Midmarket offices: An untapped investor sector

James Brady
First vice president, CBRE Capital Markets

While trophy and value-add office properties have led Denver’s investment market for the past several years, there are good reasons why more investors should be looking at Denver’s stabilized/Class B multitenant office product.

Stabilized, Class B office product is well supplied in Denver. First, there are many more investment options for mature Class B multitenant office product in Denver compared to trophy/value-add assets, which are becoming increasingly scarce. By building count, Class B properties represent 50 percent of metro Denver’s total office inventory, with Class A and Class C each claiming around 25 percent, respectively.

Campbell Davis
Senior associate, CBRE Capital Markets

However, building count alone doesn’t accurately reflect investment opportunity. If you look at multitenant office property trades from the beginning of 2017 through the end of November this year, you can see that roughly 65 percent of trades and 90 percent of total sales volume is attributable to trophy or value-add properties (sales volume percentage is skewed higher due to the higher sales prices associated with trophy properties). Knowing that these properties represent the minority of Denver’s office inventory, we can deduce that the number of remaining trophy and value-add properties not yet traded this business cycle in Denver is notably low.

Rachel Shanahan
Client services specialist, CBRE Capital Markets

Further contributing to the scarcity of trophy properties is Denver’s development pipeline. The end of the third quarter saw the lowest level of office construction activity in metro Denver since the fourth-quarter 2015, according to CBRE research. While there is healthy demand in Denver from office occupiers for new product, it is typical for development pipelines to slow as we get this late into a real estate cycle. This means we will see fewer new construction projects delivering, at least in the immediate near-term.

Mature properties face less competition. The imbalance in demand for multitenant Class B office properties versus trophy and value-add assets has the potential to create a unique opportunity for those investors willing to look outside the box. Denver’s highest-profile properties naturally garner the most attention, resulting in more competition from investors and, therefore, higher prices. Anecdotal evidence from CBRE’s Investment Properties Group reveals that, on average, trophy/high-profile value-add properties result in 119 percent more confidentiality agreements and up to 200 percent more bids than stabilized Class B offerings. Correspondingly, the going-in yield for these stabilized B assets often are considerably higher than those of the more in-demand trophy and value-add assets. Average cap rates for multitenant office trades from January 2017 through this November were 6 percent for trophy/new construction/stabilized Class A, 4.94 percent for value-add, and 8.21 percent for stabilized Class B. The truth is investors who only focus on Class A and value-add offerings may be missing out on overlooked opportunities in the stabilized Class B sector that offer promising returns with minimal competition.

Class B properties have limited need for capital improvement. It’s well-known that investors pay more for new construction properties because they are paying for all of the Class A features that have been incorporated into a project. On the flip side, when an investor purchases a value-add property, the return is only realized after the party has spent a significant amount of capital on improvements. Class B properties often fall squarely in the middle.

To remain competitive in attracting office occupiers, most owners of Class B properties already have invested in strategic capital improvements. Typical upgrades include adding amenities like food service and fitness facilities, making cosmetic enhancements that give a 1980s building a much-needed face-lift, and revising layouts to appeal to more progressive tenants seeking open floor plans. All of these improvements are expenses a new owner of a Class B property doesn’t have to incur.

Infrastructure investments are making Class B properties more accessible. Another reason why mature Class B properties make for a strategic investment is because of improvements to infrastructure and transportation. Metro Denver’s investment in the light-rail system has made transportation to the suburbs much easier. In just the past three years, the Regional Transportation District has opened the University of Colorado A line to Denver International Airport, the B line to Westminster and the R line through Aurora. The G line providing service to Wheat Ridge is near completion, with future lines to Thornton, Highlands Ranch and Lone Tree in the works. With many Class B office properties located in metro Denver’s suburbs, as these communities become more accessible via public transit, demand for those properties will grow.

Another factor poised to dramatically impact the office market is the mass adoption of autonomous vehicles. CBRE released a report this fall that predicts that the autonomous vehicle industry will fundamentally reshape the U.S. office market by 2030. The analysis found that autonomous vehicles could account for between 11 and 27 percent of vehicle-miles traveled by 2030. By enabling employees to work, relax or sleep during their commutes, autonomous vehicles could increase the distance they are willing to travel to the office, creating more demand for office properties that may have been previously categorized as outside a prime geographic area.

Stabilized Class B properties combine the best of both worlds. Traditionally, investors have been drawn to trophy assets because of their low-risk profile; they are willing to accept lower returns in exchange for the security of long-term leases with credit tenants. Alternatively, investors like value-add properties because the risk creates opportunity for high returns.

Looking ahead to 2019, an investor can think of stabilized/Class B buildings as some of the best of both worlds. They offer higher returns than trophy assets yet, in most cases, are a more secure investment than a value-add offering.

As the trophy and value-add opportunity pipeline in Denver cools down, the supply of Class B/stabilized properties remains healthy and access to suburban areas continues to improve, we look forward to a robust midmarket office investment sector in 2019.

Featured in CREJ’s December 2018 Office Properties Quarterly

Edited by the Colorado Real Estate Journal staff.