Friday, July 21, 2023

Is the American Office Market Dead?

There was a time in the not too distant past when I considered office properties “the best of all worlds.” They offered the flexibility to create leases that were in between the detailed relationships established by industrial and retail properties and the more straight-forward residential lease. Rental calculations were relatively simple—base rent plus utilities and any tenant improvement allowances. Occasionally, common area improvements or maintenance factored into the equation. The property was typically used from 7 am until 7 pm, so utilities were relatively low and predictable. Wear and tear on the property was much less than any other real estate property class.

The necessity of office space was at one point unquestioned and tenants were readily available. Space considerations were for the most part limited to whether the location was large enough and had enough amenities or services to meet the tenants needs. Leases were easy to enter, easy to renew and easy to understand. For owners, office properties offered many of the benefits of owning a commercial property with fewer of the complexities that come with other property types.

Complexity, however, is not always a bad thing, as it allows for more nuanced deals and often provides more potential for income. That said, given rising interest rates and record low absorption, no one will deny that the relationship that office property owners now have with the real estate market has become very complex. Unfortunately, this type of complexity is unwelcomed. The New York office property market boasts a near record high availability rate of near 20% and a record low negative leasing rate of nearly 40%, according to Avison Young’s Q2 2023 office market report. The national market is showing similar distress. This at a time, two years after the pandemic, when indicators of recovery in the market should have already presented themselves. The 3.6% unemployment rate, according to the Bureau of Labor and Statistics, further emphasizes this point. Unemployment is half of what is was two years ago, yet office property continues to have record low absorption in the United State. This, coupled with rising interest rates and the resulting rising cap rates makes it clear that it is a difficult time to own office property—low leasing demand, property prices trending downward and few attractive options for refinancing. Moreover, there is little hope for positive change in this market in the foreseeable future.

It seems clear that in the US, the role of the office has changed. Whereas a few years ago, work was viewed as anchored to a centralized location, that is now no longer the case. The decentralization of the workplace in the US stands in stark contrast with the office property market in the APAC regions, where there is a stronger emphasis on in-person collaboration. The conception of work in the United States has fundamentally changed in the last 5 years and although the trend toward a decentralized workplace was present prior to 2020, the more recent prevalence of remote and offsite work arrangements seems here to stay.

Unfortunately, tenant demand for office property is so low that the typical strategies of lowering rent, providing more generous concessions and improvement allowances are no longer viable options. As the Avison Young report indicates, such concessions and allowances are so commonplace that most of the remaining office tenants are competing  for the trophy and Class A properties that have now become affordable options. Class B and C properties are no longer even considered by tenants. Moreover, the common form of repurposing used by many creative owners-office to residential conversions, may not be available in the current climate, as relatively expensive rents have lowered demand for rentals and residential purchases. Also, most markets in which such conversions are possible have already been saturated in this way.

So, is the office market in the United States officially dead? If you have read any of my other articles, you know that I hesitate to say that any real estate does not or will not have value. Given that a repricing has already started in the office property market, property owners should seriously consider novel types of repurposing for their office properties. Owners may want to convert their properties into data centers or storage for network servers. Another option may be attempting to lure tenants from the embattled retail markets with the promise of better lease terms and less income participation. Creativity is always a sure path to profitability, but one thing is clear about the current state of the office property market—at the present time, no one has the answer.  

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