Executives at some of the biggest office real estate firms in the United States have touted "cautious optimism" in recent years as they struggled with low vacancies. Now they're dropping the caution from their outlook as they say demand for space has turned a notable corner.
After dealing with record vacancies, an unprecedented sublease surge and a potpourri of other pandemic-induced challenges, office real estate investment trusts in recent weeks have pointed to shifts that signal the worst could be in the rearview mirror. A recent boost in leasing activity nationally, coupled with more confidence among tenants in their return-to-office plans, supports the notion that the remote work shift hasn't left the national office market for dead.
"Working at the kitchen table wasn’t an existential threat," Vornado Realty Trust CEO Steven Roth recently told analysts. "Tenants are expanding and growing and actively searching for space. And in many of the prime submarkets, good spaces are being eaten up and rents are rising. We could not be more optimistic."
A cohort of leaders from BXP, Kilroy Realty, Hudson Pacific Properties and Cousins Properties, among others, add that the lack of new construction is further proof the demand for top-tier office space will only continue to climb as tenants compete for a dwindling pool of desirable space.
To be clear, many of those pandemic-era challenges still exist. And much of the optimism among office landlords is concentrated for those with portfolios at the highest end of the quality spectrum. The national vacancy rate remains stuck at a record high of nearly 14%, according to CoStar data, and many tenants — whether because of the uncertain economy or a focus on curbing costs — are still hesitant to make any substantial real estate investments.
"We have not seen a resurgence of large leases," said Phil Mobley, CoStar Group's national director of market analytics. "We have this incredibly active leasing market, but the average deal size continues to be pretty well below the old normal, and that seems to be more about smaller companies actively signing new deals while larger companies are sitting tight. In many places we're starting to run out of the best-located, premium new construction spaces, so that could be a reason why there are companies that are waiting rather than choosing to make a move."
Even so, here are some of the optimistic comments and expectations office REIT executives have recently shared as they prepare for the rest of 2024 and the years ahead.
Demand for Space
The typical summer slowdown "really didn't happen this year," as companies across a spectrum of industries bolstered leasing volumes across office owners' portfolios, Ted Klinck, the CEO of Sun Belt-focused REIT Highwoods Properties, told analysts. While average occupancy rates are still below their pre-pandemic levels, executives have pointed to a full pipeline of incoming tenants as proof that a widespread turnaround is waiting in the wings.
"We are starting to see larger deals and seeing some of those get done," Klinck said. "We're also benefiting and we continue to benefit from some of the distress in the market, and from some of the buildings that don't have capital to invest, we're gaining market share. In general, our activity is very good, our pipeline is full and I'm pretty optimistic that the second half of the year is going to continue to be pretty strong."
The shift among small and large employers alike to bring more employees into the office has boosted confidence among landlords that stronger in-office requirements will help bolster the demand for space. Whether it's a mix of hybrid scheduling or full, five-day workweek mandates, companies are increasingly requiring their employees to commute back to work.
BXP CEO Owen Thomas, for example, pointed to software tech giant Salesforce's escalated mandate as a sign that companies are changing their tune when it comes to hybrid or fully remote work.
For other landlords and developers, it also comes down to increased confidence among companies as they get more clarity on their space requirements.
"One of the things that we track is what proposals we have outstanding and how much square footage we have going through space planning; that's really where it starts to get very serious," said Brandywine Realty Trust CEO Jerry Sweeney. "We've seen some delays on the programmatic side where [tenants] are still trying to figure out how much space they need. Are people back three days a week, four days a week? Should they have larger common areas or smaller common areas? The space-planning process today is more protracted than it was pre pandemic."
Tech Sector's Return
Tech giants such as Alphabet's Google and social media platform Meta signed some of the nation's blockbuster office leases in the years leading up to the pandemic.
That dominance quickly fizzled in the years after the 2020 outbreak, however, when many Silicon Valley companies rolled out widespread job cuts, slammed the brakes on capital expenditures and shifted their focus away from real estate investments to higher priority ones such as artificial intelligence.
While still muted, executives from Hudson Pacific Properties and BXP have said there are some green shoots in terms of tech companies reevaluating their portfolios and realizing they'll need a space to once again accommodate their ambitious growth plans.
"You’re seeing broad-based demand [with] some relatively new-to-market tenants with big expansion plans that are looking at bigger square footage requirements based on how their businesses have evolved over the last year or so, which is really encouraging," said Kilroy CEO Angela Aman. There's "a recognition that they need to get more people back in the office, which is great to see and encouraging to see that as a trend throughout the portfolio as well."
Ready To Spend
The challenged financing climate, coupled with the uncertainty clouding the national office market, has sidelined some institutional investors as they wait out any lingering turbulence.
Yet after several years of arrested sales volume, the capital markets are beginning to loosen as the pool of interested buyers begins to widen at a time of anticipated reduced interest rates and valuations that appear to have hit rock bottom. Atlanta-based developer Cousins Properties, for example, recently made good on promises to take advantage of what CEO Colin Connolly described as "compelling investment opportunities" with the firm's $83 million acquisition of a trophy office tower in its home market.
"We've had a deal drought [in the office sector] for a couple of years," said BXP's Thomas. "Investors and other owners will have to get on with their business plans and at some point, they need to transact. Right now there's a bid out there for premier assets, and so far, no owners have elected to take it. I think the second half of this year will be interesting to see if any of those deals come to fruition."
After years of record amounts of available space weighing on the national office market, some office landlords expect the lack of new construction could portend a shortage of high-quality options.
Elevated borrowing costs and extended work-from-home policies have resulted in a dwindling amount of office space moving through the development pipeline, a phenomenon executives expect will result in a sharp drop in completed projects at a time when more companies look for space in top-tier properties across the U.S.
Vornado's Roth said the "most important dynamic in our market is that it is almost economically impossible to build new, thereby cutting off new supply," something he expects will shift the landlord-tenant power balance back in landlords' favor.
What's more, the spike in construction costs makes it increasingly difficult for any office development proposal — especially those located in central business district areas — to pencil, meaning the project pipeline likely won't be getting any significant contributions for at least the next several years.
"In simple terms, demand is increasing while supply is decreasing," said Cousins' Connolly. "This will lead to a rebalanced market. The process is underway and a shortage of lifestyle office in certain markets is not that far off. The flight to quality and the flight to capital continue to differentiate the market, and Cousins is well positioned at the intersection of these trends."