In a recent article in Biznow, the author focused on examining commercial real estate trends in secondary and tertiary markets. He defines those as not included in the “gateway markets.” 
It’s interesting to see that the nomenclature of the commercial real estate world is beginning to merge with the language of the supply chain and logistics world. “Gateway cities” have major significance in the location of corporate headquarters, as hubs for the transportation and distribution of products, as financial centers, and, in some cases as R&D centers for industries such as pharmaceuticals, high tech, and fashion. As these cities have become more crowded and commercial development sites are unavailable, the cities are becoming unaffordable and corporations are seeking other alternatives, Hence, the search for other cities.
Trepp, LLC, a data analytics company, ranks the top 10 secondary commercial real estate markets (Metropolitan Statistical Area-MSA). Yield and income growth are pushing commercial real estate investors to these markets. The cap rates in the gateway cities are higher even though the net operating income is not. This compression of the spreads means that some funds might not be able to meet their required internal rate of return, the article states.
The increased commercial real estate investment in the top ranked secondary cities is also being driven by inbound migration, low unemployment, corporate relocations and amenities that are attractive to the employees of the companies relocating.
It’s not just in the office sector seeing new investment in the secondary cities, but the industrial sector is as well as the Amazon Effect takes hold and more distribution centers are required to serve the cities.
In early September, the Colorado Real Estate Journal hosted a conference to discuss the Denver commercial office market. Since Denver is the number 5 ranked secondary market, the discussion of the availability of Class A office space in Denver and the drivers behind the current state of the market was timely.
The first question to be addressed was where is the greatest demand for Class A office space in Denver. The answer depends upon where the tenants of these office spaces think it is. The demand for office space in the central business district (CBD) continues to be stronger than in the suburbs. The CBD apparently better meets the needs of the tenants.
Those business tenants believe their employees prefer (whether this is true or not is up to discussion) sites with certain characteristics. They think they can attract and retain employees easier if the business location has easy access (lite rail lines terminate in the CBD), has high quality housing available (CBD certainly has lots of expensive apartments and condos), and has lots of amenities (restaurants, clubs, sporting events) that are attractive to employees (I would question this reasoning; are all employees, regardless of age and marital status, choosing places of employment based upon the availability of amenities?).
The arguments are that these broad characteristics of a site will make the employer more attractive to employees. Denver has a tight labor market so potential employees have options. However, do these three characteristics cover the priorities of all employees? If it is not a profile that fits all of the employees, which one should be prioritized? If one group is prioritized, will these characteristics remain constant.? What happens when they get married, have kids, and need 4-bedrooms and good schools?
I have several “site selection checklists” that I have garnered over the years while working with the real estate departments of many corporations. One of them is 57-pages long and goes into excruciating detail. I am not certain how important to site selection in Denver are the availability of mass transit and good walkability scores. Perhaps they are critical. For companies not driven by the preferences of millennials, are these two characteristics as important?
What if the company wants to locate in the suburbs because of lower rents? Do different industries have different preferences? For example, technology companies believe the availability of lite rail is important to their employees. Is that the case for the employees of medical device companies? Aerospace companies? Logistics companies? For all employees? If Aurora had high quality housing with lite rail access, lots of great restaurants, a “campus” feel with great walkability scores, and music venues would those items change its desirability as a location for businesses?
Is there a point at which the CBD rent premiums are so high that Aurora might become more competitive? Some executives are agreeing to pay higher rents ($50 PSF in CBD vs. $20 PSF in Aurora) while diminishing the average square foot allotted to each employee. “The can gets tighter, but the sardines are cooler.” According to CoreNet Global in 2012 the average space allocated to each office worker was 176 square feet. In 2017 that number was 151 square feet, a 14% reduction.
Assume a business has 1,000 employees. At 151 square feet per employee, 151,000 total square footage is required. At $50 per square foot (PSF), the total annual rent would be $7,550,000. If the offices were to move to Aurora at $20 PSF the annual rent would be $3,020,000, a savings of $4,530,000. Is that difference significant enough to drive a company to an equally nice office, but with less panache?
There is a belief in the Denver market that because of the demand for qualified employees that every advantage counts. Does branding the company as “progressive,” or “hip” attract employees? At what point does the CBD of Denver begin to compete, not with Aurora, but with Nashville or Austin? Is there any real business substance in this differentiation of office markets in this metropolitan area? If a company has a competitive pay package and an attractive industry in which to work, how important is a 151 square foot office space? Could some of that rent difference be “invested” in the employees?
The availability of land for office space in Denver’s CBD is very limited, difficult to find, and a challenge to take through the approval process. Most importantly, it requires heavy capital investment with long-term, institutional funding. Today there is 2.2 million square feet of office space under construction in seven buildings and most will be completed this year. 40% are pre-leased.
There is no substantial new office construction in the pipeline in the CBD and availability will get tight. What will happen when this occurs? Will potential tenants continue to drive up and pay increasing rents? Will they look elsewhere? Will the B and C class offices get upgraded to provide more supply? 60% of the buildings in Denver are over 30-years old and are smaller than the new builds that are entering the market today. Developers are upgrading these buildings in an attempt to fill the supply deficit. These developers are adding things like tenant lounges, gyms with showers, and building conference rooms.
The costs of these rehabs and customized tenant improvements (TI) continue their steady rise. The big, more established developers are agreeing to spend $100 psf (often includes furniture and cabling) on TI, but are are demanding longer terms in order to amortize the TI. 7- to 15-year terms are becoming more common.
WeWork is the largest office user in CBD Denver and Manhattan, by the way. They are the aggregator of small tenants. They usually require one- to two-year leases at much higher rates than those charged for longer term leases. The small business that has demand for 3,000 square feet of space does not want to invest in TI or deal with long-term leases. The vision of their businesses is of fast growth and expansion.
At 150 square feet per employee an office space of 3,000 square feet can accommodate 20-employees. Brokers think uncertainty drives tenants to WeWork. The argument seems to be that if you believe in your business, you can sign a long-term lease. If not, sign a short-term lease. I would argue otherwise. It could be that they believe in their business and are certain it will grow rapidly and will quickly outgrow the 3,000 square feet. Today the business may need to keep expenses low while it builds its cash position.
The availability of parking is a critical factor in site selection in Denver and most CBDs in the US. As companies add more sardines to the can, parking becomes even more difficult. If the trend of cramming more FTEs into the same space continues, perhaps getting to 10 FTEs per 1000 square feet, the parking problem gets worse and worse. Maybe scooters are the solution when the weather is nice; maybe not if an employee gets killed.
Every trip by car that ends in the CBD requires a parking spot. As the density of more FTEs per square foot in office buildings in the CBD increases, parking becomes a bigger problem. One solution would be to increase the supply of parking spaces. Building parking garages is expensive. It has a negative impact on the environment and often is in conflict with community master plans that hope to improve the city’s walkability, or, in Denver’s case, bikeability.
Another solution might be to use the existing spaces more efficiently by, for example, having an app that identifies available spaces all the time. Demand could be reduced by having improved mass transit, or prohibiting automobiles in the CBD by offering parking “on the edge” with buses to the CBD. Lastly, the demand could be reduced by taxing the parking spaces so much it is not economically feasible to drive one’s car to the CBD.
Maybe mass transit will solve the parking problem. So far, no city in the US has a plan that has resolved the issue.
The demand in the CBD will stay strong until the tipping point is reached. The tipping point may be driven by office rents, the lack of parking, a change in the demographics of the employees (after all some will get married and require schools and larger homes), salary demands, or a combination of all of the preceding. Perhaps some innovative developer can create the same “vibe” that the CBD presents in a location in Lakewood, or east of DTC, or maybe even Aurora. After all, Aurora has lots of available land. Urbanized suburbs are popping up in a number of cities, with highly walkable and amenitized neighborhoods presenting opportunities for institutional real estate investors, companies, and families.
 Risky Business: Investors Are on The Hunt For Better Risk-Adjusted Returns In Secondary Markets, September 14, 2018, Champaign Williams; https://www.bisnow.com/national/news/capital-markets/risky-business-investors-are-on-the-hunt-for-better-risk-adjusted-returns-in-secondary-markets-92831?rt=62678