As we entered the summer, many observers of the office market concluded that much of the asset class was in a death spiral.
Companies were struggling to entice employees back to the office; vacancy rates reached an all-time high; property valuations tumbled; and owners of distressed properties large and small were giving back the keys to lenders.
To make matters worse, economists continued to warn of an “inevitable” recession, and more interest rate hikes were predicted before year-end.
But while the evidence is damning, it may not tell the whole story, and eulogies for the office market may be premature, according to SIORs. “The demise of the office market has been overblown by the media,” says Brad Kitchen, SIOR, president of Alterra Real Estate Advisors in Columbus, Ohio. “They’re saying, ‘the office market is over,’ and ‘nobody's going back into the office’ to sensationalize it, but I think they're generalizing a little too much.”
And although no one denies that the office market is in for a rough ride for the foreseeable future, the optimism by brokers is not unfounded. For starters, the economy continues to defy prognosticators. In June, the Q1 GDP was revised upward from 1.3% to 2.0%; in June, inflation cooled for the 12th consecutive month to 3.0%; unemployment remained at near-record lows; the economy added nearly 1.7 million jobs in 2023 (through June), and wage growth remained above 6% for each of the first five months of 2023 (5.6%).
The Office Leasing Picture
There are even rays of hope within the office market itself. A Q1 2023 JLL report indicated that office attendance rates increased by 9% year-over-year to around 50% of pre-pandemic rates, and more companies were instituting mandatory return-to-office policies. And although attendance is typically highest midweek (Tuesday, Wednesday and Thursday), the reduction in office attendance doesn’t translate to a proportional decline in space requirements because hybrid workers require the same amount of office space as employees who are in the office daily. Meanwhile, national asking rents were still growing (2.1% YOY through June).
“The problem is that the media aggregates to the highest level and forgets that every market is different,” says Kostas Stoilas, SIOR, founder and managing broker of Fortress Commercial Real Estate in Tampa/St. Petersburg, Fla. “You can see that San Francisco, New York, Boston, and some of the larger urban areas are feeling the effects of the pandemic, and they’re being lumped in with recessionary issues, but they’re just byproducts of markets where working from home is more prevalent. States like Florida and Texas are doing very well. In my market, Tampa, we’re not seeing a problem yet.”
One of the issues with nationwide media reporting on the office market is the over-reliance on the “back-to-work barometer” provided by Kastle Systems. Kastle uses keycard and fob access data in just 2,600 buildings in 10 major markets nationwide to determine office utilization rates for the entire country — but only counts the buildings it serves, which is not a representative sample. Dave Provost, senior VP of Development for BXP, the largest publicly traded developer and owner of Class A office space in the U.S., questioned the relevance of Kastle’s data at a Boston NAIOP event focusing on the future of office this past spring.
BXP owns 50 million square feet of office properties in Boston (a market not included in Kastle data), New York, Los Angeles, San Francisco, and Seattle, “and Kastle Systems isn’t in one of our buildings,” said Provost. “Our clients are utilizing our space, and their utilization is growing.” BXP tracks the utilization of its properties internally, and Provost said the average worker is in the office between three and four days, with an average utilization rate of the buildings of about 70% on Tuesday, Wednesday, and Thursday. “Pre-pandemic, if you looked at the peak days, it never really got above 80%, so our average worker never worked five days a week anyway.”
It may be 70% to 80% of what the offices used to hold, and then maybe we'll have a coffee shop vibe in half the office along with conferencing facilities versus all workstations and offices. But the office is coming back.
Because the sampling is restricted to major markets, the data leaves out large swaths of the country. Kitchen reports that the Columbus office leasing market became much more active by February of 2023, and he is seeing office expansions in the small to mid-size tenants in the construction, engineering, logistics, and healthcare industries. According to CoStar data, in Q1, the overall market vacancy in Columbus was 10.7%, well below the national figure. He says that much of the vacancy is attributable to a few large single-tenant buildings, including a 406,000 square-foot office in Dublin, Ohio, vacated by Cardinal Health and several hundred thousand square feet vacated by a pair of insurance companies. Kitchen notes that if you exclude the market’s 30 largest vacancies, the overall office vacancy is only 7.0%.
Large occupiers’ vacating properties are having an outsized impact on vacancy rates throughout the U.S. A spring 2023 report by CBRE determined that 10% of all office buildings the firm tracks in each market accounted for 80% of total occupancy loss by square footage between Q1 2020 and Q4 2022.
In Florida, Stoilas reports that Tampa/St. Petersburg market is also doing relatively well. Like most of the country, there is a substantial amount of sublease space on the market, but “office brokers aren’t worried.” Leasing activity remains robust as tenants downsize and relocate to higher quality space, and “all of the new product that was built in the last three years is pretty much 100% leased with the flight to quality,” he says.
On the other side of the world, Bjarne Bauer, SIOR, managing partner at the NAI Sofia Group in Shanghai, says the office market in China is “much healthier than in many other markets around the globe.” The office occupancy rate is around 80% — down from 90% pre-pandemic due to additional supply outpacing absorption in recent years.
He attributes the occupancy rate to two primary factors: management style and population density in the cities. “The management structure here is a bit more old-fashioned, so they like to see their team at the office,” says Bauer. “And work from home is much less of a thing over here than in the Western world. A lot of people live in small apartments, so they actually like to go to the office, especially since there’s free air conditioning and coffee.”
Capital Markets
While there are ample reasons for optimism on the leasing side in many markets, the overall picture for many building owners — particularly those with older B and C properties — is far more dire. The national average sale price of an office building fell from $250 per square foot in 2022 to $195 by June, a decrease of 22%. And a report released in June by Capital Economics projected a 35% decline in nationwide office values by the end of 2025, with values unlikely to recover by 2040. Kiran Raichura, the firm’s property economist, compares the hit to net operating incomes to what malls have experienced over the last six years.
A report from Morgan Stanley released last spring estimates that about $1.5 trillion in U.S. CRE debt will come due before the end of 2025. Although only a portion of that number applies to office, the tightening by lenders and the decrease in valuations may create a refinancing nightmare.
“Many lenders are already heavily invested in office — much of which is declining in value — so the idea of deploying more office debt just doesn’t make sense for those lenders,” says Landon Williams, SIOR, SVP for Cushman & Wakefield in Memphis, Tenn. What that means for the investment sales market is that bargain-hunting season has begun. In June, Alexandria Real Estate Equities sold a 510,000-square-foot Class A office asset just outside Boston for exactly half the price they paid for the asset ($235 million) immediately before the start of the pandemic.
Williams references $400 billion in dry powder earmarked for deployment into CRE by global investors, as indicated in a 2022 CBRE report, “and they’re like sharks in the water waiting for distress, waiting for that other shoe to drop on upcoming loan maturities,” says Williams. “We will certainly see banks take them back in some cases while borrowers sell at a discount in other instances.”
The Future of Office Leasing
For all of the headwinds facing the office market, there are encouraging signs. JLL predicts that once industries find the hybrid workplace balance that works for them, there should be a gradual return to the office. Tripp Guin, SIOR, principal of Tripp Commercial in Charlotte, N.C., agrees, although there will be significant changes in office design that will reflect the new normal, and he believes the full transformation could take nearly a decade. “Will it be different? Yes. People are shifting how they plan for their space, but I believe people will be back in the office,” says Guin. “It may be 70% to 80% of what the offices used to hold, and then maybe we'll have a coffee shop vibe in half the office along with conferencing facilities versus all workstations and offices. But the office is coming back.”
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