Office Industry Brief
It may be too soon to declare that the office amenities’ wars are over, yet that element as a driving force in the office market is being supplanted by two fundamental alternatives: shorter commutes and ‘cool’ neighborhoods. Convenience, and proximity to one’s home – especially for hybrid workers, is behind the latest trends and tenant preferences.
During the pandemic, premium, amenity-rich office space outperformed in terms, rent, and occupancy, and reached a high-point last year at about $70 a square foot on average across the U.S., yet dipped into the high-$60s by the end of 2023. Leasing activity is also declining in the best of America’s Class A office space, with Costar reporting that its five-star office buildings (Costar’s highest rating) accounted for 8% of all office leasing in 2022 and 2023, compared with 10% in 2019.
Costar also reported that new construction of office properties is at a 25-year-low, measured by percentage of inventory, with just 31 million square feet of new office starts last year, which would represent only 1% of the total U.S. office inventory by 2027, when most of those projects would be delivered.
Meanwhile, the U.S. office market vacancy rate reached 19.6% at the close of the fourth quarter 2023, and it is the highest number since at least 1979, which is as far back as Moody’s data go. By comparison, it peaked at 16.3% during the Great Financial Crisis.
Even with reports that companies are not downsizing their office footprints as much as the market expected them to, the post-pandemic, hybrid and work-from-anywhere era is creating more demand for community space, vs. private offices, and that is keeping office occupancy (by square feet) at nearly par to what it was before the pandemic. There are notable exceptions to this and principally among law office occupiers – especially law firms that are recruiting, as they are offering privates offices to attorneys, rather than shared office space which increasingly became more common in the years leading up to the pandemic, according to Mike Arnold with NAI Capital. (More from him later.)
However, the sheer volume of upcoming lease expirations is daunting.
According to the CRED iQ research, about 217 million square feet of office space across CMBS collateral have leases with expiration dates in 2024 or 2025. An additional 92 million square feet and 110 million square feet of office space are predicted to expire in 2026 and 2027, followed by a whopping 415 million square feet projected to expire in 2028.
Those annual totals compare to 21 million square feet that expired in 2023.
San Francisco is the current poster child for the highest office vacancy rate among major U.S. markets, at 35.9%. It is also the highest it has ever been in New York City, at 22%. That translates into a whopping 101 million square feet of available office space, given New York’s total inventory of 463 million square feet of offices, with most of it in Manhattan’s Midtown. San Francisco’s total office inventory is miniscule by comparison, at 88 million square feet, which equals a little more than 31 million square feet of available offices in the Golden Gate city.
For perspective on office market sizes, Central London has approximately 290 million square feet (msf), Berlin 208 msf, Paris 198 msf, Brussels 147 msf, Frankfurt 110 msf, Seoul 107 msf, and Hong Kong about 91 million square feet (Grade A only).
Tenant Leverage is the Highest in Years
Given the state of the office market and consistent with previous, cyclical downturns in the sector, “we continue to see flight-to-quality and tenants are getting a lot of concessions,” according to Mike Arnold, EVP and Founder of the Tenant Consulting Group at NAI Capital in Los Angeles. Arnold is also the Vice Chairman of NAI Global’s Elite Corp Services Group. Speaking to us on a break from NAI Global’s Annual Convention at the beginning of February (in Frisco, Texas), Arnold added that the office market situation in many international markets isn’t much better, according to NAI professionals he routinely speaks with in virtual meetings or in person.
However, and despite the distress in the office sector that is already here, as well as the expectation that we will experience a wave of foreclosures the next few years, he thinks there could be some stabilization developing as we get deeper into 2024.
“As lending rates stabilize and perhaps even start to come down, institutional owners will have greater ability to finance maturing loans or just decide to sell at some level of discount, and move on. That, in turn, should trickle down to local markets. Even so, there is going to be a lot of pain distributed unevenly,” said Arnold.
In the event of a default on an office building, he encouraged tenants to be sure to have SNDA clauses in their leases, for protection. Without a Subordination of Non-Disturbance Agreement, tenants could be kicked out of a building in a default situation, if the lender chooses to sell the asset for redevelopment purposes or otherwise cannot support the building’s ongoing operations – with or without a special servicer.
In the meanwhile, tenants have options to strengthen their lease positions to their advantage, by restructuring leases early. Arnold just did this with a client in Los Angeles, renewing three years early and committing to a new 5-year term with the landlord. Tenants benefit from these in different ways, from new TI packages to parking concessions and of course, lower effective net rent, while the building owner extends the term of the lease to enhance their respective position with lenders.
Arnold also said tenants that occupy 10% or more of a building’s total rentable square feet have greater leverage in negotiating lease terms because the tenant becomes more intertwined with the owner’s borrowing position with lenders – in a similar manner to grocery store operators that as the anchor tenants in shopping centers, they not only serve to attract tenants to shop space and pads at their respective centers, but they also provide the security lenders need to extend loans to shopping center owners.
