What Denver Real Estate Teaches Us About Market Patience

This month, the building housing the world headquarters of Denewiler Capital Management was sold. In the 21 years we have been here, it has changed hands at least four times. A few years back, at the height of the low-interest rate frenzy, it sold for around $60 million. This time around, the price tag is rumored to be somewhere close to $10 million (verified by the new owner). You might ask: What does an office building have to do with the stock market? A lot, if you consider how rental income and dividend income are similar.

 

 

How does a 20-story Class A building in the heart of downtown Denver drop from $60 million to $10 million in less than 10 years? The answer lies in the numbers. Our building has 173,000 square feet of rentable space. A quick back-of-the-envelope analysis shows that with a 90% occupancy rate and an average rent of $30/sq ft., the building generates about $4.7 million in rental income per year. Assuming half goes to expenses, that leaves approximately $2.4 million of profit to the owner. Owners always want to know what return they can expect from an investment, and what is acceptable. Just a few years ago, in an environment where ultra-low interest rates were the norm, 4% was considered attractive. That is when a $60 million valuation made sense. Today, everything has changed.

 

 

Vacancy rates in downtown Denver have skyrocketed, with some buildings seeing 50% vacancies—or even worse. Our building has about 70% occupancy, so it now earns roughly $1 million in rent after operating costs. The real problem is with much higher interest rates, a mortgage on the building is now much more expensive. Even if an investor puts 25% down, it barely makes any money. Add to that the risk of higher vacancies, rents falling, and the fear that downtown Denver could become like downtown Detroit or St. Louis. This is what makes the $10 million sales price relatively in line with current market conditions. Many buildings like ours that were bought at much higher valuations can no longer afford the debt payments, so now you have foreclosures and a distressed downtown commercial office building market.

 

 

If you are familiar with Denver, this is not the case for residential real estate. Moreover, the entire country appears to have a relatively strong housing market. This illustrates two real estate markets that have diverged dramatically. The answer is simple: supply and demand. There is too much office space in the downtown area and not enough housing in metro Denver, or even the nation.

 

 

It might seem obvious that buying a 20-story building for $10 million will eventually make money. The challenge is that it may take a decade to get there and possibly require more money invested in the project. Rent in 2003 for the world headquarters was $1,643/month, and currently, it is $3,100/month. Rental income has almost doubled in 21 years, but the total return is likely negative. The key to this discussion is staying power and patience—which leads us to the stock market.

 

 

The dividend of the S&P 500 in 2003 was $17. Currently, it is $72. That is a 4-fold increase versus a twofold rise in rents for our building. Over the past 21-year period, real estate saw about a 3% annual growth rate, while the stock market’s dividend grew at 7%. This aligns with the long-term trend of real estate appreciating close to the rate of inflation, while the 100-year growth rate of the S&P 500 dividend is historically much faster. The simple reason? Corporate America provides the income to pay office rent and the income for employees to buy a house. To provide decent lifestyles to employees and for the company to afford rent on their buildings, company profits must grow faster.

 

What if our building was never sold and was held for the entire 21 years? Assuming an 80% occupancy and an average $10/sq ft. net rental rate, the building would have earned about $29 million in profit over 21 years. The buyer in 2003 wouldn’t be thrilled about the recent downturn in property values. However, the owner would still be earning a decent return if our building is currently earning $2.4 million annually. Even still, it is highly likely the building has seen very little appreciation since 2003, especially since that was shortly after a recession. There was also a substantial compounding effect of those rent payments over 21 years, but not nearly enough to equal the S&P 500.

 

 

In comparison, the S&P 500 has had a total return of 8x since 2003, and dividends have grown by a factor of 4, despite two major declines in that period. The lesson is that sustainable rental or dividend growth, patience, and time can turn even an unpleasant investment into a profitable one.

Observations On The Market No. 399