2024 OFFICE MARKET UPDATE
In June of 2021, we published an article addressing the short term and long-term effects of the COVID pandemic on the markets for office real estate. On the one hand, numerous pundits were forecasting gloom and doom for office occupancy and commercial real estate in general. The other viewpoint, perhaps somewhat self-serving, came from real estate professionals and investors who expected a rapid return to the pre-pandemic occupancy levels and overall real estate health. This writing is a follow up to that piece, as well as a discussion of unforeseen factors that have had a significant impact on commercial real estate in general.
THE OFFICE MARKET IS NOT DEAD
Although our 2021 expectation was for an eventual return to office of somewhere in the range of 75% to 95% of pre-pandemic levels, current statistics do not bear this out. The widely quoted measures of keycard swipes put out by Kastle Systems pegs weekly occupancy at 52.5% of pre-pandemic levels in the ten largest office markets as of the end of February 2024. Even Kastle will admit, however, that this data is somewhat inherently flawed. The company is only able to measure keycard swipes in buildings utilizing Kastle access systems in both 2020 and currently. That excludes a significant amount of data. As stated in the New York Post,
“But its sample includes no buildings of SL Green, Vornado, Brookfield, Rudin Management, Tishman Speyer, Related Companies, Boston Properties, Silverstein Properties and Rockefeller Group. It doesn’t count the Empire State Building, the Durst Organization’s One Bryant Park, or headquarter towers of Goldman Sachs, JPMorgan Chase and Morgan Stanley. Those marquee properties have the highest attendance because their financial and legal tenants require more employees to be there, and because their state-of-the-art amenities make them appealing to workers.”
What’s more, the focus on weekly data ignores the change in work habits that result in much higher occupancy on Tuesdays, Wednesdays and Thursdays. Kastle acknowledges this and has begun publishing peak day data. Its end of February measurement put a Tuesday average at 62.1% of 2020 levels for the ten major markets it tracks, and Wednesday’s numbers were even higher. The latest Tuesday measurement for Chicago showed 69.3% and it still seems to be rising.
IT MAY NEVER RETURN TO THE OLD LEVELS
While the recent data suggest a continuing slow upward trajectory for office utilization, a return to a level that is on par with the pre-pandemic usage is very unlikely. The pandemic forced a rethinking of office usage, particularly for many large employers. In Chicago, for example, major growth-oriented companies such as Uber and Salesforce put massive amounts of planned growth space up on the sublease market. While many large employers have issued return to office “mandates”, some enforced and some not, the culture of reporting to the office 5 days a week is for many users a thing of the past. Hybrid or full-time remote work was becoming a trend before the onset of COVID, and the pandemic brought about an acceleration.
The impact of this shift on space usage is continuing to develop. While some companies with hybrid approaches (i.e., work from home on some days, in the office on others) have maintained space design that gives every employee an assigned desk/office/other work space whether they’re in the office or not, many larger employers have gone to some sort of hoteling or sharing practice. For those who will be in the office three to five days per week, they maintain their own assigned workspace. For those who will be in the office more intermittently, they will claim or be assigned a workspace when they come into the office. To manage this process, there are various scheduling software options available.
Hybrid work can result in a smaller overall space requirement, but we are seeing many employers leasing the same amount of space but configuring it differently. There is a trend toward more communal, collaborative and leisure spaces within the office. The old space model may have included mostly offices, workstations, conference rooms and small kitchen/break areas. Now there is more of an emphasis on larger café areas, soft seating meeting areas scattered throughout, small collaboration conference rooms, phone rooms or booths for private calls, and game tables.
THE BOTTOM LINE
The conclusion seems to be that yes, there is some permanent change in work habits, company culture and space usage that have the overall impact of less office space being leased and occupied. It remains a situation in flux, however, and we are still seeing changes.
NEW CHALLENGES FOR LANDLORDS / REAL ESTATE INVESTORS
While office real estate owners have been hit with decreased demand resulting in lower occupancy levels, another factor is having a substantial impact on the liquidity and financial health of commercial real estate in general. Traditional markets for real estate debt capital have tightened considerably, causing a major inconvenience for some and a crisis for others.
In the past couple decades, much of the mortgage lending for commercial real estate has come through Commercial Mortgage Backed Securities (CMBS). These are investment securities backed by pools of mortgages on specific property types. The CMBS market was particularly active in the 2013 to 2016 time period. As most such loans have ten year terms, a significant portion of those underwritten and issued in the active period are coming due.
At the same time, interest rates are significantly higher than they were when those loans were issued. Ten year treasury yields are fully 160 basis points or more higher than they were when these loans were first issued. Taking into consideration the increased risk premium for commercial real estate loans over the low risk treasuries based on softer demand, the decreased appetite by investors for commercial real estate of any type (both equity and debt) and the uncertain nature of future interest rate levels, you have a recipe for a largely frozen capital market.
IMPLICATIONS FOR TENANTS
The current market presents opportunities for tenants who are able to commit longer term. The nature of market valuation and limited financing opportunities, however, dictate the form those opportunities take.
Existing tenants who are willing and able to commit to a longer term can restructure and extend their leases, reaping substantial near term rewards in the form of lease concessions (primarily improvement allowances and free rent periods). A lender or investor is more interested in a secured long-term cash flow, so owners are offering much larger concessions to lock up tenants for an extended period.
Do not expect dramatic drops in the face rental rates, in spite of the softer market and the turmoil owners are facing. Current owners, prospective future owners and lenders want to see a secure cash flow at a higher level, even if they have to give up enormous upfront concessions. Reducing rental rates has a material effect on property valuation and financing opportunities. For more on the rigid nature of rental rates, see our prior article “The Market is Weak – Why Are Rental Rates Not Plummeting?”.
As with many aspects of business in general, real estate markets are continually evolving. The pandemic had a significant effect, as has the current state of the financial markets, but the doomsday scenario that many have expected does not appear to be coming.