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Is Class B Office the Big Play for Denver in 2020?

navpoint  /   February 12, 2020

Originally Published in Western Real Estate Business Magazine

The Denver office market remains strong. Vacancy continued to compress in 2019 as rental rates and sale prices forged ahead to the highest levels in history, allowing landlords and sellers to remain in control of the market. Class A office transactions accounted for $1.7 billion office sales in Denver Metro over the past year, versus $1.2 billion of Class B office sales, with average market cap rates of 6.6 percent and 7 percent, respectively. Interestingly enough, vacancy rates are higher in Class A product at 11.7 percent versus 10.1 percent in Class B. Sale prices and rental rates continued to grow in both classes. However, there was a significant difference in rental rate and sale price numbers as Class B lagged by about 20 percent to 25 percent in both categories. With a potential downturn looming, it begs the question, is Class A or Class B office a better long-term value?

Considering rental rates and income are a direct derivative of what investors will pay for office buildings, investors must ask themselves whether rental rates are sustainable. It is apparent that the “chase” for the cool, hip, new Class A office is real, but the question is whether Class B may be a “safer” play as we look toward the future. According to CoStar, Class A space is much more volatile, while the  Class B office market trends to be more consistent.

If a downturn is, indeed, creeping upon us, how will the market react? How will tenants react? How will tenants react? Strong credit tenants have clearly “chased” the Class A space as well, but how will they react to a negative economic impact? Will there be a need to downsize and reduce overhead costs? To an investor, a 10 percent to 15 percent rental rate reduction will likely hurt the Class A landlord aiming to achieve $30 per square foot rates more than the Class B landlord currently achieving $24 per square foot rates.

Asking lease rates for new Class A will also remain on the rise as the newly constructed Class A continues to be delivered and construction costs continue to soar. Class B office holds the ability to be purchased at a price lower than constructing a new building, event with some capital improvements. Purchasing Class B office product may be a longer-term sustainable approach for the Denver market. In fact, it may just be the “golden child” of 2020.

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