder, Denver metropolitan areas and the entire Colorado market.