The villages of Phoenix and a misleading statistic

John Greenman

Letter from Denver

I recently was in Phoenix to research the current state of that city’s office market and came across what seemed to be a puzzling statistic: the current Phoenix office vacancy rate is reported at 19%, much higher than in most office markets around the U.S. (by comparison, Denver’s office vacancy is currently 12%), and seemingly too high for this stage in the general economic recovery. Yet, despite this high vacancy number, Phoenix jobs growth is strong, rents are rising rapidly, and there is ample new construction of office properties. So what’s going on?

It turns out that the historic average vacancy rate over the past ten years for Phoenix is that same 19% number; in other words, Phoenix is just getting back to “normal” after several tough years following the Great Recession.

A key reason why Phoenix can have chronic oversupply and yet some good office investment performance lies in the design of the metro area, which was always intended by its city planners to be a series of low-density “villages” connected by highways. As a result, many small submarkets grew up within the overall market, often a great distance apart from each other. This means that oversupply in one submarket can have minimal effect on another located on the other side of the metro area.

In an overall office market of about 100 million square feet (9.3 million square meters), which is about the same size as Denver’s, no single submarket in Phoenix is bigger than 11 million square feet. Even the Phoenix central business district is just another “village”—though of the high-rise variety—with only 7 million square feet of office properties, equal to 7% of the total market. (By contrast, the Denver central business district has 30 million square feet, about 30% of the total market).

To find the best investment value within such a decentralized metro area requires a more granular analysis, looking at specific submarkets whose vacancies are lower than the market average, and then within those submarkets, seeking the “micro-markets” of the highest quality. (A micro-market is a term of art, but could be defined as the 1 to 3 million square feet (90,000 to 280,000 square meters) or so of neighboring office properties that compete most directly with each other). A high-quality micro-market will have good transit infrastructure; easy access to restaurant, hotel and other retail amenities; and close proximity to “upper bracket” executive housing.

Assets located in micro-markets with those qualities will offer the investor the best downside protection during periods of overall market weakness and the greatest potential for long-term value appreciation. Examples of the most attractive Phoenix micro-markets are the Kierland and Waterfront areas within Scottsdale, the Town Lake district of Tempe, and the Biltmore/Camelback neighborhood of central Phoenix.

Though a rising tide indeed can lift all boats, investors should start with the best possible vessel.