Commercial real estate is facing a lot of stress. Many analysts and investors, including myself, expect to see significant value declines across much of the sector in the coming year.
But one particular type of commercial real estate is facing the biggest crash potential of all: office space. And even if you don’t currently invest in office space, the future of this huge asset class will have large implications for the broader real estate market and the economy as a whole.
The idea that the office market may crash makes sense on a logical level, as more people are working from home, but from a data perspective—it looks even worse.
Since 2019, net absorption, a crucial indicator that measures the balance of supply and demand for office space, has turned starkly negative. In this time frame, tenants have given up a whopping 140 million square feet. 25 million of that lost square footage has come in 2023, so there’s no sign of slowing down. In fact, evidence points to this horror show continuing, with another 67M square feet of new supply projected to come online this year—that’s the most new office space coming online since 2009. So there is a huge glut of supply flooding the market, and it’s happening at the worst possible time—when demand is declining.
Demand is obviously down due to remote work. Although the total number of days worked from home has come down from pandemic highs, it’s still estimated at 400% higher than pre-pandemic levels. While there does seem to be some anecdotal evidence that remote work will decline a bit more in the coming years, to me, it seems unfathomable that it will decline to anywhere near pre-pandemic levels, ever.
The second reason demand is struggling is due to the broader economic climate. Most economists believe, including the Federal Reserve’s own analysis, that unemployment will rise over the coming years. With stagnant or declining headcounts, few businesses are looking to increase their office space. And even for those businesses that are hiring, there are likely relatively few that want to sign long, expensive leases.
No matter how you look at it, companies are just using less office space. This is reflected in much of the data I look at (which comes from CoStar). Let’s dig into some of the most important indicators:
As of Q1 2023, office vacancy is up to a record 13%, surpassing the previous peak back in 2010. The pre-pandemic vacancy rate was about 10%, so it’s risen about 30% since then, but CoStar expects vacancies to go up even more. Their forecast shows national office vacancy climbing to almost 18% by 2026, and tellingly, they don’t show it declining at any point in their five-year forecast.
Net Absorption, Net Deliveries, and Vacancy Rates (2017-2026) – CoStar
Notice some of the construction and absorption trends on the graph. Net absorption has been negative since the beginning of the pandemic and is expected to get even worse in the coming years. Meanwhile, net deliveries (new supply) will spike at the end of 2023 before reaching an almost complete standstill in 2025 and beyond. Builders see the writing on the wall and are going to stop building office space, but the units in the pipeline will likely still come to market, driving up vacancy.
Subleases are when an office tenant no longer wants some or all of their space and seeks another business to take over some or all of their lease. Currently, 216 million square feet of sublease office space is available—more than double pre-pandemic levels. San Francisco alone has 12M square feet—which is roughly 6% of the city’s entire inventory. New York City has 31M available, a truly staggering amount, but it is proportionately less than San Francisco, at 3.1% of inventory.
The trend of rising sublease availability is happening everywhere. Large markets, small markets, urban, suburban, you name it. This is as close to a national trend as we can see. Companies are trying to get rid of their office space, and there is not sufficient demand. To me, this means that even though vacancy is at a record high, it’s not even telling the whole story. Even the companies who have leases don’t want their leases.
Office rents have recovered somewhat since the depths of the pandemic, but that’s not expected to last. Higher vacancy rates, coupled with outsized sublease availability, are likely to push down rates. For example, some subleased space is being offered at huge discounts of 30%-50% to direct rates.
At $35.00 per square foot, the national average for rent is on par with what it was entering 2020. So it’s not terrible yet, but rents are forecasted to decline, which tracks with the other data we’re looking at here.
Market Rent Growth Year-Over-Year (2017-2026) – CoStar
Will the Market Crash?
When you look at the above data and consider the logical outcome of current trends, it does seem like office prices will drop beyond 15%—which I would consider a crash. But how will this actually happen?
Commercial assets like office space are typically valued based on the cap rate and the net operating income (NOI). With high vacancies and lower rents, NOI will almost certainly drop. This will hurt valuations on its own. With higher interest rates and high market risk, cap rates are going to rise. CoStar forecasts office cap rates to rise from about 7.2% to about 8.5% nationwide.
Market Cap Rate (2017-2026) – CoStar
When cap rates rise, prices go down. As an example, if you had a property with an NOI of $100k, the value would be just under $1.4M at today’s 7.2% cap rate. If cap rates rise to 8.5%, that property would be worth about 1.18M—roughly a 15% drop in values. But that’s just cap rates. If you combine higher cap rates with potentially lower ROI, things could get even worse. But how bad will it get?
CoStar estimates the price per square foot for office space will drop about 23%, based on rising cap rates and falling NOI. And there is some good evidence to support a drop of this much, or even more. If you look at publicly traded commercial office assets (Office REITS), we see significant declines. The biggest office REIT, Alexandria Real Estate Equities (ARE), is down more than 30% over the last 12 months. Another huge REIT, Boston Properties, is down 53% as of this writing. According to NAREIT—a REIT association, office REITs are down 21% in 2023 and are down 41% over the last 12 months.
There is good reason to believe that private valuations will follow. Public REITs are repriced constantly, so investors who see the writing on the wall have already pushed down public valuations. Meanwhile, private valuations take longer to correct, as they only get repriced upon a sale. My general thinking is that offices in the private sector will see a similar drop—somewhere around 25-30%.
Another thing to consider is that banks are shying away from lending to office investors, making a recovery more difficult. Even if an investor wants to get into the office space and help set a bottom for the market, the financing may not be available.
Of course, there will be big variations. Some locations and sub-markets will do okay or may only see slight declines, while others in markets like New York and San Francisco will see even bigger drops. High-quality assets, such as buildings constructed during the last decade, are still doing well and have positive net absorption. Demand has persisted in many Sunbelt markets. Niche offers, like life sciences, are doing well in Boston and San Diego and may continue to do so. But those are exceptions to the broader national trend.
So what does this all mean for real estate investors who may or may not be interested in office space?
First, and most obviously, I would be extremely careful about buying office space right now. I think private valuations are way too high still and need to come down. If you are going to try to buy office space in the coming years, you need to be buying at a steep discount off previous highs and underwrite with increasing vacancy and declining rents for the foreseeable future. It will be a tall order to make that pencil, but if prices really do drop by the amounts I think they could, there may be opportunities when the dust settles.
Second, real estate around central business districts could be impacted. Everything from retail to multifamily to single-family homes may be negatively impacted by the same trends that are negatively impacting office space. I’m not saying that office valuations and valuations of other asset classes have a causal relationship, but because fewer people are going to the office, demand could drop for other types of real estate in the area. Similarly, there is a risk for banks that have a lot of exposure to office loans. That could spill over to other commercial asset classes.
Third, I believe other areas of CRE will see large declines, but probably on a smaller scale than office. I expect multifamily and retail to come down, but the fundamentals indicate that office will suffer the most. Vacancy and rents in multifamily are unlikely to get hit nearly as hard as office.
Lastly, remember that this is a broad nation-level analysis, but each region will perform differently. Big cities like NYC and San Francisco are getting hit really hard, while some places in the sunbelt could continue to grow.
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