Utah’s commercial real estate market is experiencing record highs in lease activity, investor interest and new development. But do those highs indicate a bubble? Our panel of industry veterans peer into the future to address that question.

Participants:

Dana Baird, Cushman & Wakefield/Commerce
Jim Balderson, JLL
Nate Ballard, Wadsworth Development Group
Bruce Bingham, Hamilton Partners
Bryce Blanchard, Newmark Grubb ACRES
Jake Boyer, The Boyer Company
David Broadbent, Holland & Hart, LLP
Andrew Bybee, STACK Real Estate
John Dahlstrom, Wasatch Commercial Management
Brandon Fugal, CBC Advisors
Bret Mackay, DLM Development
Vasilios Priskos, InterNet Properties
Kyle S. Roberts, Newmark Grubb ACRES
Mike Roderick, Roderick Enterprises
Rajv Shah, Vectra Management Group
Paul Skene, Cresa
Jeffrey Woodbury, Woodbury Corporation

A special thank you to Melissa Cline, executive director of the Utah Chapter of the Commercial Real Estate Development Association (NAIOP Utah), for moderating the discussion.

At the very beginning of the year, the market was going crazy. How are you all feeling about the market now?

BOYER: I keep telling the younger people in our business that this is not the way the real world is. This past year has been unbelievable in terms of development opportunity. We have finished or are under construction on 1.2 million square feet in Draper and about 400,000 square feet in Lehi. And that’s just this year. When have we ever seen anything like that in our careers?

I hope the momentum continues, but I don’t see it continuing at that pace. But I think we’re going to continue to chug along at a good pace. It may slow down a little bit because of a couple things. One is unemployment. Our unemployment numbers are down to roughly 3.6 percent. We’ve heard of companies that are a little bit concerned about coming into the market because of that.

FUGAL: These are historic times. We’re seeing 3.6 million square feet under construction right now. And when people ask me whether we are observing an overheated market or a bubble, I have to honestly inform them that the majority of that space is pre-leased and already absorbed.

It’s an interesting dynamic. In a market with record construction and even some of the first significant speculative development in a long time, we’re seeing increased positive absorption and exciting activity and growth. And it’s not all attributed to technology; it’s from a diverse range of industries, which is encouraging.

Last year was a record year, and we’ve launched into 2016 with even more significant office developments and headquarters under construction—CHG Healthcare, Overstock.com, Ancestry and a host of others are under construction, along with a list of companies that are close to being announced as anchors for some of the buildings currently under construction. Combine all of that activity, and it appears to be a repeat of last year’s record-setting trends.

BALDERSON: My concern for ’16 is the labor markets and all this building. I mean, 11 buildings under construction or delivered in Lehi and then six or more in Draper. Who’s going to fill those buildings?

And the perspective that we see the market with a lot of Fortune 500 companies and national tenants from out of state—our phone is not ringing as much with clients looking to add 200 people, 300 people in this market. So concern is over labor. Do we have the labor to fill all of these millions of square feet that are being built?

BAIRD: In the last 18 months, we’ve done almost 5 million square feet of deals and transactions that are 50,000 square feet and above. We look back on our records and it’s definitely a record for high watermark. I’m a little concerned about sustaining that amount of tenants that are looking for 50,000 square feet or over. The deals we’re seeing now are in the 8- to 10-thousand-square-feet range. I’m getting calls for that more often.

With regard to labor, we had a meeting with NAOP last week where we brought Workforce Services in, and they said local companies are able to attract the employees. But it’s the national tenants coming in who are getting scared, and they’re just saying no.

SKENE: There’s another phenomenon going on right now, more so from the tenant’s perspective. With the heated market and the amazing amount of development that’s going on, the costs for construction have gone up dramatically. What’s happening is a lot of these tenants who their last go-around on their lease was negotiated maybe in a down cycle, they’re seeing some significant sticker shock right now. It’s not only on lease rates, which have gone up substantially in certain submarkets, but it’s also from a tenant improvement contribution perspective. So a lot of these tenants are coming into the market and they’re seeing the limited options, and they’re all at a completely different pricing level than they were the last go-around. Combine that with a huge cap X number for them to pick up and move their operations or expand and write a big check for a contribution to the construction of the premises. That’s another dynamic that some of these tenants are really struggling with.

DAHLSTROM: We also continue to see some consolidation and efficiency gains with tenants as they renew their leases. They’ll see that the space that was built out 10 or 15 years ago when they first signed their lease no longer meets their business model with their national footprint. So they’re going from eight-by-eight system furniture settings down to a smaller four-by-six and adding more people per foot in their layout. We’re seeing with some of our big national tenants a major shift in the efficiencies they’re requiring in the space. That’s a big trend in the last three or four years.

SKENE: That translates into a significant need for parking. Parking is a big issue for most tenants nowadays. It’s an added cost, but it’s the only way they can pick up efficiency and get more out of the lease rate they’re paying.

BINGHAM: One of the things that can offset that intensity of a population of tenants, instead of being four or five per thousand, they’re at seven, eight, nine, 10, 12 per thousand. Goldman Sachs here, they don’t have cubes, they have benches. And you get this much bench, two screens, a drawer for your pencils—and clean it out every night because somebody may be in that spot the next day.

Some of the mitigating factors are mass transit and transit-oriented development. The decision makers don’t really believe in it yet. They say, OK, we’re close to a Trax stop. That’s very helpful. I still want seven per thousand in terms of parking. In time I think they’ll learn to adjust. But for the moment, there’s a benefit, a TOD opportunity that isn’t completely recognized.

PRISKOS: In downtown, 111 Main is at 75 percent occupancy, which is pretty good since it hasn’t even been finished yet. It’s encouraging, and it shows that Salt Lake City is willing to pay for quality. Tenants are willing to pay for quality. We haven’t seen the market in the mid 30s ever.

It’s a really interesting dynamic right now because the people that own the land are not building anything. The church still has 10 acres down the street on Fourth South, the David Bernalfos of the world aren’t selling anything, even though they’re getting offers near $150- to $200-a-foot range, and these are from office speculators. So one of our issues downtown is that outside developers cannot find land downtown. It’s a very interesting dynamic where you have a close set of people controlling a lot of land downtown. I just hope we keep building through this. We have a unique market down here.

But there are great things happening downtown. Main Street is doing great. The old Daly building, we’re partnering up with them. The two buildings have been shuttered for 20 years next door. We’re going to have 50 new housing units above. The retail is all spoken for. So we’ll have about 200 units total downtown on Main Street, all pre-leased, ready to go, which is really nice.

The theater will be open this year. We have a new restaurant going in there, Ollie and Molly’s, which will be nice right next to Eva’s. And the theater’s looking fantastic. The office building is looking fantastic.

The church stepped up to the table again on Regent Street. They’re going to have 15 to 20,000 square feet of new retail under the Regent Street parking structure. They’re refacing the old power building on Regent and First South, including a restaurant on that corner. On the other side of Regent, we have highrise hotel, boutique hotel, and many other hotels. Then you have Brent over on Fourth South and West Temple with another boutique hotel, another couple hundred rooms. The Sweet Candy site is going to bring a Marriott in on that corner.

The big thing is the convention hotel. That thing has progressed. A decision came out yesterday on the chosen developer. We’ll see where that goes now. They have a couple of months to negotiate that. So hopefully by this time next year we’ll maybe see something coming out of the ground for a convention hotel. That will impact our city, our restaurants, everything. A project that big, a $350 million project downtown, a convention hotel will definitely make an impact and change a lot of things.

Can you compare what’s going on downtown with what’s happening in the suburban markets?

BOYER: There are a couple of different dynamics. Number one, most of the companies that are going out to the South Valley or North Utah County require high parking ratios. They’re not willing to get over that. They’re not willing to get creative like a lot of the downtown tenants are.

The other thing is a lot of them are growing so fast they don’t have the time to wait for something to happen downtown. So if it’s not prepared and ready to go, most of the tenants we deal with have to be in within 11 months, and we have to build a building in that time. So there are time pressures that are another issue with South Valley, North Utah County compared to downtown.

And these tenants are very cost sensitive. While a lot of people are willing to pay for quality, there’s some tenants that are not willing to do that. There’s some tenants that are very driven on every penny of the cost structure. They want six or seven slots per thousand. They don’t want parking structures because they’re not willing to pay for them. So I would say the contrast is timing, cost and parking.

BYBEE: On the rate side of things, we’ve come a long way over the last six or seven years. When we pulled our first building out of the ground, it was $23 a foot. We’re now up at $27 and we’re getting it consistently. That’s healthy in the suburban market. As construction costs go up, TI allowances are going up. So we have to mitigate that with the lease rate a little bit.

But it’s healthy. It’s strong. We’re 85 percent pre-leased in our T stat four building. We’re going to wrap up here in the next couple of weeks and then we’ll be 100 percent in all of our inventory down there. We’ll have another building that comes out of the ground next week, T stat five.

We’ve noticed a little bit of an interesting dynamic, in that we are getting a lot of tenants who are taking space, so it’s pre-leased, but they’re not filling the space totally yet. It’s a little bit of a space grab to preserve room for growth in the future, because the last three years they couldn’t get it when they needed it. So now they’re grabbing it and keeping 10,000 square feet and trying to sublease it, which has been a little bit of a different dynamic.

DAHLSTROM: The increased construction costs are going to have an impact on this. We’ve seen some success in bringing tenants that are looking at construction costs and seeing that maybe, for the same cost, they can move into an existing facility that has vacancy downtown.

The downtown amenities are increasing with more people living downtown. You see large tenants that are used to an urban environment, understanding the transportation aspect of it, and opting for a situation that’s better amenitized and provides a better lifestyle for their employees.

BAIRD: A tenant of mine that went into City Center—Workday—they came into town from Pleasanton, California. They said, we are an urban company. We don’t want to live out in the suburban market. And we actually quickly filled up City Center with Benify, Workday and Disney Interactive.

SHAH: Asking rents in the downtown area have really changed dramatically, because the recession has dropped off. It’s turned into a landlord’s market, which has turned into some difficult conversations with tenants that did deals five years ago.

BINGHAM: It’s not a landlord’s market, let’s get that straight.

DAHLSTROM: It’s better than it’s been.

FUGAL: A market that is driven by larger tenant requirements—out of the millions of square feet of deals being consummated, they’re driven by 50,000-square-foot or greater tenant requirements. There’s very little product to accommodate those needs. If you’re representing a company looking for 50- to 100,000 square feet between central valley down to American Fork or Lehi, your options are very, very limited. They’re even more limited downtown.

So you’re going to see a number of new projects launched this year in Sandy, South Jordan, Riverton, in order to meet perceived demand and also to accommodate some of the larger tenant requirements that, frankly, can’t be accommodated in existing projects either under construction or second generation.

BAIRD: Just expanding on that, you’ve got 1-800, Progressive, Thumbtack, all of them have taken extra space. So all of these tenants are actually putting their space up for sublease. The sublease market is going to increase and you’re going to see some of these tenants that are growing move into that space. They’ll move into the space, and then eventually they will move out into their own as the master tenant grows.

Let’s delve into the industrial market.

ROBERTS: We’re seeing employee-intensive uses grow at a pretty astronomical rate. We’re seeing industrial buildings that look as much like office buildings now as they do industrial buildings. We’re seeing a huge increase in the ratio of office warehouse space. And planning for that, engineering for it, being able to park it, being able to get the municipalities on board to allow you to have the parking has been somewhat of a challenge and it’s required changes to parking code. It’s been difficult.

We’ve seen lower net absorption in this last year than we’ve seen in the prior three on the same amount of market activity, almost 5 million feet of deals that were done in Salt Lake County and about 1.4 million square feet of net absorption, which is disconcerting.

RODERICK: Another thing curbing growth a little bit is we’re running out of available, affordable land in the Salt Lake Valley. We’re getting outbid by multi-family uses, residential uses. And that’s a real concern to us. The construction issue is getting very difficult, too, because it’s growing much quicker that the rent growth we’re seeing. Our projects are taking much longer than they normally should. TIs have gone through the roof. Compared to our TI four or five years ago, today they’re 30, 40 percent higher on TI space.

WOODBURY: It’s still cheaper here than most of the markets. Even if you go to other flyover markets like Idaho or Denver, construction costs are higher just because there aren’t as much subs. That’s the big part of the construction cost increase—the labor market has really kind of dried up from that standpoint. Fortunately here in Utah, we get a lot of subs bidding on our projects.

It’s interesting to see the intensification of industrial because now if you have a 20-foot ceiling, it’s worthless to all of these companies. Now you’ve got to have 32 or 36 in order to satisfy the density in that space. But when we look at our $27-a-foot lease rates, in the California Bay area it’s over $100, $120 a foot. That’s why we say it’s not a landlord’s market yet because tenants are still beating us up. We’re kind of gambling on the re-lease to a certain degree as we get into a lot of these projects.

ROBERTS: That may be true for office but it’s not true for industrial. The construction costs are very similar to California on a dollar-per-square-foot basis. The entitlement process is longer, the impact fees are higher, but they’re building to 3.5, 4 percent exit yields in some cases. And Denver, Reno, Phoenix—their construction costs per square foot are significantly less.

MACKAY: Land prices, which were down in the $2- and $3-a-foot range, are well over double. But our rents aren’t well over double. Last year we talked about are we a second-tier market or a third-tier market? And it depends on whether you’re talking about an office market or whether you’re talking about an industrial market. It also depends on if we’re talking about a specific segment within that market. But if we’re talking about big- box industrial, the stuff that Freeport is building, they’ve done huge amounts of buildings and they’ve been very successful.

The market, though, on the larger tenants is slow. We don’t have the same velocity. We’re not in the same place we were a year ago. When we talk about the kind of buildings that Mike builds, which are these wonderful crossover buildings—people drive by Pheasant Hollow and they love it, it’s such a fun-looking project—but it actually drives a higher build-out.

We have historically tried to be safe about our parking ratios. We can utilize parking truck ports to park cars, which sometimes you can’t in other types of scenarios. But at the end of the day, if I build out 20 percent or 30 percent office, I’ve got to have some place to put those guys to park. And I’m not going to build a parking structure in an industrial building.

From an investment standpoint, are we still at the top of the list?

BLANCHARD: Investors are generally very bullish still in Utah because of all the performance metrics we’re hitting on absorption and lease rate increases. So we have no shortage of demand-side buyers looking for deals.

It’s an interesting paradox as we assess the things that affect pricing. We’re now in our seventh straight year of appreciation in the sector. And for that appreciation to continue, we have to have two things happen simultaneously. One is we have to continue to be in a relatively low interest rate environment so that the relative attractiveness of other yielding opportunities don’t trump real estate. And we have to continue to see NOI growth, and lenders have to be able to underwrite, equity people have to be able to underwrite, that we’re not going to have any kind of glitch that changes the market’s direction. So as long as those two things hold up, we can continue to see assets appreciate.

From an investment volume standpoint, last year we did over $1.7 billion in sales. That was a second consecutive year we hit that, and it’s an all-time number. Previous top-of-the-market was ’06, ’07, and that’s the last time we achieved similar volumes as we did in 2014 and ’15. But through the first two months of the year, if you prorate what we’re looking at from an investment volume standpoint, we’re only trending to $800 million.

One reason is people aren’t pricing our assets right. Everybody is getting the message that it’s a seller’s market, and our sellers and our brokers are starting to overreach on price points. If you look at the deals that are starting to hit the market in the advertise cap rates, we are really stretching. We have to remember that Utah always has to have a delta between our price points on a cap rate and primary markets. So we can’t get too overzealous that we are a five cap market. Yet sellers and brokers are trying to reach below the stabilization point. And they’re disappointed they’re not getting offers. It’s just they’re mispricing things.

MACKAY: But we still need to have that gap between LA and these super regional markets and our market. When LA is sub four, we’re at six. We still have 150 basis points. So we can be down in sub seven. The industrial market and retail market are still coming in really low cap rates, as opposed to office, even where we have these beautiful buildings. The cap rates struggle to get below seven in an office building, and yet in our industrial buildings, we have no problem with sub seven.

BINGHAM: One piece of evidence that Salt Lake City has reached maturity as a second-tier market is an investor’s exit strategy. They’re always concerned about how do I get out of this? This applies to national investors, not to locals. But they want to know, Can I get out of a deal that’s in Utah County? And the answer is, Yeah, you can. There is enough generation of activity that there is a way out for somebody who’s looking for it.

BALLARD: These outside buyers have had the opportunity to see Utah and the market go through the recession and watch exactly what it did. And you compare it to bigger markets, similar markets, it doesn’t have the highs of the highs, but it also doesn’t have the lows of the lows, and that’s a much more stable environment.

We’re a family-owned portfolio. The idea for us in development is to hold these things, but we’ve been approached on several assets at rates that will turn your head. And we’ve sold things that we didn’t anticipate would sell just because of that.

ROBERTS: If you look at, for instance, the IE in Southern California, they had 22.4 million square feet that was under construction and pre-leased this calendar year. Six buildings, over a million square feet, all gone, pre-construction. Our market, by contrast, did just under 3 million square feet of deliveries and 1.4 million square feet of net absorption. However, in 2008, there was 35 million square feet in a smaller market in the IE that became available almost overnight. So you see whipsaws. Phoenix saw the same thing, barely came into recovery. Chicago, same thing. If you look back at least over the past 10 years, our rent volatility is nowhere near what it is in some of these gateway markets. So investors are able to underrate to a six cap because the likelihood that there’s going to be significant arbitrage to that cap rate when the market changes, historically it won’t.

Are we a little overconfident about the multi-family opportunity in this market?

BINGHAM: There is a lot of building of multi-family going on. But there’s also absorption in multi-family. The vacancy of multi-family is at 3 to 4 percent and has been for the last three or four years. It does not seem to be letting up.

DAHLSTROM: I think we may be nearing the point of oversupply, and our strategy reflects that. But so far we’ve been able to maintain lease rates.

Someone who decides they want to live in an apartment is looking for lifestyle, and part of the strategy is to meet that lifestyle with the product that you’re providing. Sometimes it’s difficult to get municipalities to allow you to build this type of housing in their area. Once they see what you’re talking about, it’s nearly a condo-like product, they warm up to the idea of having that in their community. That’s been the big shift: Those who are choosing to live in apartments in Utah are people who normally would have bought a house. We don’t see people who are living in an apartment because it’s their only choice. They’re living there because they’ve made a lifestyle choice.

WOODBURY: As long as you see the office growth and you see the business growth and the community, there’s still going to be apartment growth coming. The big percentage of the employees for these office projects are renting. When it comes to recruiting and solving the employment problem, the better our community becomes, the better our retail becomes, the better our apartment communities become—the higher we raise that stock will solve some of the employment problems because more people will be willing to come in.

MACKAY: We have this wonderful community with this wonderful base of culture, but it reflects back on how we’re perceived outside of the community. And as simple a thing as having one of our premiere retail centers closed on Sunday, which is a cultural thing for our valley, is a huge impact to how people perceive this community. Probably most of us around the table wouldn’t disagree with that decision, but that’s a hard thing. I’ve worked quite a bit in the west side of Los Angeles, which has a huge Jewish community. If things are closed on Sunday, my Orthodox Jewish friends don’t get to go shopping. So that is absolutely a cultural thing that has to be figured out if we really shine as that second-tier city as opposed to being a second-tier city almost. We’re on the threshold of being a great city with these wonderful things. It’s how do we deal with these challenges: transportation, education, air, water or cultural issues.

BINGHAM: We are a great city. We are a small city. We are still a growing and developing city, but we are a great city. There are 26 cities in America that have a symphony, a ballet and an opera. Salt Lake City is one of those. Are we perfect? No. Do we have more to do? Yes. Will we do it? Darn right.

PRISKOS: Looking at housing, Sugar House has had so much success and people do want to be near the action. They don’t want to drive. They want to be able to walk to a bar or walk to a grocery store. That’s what people want and we have it here.

Our problem downtown is, again, land. These places are being built on the outskirts of our city. I mean, 5th East and South Temple, we put that on the market. We had 16 offers, ten of which were over $70 a foot. We’re going to close in a couple of weeks near $80 a foot. And we’ve hit the $70 price tag on Second East and people are still looking.

It goes back to building the quality the Goldman Sachs of the world are paying downtown—will those people live in $2-plus-a-square-foot apartments? I think they will. Nobody is taking that chance. And it really is a shame because you talk about sustainability—that’s sustainability in building.

We keep talking about low-income housing. But the other thing is housing for the people that work downtown. We’re missing the high-income people and the people that are everyday workers that want to live really close to their city.

BOYER: Circling back a little bit, The Gateway is under new ownership. I think Vastar will be a great owner for Gateway long term. We’re optimistic about the changes that hopefully will be made with adding more retail. They’re going to have to build on what City Creek has done, and do the things City Creek does not. For example, The Gateway is open on Sundays, which City Creek is not. And Vastar is gearing more toward entertainment and restaurants.