The Denver Office Market
Quarter One 2002

The State of the Denver Office Market

A number of business media articles have sensationalized the recent weakening of the Denver office market to the point of suggesting a major depression. This is simply not true. The articles did not point out that Denver office market actually fared better than those of most U.S. cities and is likely to improve within the current year.

As we stated in our last report, the Denver economy has experienced what we call a “Growth Recession” where positive rates of growth simply recede while unemployment rises moderately. This view is supported by the underlying economic data that clearly describe an economy that continues to grow, albeit at slower rates.  Job growth in Colorado has regularly exceeded 5 ½% during the past four years, a rate that will fall to 1% in the first quarter of 2002.  Similarly, unemployment has edged up from 2% to a current level of 3.5%, and may top out at just over 5%.  By comparison to any period other than the one just ended, a continued positive job formation and 5% unemployment would be considered extremely strong performance and in fact that is the case.  The Colorado economy remains on very solid ground.

During the last half of 2001, the Denver Metropolitan office market experienced one of the sharpest turnarounds on record, as almost five million square feet of new construction met with a sudden deceleration in demand.  The equilibrium conditions that characterized the Metro for the past five years were abruptly reversed as overall vacancy levels more than doubled, going from under 9% to more than 12%.  The damage was particularly severe in the Class A market which saw vacancy climb to 24.3% at year end 2001 versus a healthy 7.9% just twelve months prior.  Understandably, the high tech sector that has contributed so significantly to Denver’s growth in the recent past was responsible for much of the weakness.  This was particularly true in the hard hit telecom industry, as former bellwethers such as Qwest and Nextel reduced staff and put sublease space back on a market ill-prepared to handle it. In a recent (February 18) article in The Mercury News, however, it was noted that the Denver office market performed better than most major urban office sectors; Denver’s 12 percent vacancy compared quite well to New York (15%), Dallas (30%), Los Angeles (17%), San Francisco (16%), Atlanta (16%), Miami (14%), and Chicago (13%). We do not wish to take solace from other cities misfortune, but we must note Denver’s resilience in the face of national weakness argues for superior performance in the coming recovery.

While the “growth recession” describes a relatively healthy overall economy, the mild recessionary characteristics have hit urban office markets harder than in previous cycles because of the industries that were affected. The downturn began with the dot.com collapse before turning to telecom and then to technology in general. These industries are relatively heavy office users and their weakness showed up quickly in the above city’s vacancy rates.

Thus, although current conditions warrant extra vigilance, we continue to view specific office types in precisely defined sub markets positively.  Unlike the late 1980s, office buildings are not changing hands at prices greater than replacement costs.  In consequence, the new supply pipeline has been virtually shut down.  Ross Research Services estimates that completions will drop to 1.7 million square feet this year, and close to half that space will not be competing for tenants in 2002. This is an insignificant increment in a market of nearly 80 million square feet. Vacancies and rental rates improved rapidly following the 1993-94 dip and we would anticipate the same (again for selected product types in prime locations) beginning in the 4th Quarter 2002.  The IEC portfolio is outperforming the market, even in the current environment, and we believe we are well positioned to be the beneficiaries of a year-end upward move.

The Concentrated Nature of the Denver Office Vacancy and the IEC Portfolio

While Denver’s office market weakness was less than in most other cities, it was by no means spread evenly among its sub-market. Most of the weakness and vacancy occurred in two places: the northwest sub-market, where technology and telecom firms were expanding rapidly, and the north Denver Technology Center (DTC). As always, location plays a vital role.  A detailed examination of the broad statistics reveals that not all sub-markets are created equal.  The referenced Ross Report notes, for example, “The CBD [Central Business District] has been able to hold up fairly well despite a large amount of negative absorption . . .. Although vacancy in the CBD climbed to 11.84% from 5.05%, it is still the lowest of any sector.”  CBD rental rates fell less than other sub-markets with asking rents off about 10% at year-end.  Contrast this with the performance seen in the Northwest Sector, which experienced the greatest rise in vacancy: a near tripling to more than 35%.  The Interlocken Business Park (Northwest) experienced massive amounts of sublease space suddenly thrown on the market by Sun Microsystems, Level Three Communications, 360 Networks, Storage Technology, and a host of internet start-up companies.  The collapse in telecom/technology capital expenditures hit the Denver Tech Center with equal severity.  The capital markets reacted with equal speed however: new speculative construction came to an almost immediate halt.  Unlike the 1991 cycle, we believe that the current office market may be characterized as over-leased rather than overbuilt. Weakness in the DTC was caused by poorly timed new construction aimed primarily at Telecom tenants who were contracting. Most other Denver sub-markets were not seeing significant weakness and some were seeing surprising strength.

We are pleased to report that the Interstate Equities portfolio of properties was particularly well situated to ride out these turbulent conditions, and in fact most of our buildings are at or near all time record occupancy.  To understand this paradox, it is necessary to look beyond the macroeconomic numbers and focus instead at the detail level.  While the newspapers are rife with across-the-board descriptions of an overall office market in distress, we note that the Class C niche remains in relative balance.  As Ross Research Services reported in their year-end 2001 Denver Office Market Report, “The Class C market sustained the least amount of damage .  . . with 320,000 sq. ft. of negative absorption and a three-point rise in vacancy to 11.63%.”   The overwhelming majority of the IEC office inventory is in the Class C category.  As we have observed on multiple occasions, periods of economic weakness provoke a new respect for cost control among businesses that may have lost such discipline during upswings.  Our Class C buildings provide an economical alternative, which explains both the relative health of this sub-market and the occupancy levels enjoyed by the IEC portfolio.

How have specific IEC properties been affected by the turbulent market conditions?  Three properties were the greatest beneficiaries of the above changes. These properties were the Citywide Bank Building (or DIA Office Plaza), the Iliff Office Park and the Parker Plaza. These buildings benefited in occupancy because they provide the greatest rental value to cost conscious tenants of any property in our portfolio. They also benefited from being well located to avoid the congestion caused by the T-REX highway construction project discussed below.

Our Merham Office Park in Southeast Denver could theoretically be hurt by the DTC vacancy but, as we noted in our last report, was actually performing better than in previous years because its rental rates undercut new space significantly.

 Our two Northwest properties have been affected by market weakness in that area from the standpoint of not being able to sell these properties that were otherwise ready for marketing. Their operating statements are largely unaffected by the sub-market weakness but buyers are scarce when there is so much local vacancy. Office building buyers are active in Denver in its healthy sub-markets such as the Eastern and West side markets but are seldom seen in the markets with concentrations of vacancy.

Our International Building in the downtown has been somewhat affected by the increase in sub-let space in that market, primarily caused by the contraction of Qwest. The impact is to lower our office rents on upcoming vacant space from $18 to $15 temporarily and shorten leases so that this change is temporary. We do not expect this weakness to affect our five-year business plan for this property. Our retail lease rates are unchanged and activity remains strong.

Transportation Developments and the Denver Office Market

In one of the most important transportation developments in the state’s history, Colorado’s Transportation Expansion project, or T-REX, is well underway and portends momentous change of the two major freeway arteries, I-225 and I-25.  This $1.7 billion dollar, six-year infrastructure development involves adding three lanes in each direction, light rail, the reconstruction of eight major interchanges including the I-225 and I-25, the demolition and replacement of numerous bridges, and a total redevelopment of the “Narrows” (Broadway to Steele Street) in the CBD. The project is proceeding with such initial elements as the midnight demolition of numerous bridges to small for the new highway and is expected to create congestion for at least five years. We anticipate that our Iliff and Parker Road office buildings will see substantial benefit as businesses seek to escape the inevitable disruption occasioned by this massive project.