Office absorbs a dual hit with COVID-19, oil prices
With the impact of COVID-19 still unfolding, much remains unknown about the future demand for office space. We know that downtown Denver’s office market was strong heading into the pandemic, with significant leasing activity representing a diversity of industries. But a global pandemic – and a record-breaking decline in oil price futures – has introduced significant economic pressure on many companies. Those effects are starting to show in the downtown Denver office market with available sublease space rising to more than 1.5 million square feet at the end of May. That represents a 15% increase from a month earlier and is 65% higher than second-quarter 2019.
What happened in the first quarter? In downtown Denver, specifically, leasing volume was strong with approximately 700,000 sf of leases transacted in the first quarter, a 71% increase year over year. The technology sector had continued to lead tenant activity and accounted for approximately 30% of all lease activity over the past four quarters.
The first quarter marked the 12th consecutive quarter of positive net absorption in metro Denver’s office market, totaling approximately 415,355 sf and driven mainly by a flight to quality for many tenants to Class A and Class B space.
While the first quarter statistics did not yet reflect the influence of the COVID-19 pandemic, which became apparent in Denver in mid-March, we expect the second and third quarters to more accurately reflect a recession resulting from sharp declines in gross domestic product and employment.
What’s the impact of the oil price drop? This year, oil prices have experienced a steep decline as the result of a price war and decreased demand for oil in the wake of the global coronavirus pandemic. In March, prices fell by 57% then, for the first time in recorded history, future prices dragged into negative territory, hitting -$37 per barrel.
The full impact of COVID-19 compounded with the oil price drop cannot be projected, but historical analysis can provide perspective. There is evidence that a full recovery can be achieved in downtown Denver after an expected contraction, given the market fundamentals leading up to these events, as well as Denver’s performance in the wake of past market shocks.
In past oil-price declines, the downtown office market has shown resiliency. The price decline of 2014-15 resulted in a spike in vacancy rates, a flattening of lease rates and an increase in space offered for sublease downtown. The disruptions were temporary, and growth in other industries, particularly financial services and tech, shielded downtown Denver from the severest impacts.
CBRE data shows that Denver’s downtown office market has diversified significantly over the past five years, with growth from industries like tech and financial services leading the way. Whereas energy companies claimed 17% of downtown’s office space in 2015, that share has receded to 14% this year, 4.1 million sf. Meanwhile, tech firms occupy 11% of downtown office space this year, up from 2.4% in 2015. This diversification insulates Denver to some degree from economic shocks that may disproportionately impact select industries.
What is the outlook? As statewide and local orders are evolving, we will be watching to see how businesses and communities react to reopening with modifications, and how landlords respond.
As offices reopen, the full amount of excess space may not become available immediately. Even as employers may have reduced their headcounts, this will be counterbalanced by the near-term need to account for additional space per employee to maintain social distancing. Regardless, the second quarter is showing softening of the downtown Denver office market due to the impacts of the pandemic. With significant sublease space on the market combined with the impending delivery of approximately 1.1 million sf of speculative office development, many companies will be able to select from a larger number of options.
Due to the immediate nature of the pandemic, absorption has been impacted sooner and more drastically than in previous recent downturns. This is the result of forced work-from-home policies, which may become more prominent in go-forward strategies, reduced occupancy mandates, as well as health and safety concerns on how to appropriately reenter the workplace. With an anticipation that leasing velocity will decrease while availability increases, the competition for diminished near-term tenant demand inevitably will put downward pressure on rents and upward pressure on tenant concessions. As we emerge from the full stay-at-home mandates and companies look to formalize their second half of 2020 strategies and headcounts, they should find themselves in a more economically favorable office market. This new environment could support cost-savings initiatives on a direct leasing basis; however, in the event of a relocation, it may present a challenge if companies find themselves in a position of needing to reduce square footage by listing excess space as available for sublease.
Featured in CREJ’s June 2020 Office Properties Quarterly