Is this thing on? Good, because we have a public service announcement for office tenants, landlords, and investors: Office rent is not as stagnant as it may seem.
Recently, it has been widely publicized that office rent hasn’t moved in years. While some data sources could lead you to believe this, digging into the data shows there is more to that story. It is important for both commercial space tenants and landlords alike to understand what goes into gross rent, and how a shift in the makeup of gross rent has led to an inaccurate picture of commercial rent trends. So, for the benefit of tenants, landlords, and any potential investors in commercial real estate, we’d like to dig a little deeper on the true status of office rents in Northern Colorado.
If you are a landlord in Northern Colorado, perhaps you yourself has observed seemingly stagnant base rent on your commercial office space. Let not this micro snapshot of seemingly stagnant commercial office space rents to be a deterrent from investing in commercial; this does not signal that commercial office space is no longer a good investment.
While owning a building seems like something every successful business should do, that’s not always the case. For many companies, it makes more sense to continue leasing space, freeing up time and capital that can be better utilized in other ways.
Here is the more accurate picture at a macro level: Unless you’re living under a rock, you are well aware of the increasing price of real estate along the Front Range as the economy overall has rebounded from the 2008 recession (and of course commercial real estate is not exempt from this increase).
Such growth coupled with other economic factors has significantly driven up property values around the state and especially in our northern region. Despite some of the issues that come with accelerated growth and prosperity, many of us are fortunate to live in our thriving communities. Local government would just feel left out of the party if it didn’t partake in the prosperity, increasing property tax commensurate with the value appreciation we all have enjoyed.
When there is an increase in property tax, there is an increase in what is called triple nets, also known as NNN. NNNs are costs that go beyond the tenant’s base rent and include property taxes, insurance, and common area maintenance. An increase in property taxes results in an increase in NNN costs, and these costs are passed along to the tenant as an expense atop base rent. Together, these make up the gross rent for the tenant. Simply put, the increase in property taxes has resulted in an increase in NNN expenses, leading to a tenant’s gross office rent expense.
OK, so NNN costs have increased, but why would that cause an apparent stagnation of office rents? The accelerated rate at which the taxes have increased have put downward pressure on base rents that property owners can successfully charge.
From a tenant’s perspective, their gross rent expense continues to rise with each new property valuation. So while their base rent may not show much of an increase, their monthly rent invoice from their landlord sure doesn’t feel like rent stagnation.
Need a little data to validate what we’re saying? A recent Waypoint sample study found a 33 percent average increase in property taxes between 2012-2017 of Fort Collins Class A office space. More broadly, according to a study conducted by the city, between 2016-2018 alone, all commercial office space in Fort Collins experienced a 16 percent increase in property valuations. Obviously, these massive increases cannot continue forever. In the short term, however, base rental rates will take the hit, as NNN rates continue to raise the total gross rent that tenants are paying.
After an extended period of value appreciation, property values (and tax assessments) should stabilize, and we would expect to see a little buoyancy in base rents with only 5.2 percent office vacancy rate in the northern Colorado market. At that point, investors in commercial real estate will again be able to realize a more normalized increase in base rents/net operating Incomes. Until then, sit tight and understand that there is more to the story than one data source may suggest.
Nick Norton is a broker associate with Waypoint Real Estate in Fort Collins.