The NAIOP Research Foundation, as part of its Industry Trends meeting, recently hosted a panel discussion on what’s next for the office sector. Analysts from leading service firms joined NAIOP Research Foundation Governors and office developers Greg Fuller, president and COO, Granite Properties and Paul Ciminelli, president and CEO, Ciminelli Development, to discuss problems and potential opportunities. The panelists agreed that the sector will undergo a shakeout that will include transformation, streamlining, new approaches to work and holistic solutions.
A “Broken” Market
Remote work and economic headwinds have created a negative demand shock in the office sector and a temporarily “broken” market that has not yet reached stability. Before the pandemic, office workspaces were densifying, with less square footage assigned per employee. Remote work and downsizing accelerated this trend, with tenants now needing less space per employee. Although office-using employment has rebounded from the brief pandemic-induced recession, office space demand has declined sharply. Phil Mobley, national director of office analytics at CoStar, estimated that the gap between office-using employment and previously expected demand could be as much as 400 million square feet. As supply continues to come online, vacancy rates will continue to climb over the next three years with negative absorption levels higher than during the Great Financial Recession.
According to Mobley, sublease availability is a key indicator of the market’s health, and it has more than doubled since 2019 and continues to rise. While transactions have slowed down, the ones that have taken place in the last two years have been at lower price points, but with strong fundamentals such as lower cap rates, which gives the impression of positive price growth. However, this masks some of the underlying problems that will inevitably come to light during loan maturities and price discoveries. The Mortgage Bankers Association reports that over 40 percent of office loans are maturing in the next 20 months.
The Hardest-hit Buildings
Not all markets, nor all types of office buildings are experiencing dramatic setbacks. CBRE’s Global Head of Occupier Thought Leadership, Julie Whelan, and her team conducted a study to identify the buildings that saw the most significant increase in vacancies. Their research revealed that smaller buildings (between 100,000-300,000 square feet) constructed between 1980 and 2009, located primarily in downtown areas with limited surrounding amenities and/or in high crime areas, were the most affected. Furthermore, the study found that only 10% of the buildings in the 64 markets examined accounted for 80% of the vacancies from Q1 2020 to Q1 2023.
During the pandemic, the vacancy rates of buildings in downtown markets have surpassed those of suburban areas. Specifically, 41% of buildings with the highest vacancy rates are in downtown markets, mainly in the Pacific Northwest and Northeastern regions of the United States. For instance, San Francisco’s vacancy rate has surged from 4% before the pandemic to almost 30% due to its reliance on the tech sector. Additionally, buildings located in high-crime areas (usually downtowns) and those with fewer adjacent amenities (usually suburbs) are struggling to retain tenants. However, there are opportunities to reposition or reinvent these properties, but they will require innovative public-private partnerships and community-based approaches. What surrounds office buildings, such as safe and walkable mixed-use communities, is just as crucial as what is inside them, according to Whelan.
Back to the (New) Office
The shift to remote and hybrid work has had a significant impact on office space demand. However, many companies are realizing that returning to the office more often offers advantages. While some employers have opted for 100% remote, hybrid, or office-centric policies, Lauren Hasson, the vice president of workplace strategy at JLL, has noticed a growing number of companies that want their employees back in the office at least three days a week. Studies have shown that it is difficult to engage and mentor employees who are not physically present. Furthermore, there has been a decrease in innovation, as evidenced by a decline in patent applications. Remote job postings have decreased, but employee demand for remote work remains high. Remote job listings on LinkedIn reached their peak in early 2022 at around 20% before recently falling to 12%. However, over 50% of job applications submitted are for remote positions, indicating that many job seekers may need to accept hybrid or in-person jobs. Markets with higher costs of living, intense talent competition, and long commutes, such as Boston, San Francisco, and New York, tend to advertise a higher percentage of remote positions and have slower rates of return to the office.
Hasson has reported that companies that require employees to work in the office only one or two days a week have the highest turnover rates. Thus, companies that offer either full-time remote or full-time in-office work have a better chance of retaining their talent. However, tenants that require in-person work are offering more amenities, and flexibility while creating C-suite positions such as “Chief Workplace Experience Officer” to ensure employee satisfaction and engagement. Hasson believes that enhanced office workspace will become the ultimate recruiting tool, similar to how prospective students consider a university’s athletic facilities and campus environment. According to Hasson, the new experiential office environment, which will be fueled by innovation, creativity, employee diversity, and cutting-edge technology, will recalibrate the sector and ultimately usher in a “golden age” of work.
According to Ciminelli and Fuller, the office market is going through both cyclical and structural changes. While some office properties are flourishing, others lack the necessary amenities and locations to attract employees. Fuller noted that pre-pandemic, office buildings were rarely completely occupied, with a strong occupancy rate of 72%. Currently, occupancy rates vary between 40 and 65%.
Certain buildings are structurally obsolete or not ideal for conversion, particularly when considering residential use. In some cases, it may not be feasible to convert due to the property’s floorplan or location. Furthermore, the costs associated with redevelopment have risen considerably, making it necessary to acquire properties at lower costs.
Despite the challenges ahead, Fuller and Ciminelli anticipate opportunities once the dust settles. The office market will gradually reach an equilibrium as employees return to work, albeit with more flexibility and discipline in office space utilization. Like the retail sector, the office market will undergo a rightsizing process, ultimately emerging more streamlined and beneficial for both employees and employers.