Some commercial real estate professionals say uncertainty surrounding the national office market is unlikely to fade in 2024 as they try to determine when demand will bottom.

With a record-high vacancy rate and more unwanted space available for sublease, stakeholders indicate in interviews they are bracing for more pain this year as valuations fall. What's more, emptied office buildings and smaller lease sizes may compound challenges for landlords, they say, especially those facing maturing mortgage loans.

With the year starting with corporate job cuts, persistent inflation and signs of slower consumer spending, concerns about the state of demand in the office market — and its ability to drag on other parts of the economy — have become more pronounced.

On the real estate front, what is happening in the office market is not unlike what has been going on with regional malls over the past seven to eight years, according to Richard Barkham, global chief economist for Dallas-based brokerage CBRE.

“There is a clear parallel there with the digital economy affecting patterns of real estate usage. Clearly in the case of regional malls, it was about trade diversion with goods going direct to the consumer,” Barkham said. In the U.S. office market, he added, "it's about people getting back a bit more of their day and technology allowing remote work.”

It has taken almost eight years for regional malls to regain their footing after institutional investors started abandoning the property type around 2016, according to Barkham.

“I think that's probably likely what's going to happen to office, but it's going to fully recover around a smaller footprint,” he said.

Until then, it's going to be a long, hard grind down, Barkham said, but over the next 10 or possibly even 15 or 20 years, some office stock will be demolished, some will be repurposed, and some will be redeveloped.

That outlook shows why there's a view right now in the industry of "we're not yet at the bottom, but we're getting close to seeing it," said Phil Mobley, CoStar Group's national director of market analytics. "There is still a lot of uncertainty. Of course things can change and anything can happen, but based on what we've seen in the last four years and particularly the last year, we're unlikely to see any immediate, dramatic return to where the market was pre-COVID."

Office attendance rates that have fallen and plateaued at about half of what they were prior to the pandemic reflect that viewpoint, Mobley said. Companies have responded by closing offices, reducing their real estate use and redesigning their remaining space to cater to a more flexible working environment.

Those moves come as economic concerns have been fueled by softening consumer spending and persistent inflation that has been complicated by uncertainty over how quickly the Federal Reserve could begin lowering interest rates. Retail sales in the United States dropped by 0.8% in January compared to the month prior, a larger-than-expected drop that raises new questions about the durability of the nation’s economy.

Widespread job cuts announced since the beginning of the year have added another layer of uncertainty as employers respond to slower growth estimates and the need to do more with less. Tech companies alone have eliminated upward of 34,000 positions so far in 2024, with other corporate heavyweights such as the United Parcel Service and Nike making their own cuts.

There was more than $2.7 billion of outstanding office loans in the U.S. by the end of last year, according to CoStar data, at which point the delinquency rate shot up to 7.3% from the 1.4% reported at year-end 2022. Within the past two years, office values have slid as much as 15%.

"Valuations are falling. And so it's obvious that there's going to be stress and losses that are associated with this," U.S. Treasury Secretary Janet Yellen said of commercial real estate at a Senate Banking Committee hearing this month. "I hope and believe that this will not end up being a systemic risk to the banking system. The exposure of the largest banks is quite low, but there may be smaller banks that are stressed by these developments."

In conversations with CoStar News, real estate industry professionals shared their views on the office market and what could be in store for the year ahead:

Generally, the value of real estate reflects what is happening economically, not the other way around. In other words, office building value declines are not “hurting the economy” per se, said Anthony Graziano, CEO of Integra Realty Resources. Valuation declines, coupled with rising interest rates, have essentially “frozen” the trading market for real estate, said the head of the Chicago-based real estate research and advisory firm.

However, “bankers, mortgage brokers, appraisers, real estate brokers, asset managers, property managers, et cetera, were all in recession conditions in 2023 within their industry segment," Graziano said. "Most commercial brokerages saw 50% or more declines in revenue last year, which translates to a lot of people making half as much money.”

And that hits individual consumers and their pocketbooks, he said, a phenomenon that could rattle day-to-day consumer habits that play a critical role in the broader economy.

“Many individuals with a 401(k) or pensions have a stake in institutional funds who are invested in major office buildings," he said. "Broad declines in the fundamental demand for office, and the values upon which those funds are based, could negatively affect the performance of retirement and pension accounts. The larger impact on individuals [and the] public is the negative economic impact on neighborhoods and cities.”

Office buildings themselves also attract and generate their own economic activity. The workers inside can frequent nearby restaurants, nail salons, dry cleaners and other neighborhood retailers, and ground-floor spaces can help activate a street block to help drive foot traffic. All of that helps support demand and property values where jobs are located.

“When office occupancies fall dramatically, and office buildings struggle to attract tenants, the multiplier effect is that every neighborhood business is negatively impacted economically,” Graziano said. “This will affect service jobs, retail jobs, housing values and the local tax base which is invested in infrastructure [such as] parks, roads, mass transit, et cetera.”

That has already played out in areas such as California's Silicon Valley, where remote work and job losses have dealt a blow to the local economy. It is all connected to the drop in daily office use, said Alexander Quinn, real estate firm JLL's director of research for Northern California, who said the adoption of remote and other flexible-work policies has deteriorated values.

“The remote nature of work may impact the competitiveness of innovation cities as some of the important cultural drivers that fuel an innovation spirit gets lost in remote-friendly work environments,” Quinn said. ”We don't know if this is an enduring trend, but if the core principles of the creative economy are undermined by remote work, we could lose some of the secret sauce that made the Bay Area so productive.”

As a whole, the commercial real estate market contributes about one-tenth to the national gross domestic product, with office space accounting for about 15% of that economic activity, said Greg Friedman, the CEO and managing principal of Atlanta real estate investment firm Peachtree Group. With that large of a role, he said, any challenges within the sector will have wider effects on the broader financial market.

“Any shock to this sector would be material in size and ripple through the economy, however, it will not be a death knell,” he said. “While the office sector may never recover in value to pre-COVID levels, it should be rebalanced, similar to what regional malls faced several years ago. There is a huge investment opportunity as the office sector redevelops into other uses, which will ultimately help grow the economy.”

Despite the uncertainty, the office market will eventually adapt as it moves through the subsequent stages of recovery and expansion. That is, at least, until a new set of economic, technological or consumer changes hit and the market is once again forced to transform, Friedman said.

A majority of investors have stuck to the sidelines as office deals decline. Sales volume fell nearly 60% last year compared to 2022 levels, according to CoStar data, hitting a pandemic-era low.

However, some buyers are looking beyond the sinking valuations and rising interest rates. Instead, they're eyeing the chance to take advantage of the limited competition and score deals they otherwise wouldn't be able to entertain.

South Florida's Morning Calm Management and San Diego-based commercial real estate finance company Reven Office REIT both see silver linings in the market's current downturn. Both plan to take advantage of the rising number of office defaults and depressed pricing by investing in trophy properties located in top-tier markets across the country.

Delinquencies for Fitch-rated office loans sold on the commercial mortgage-backed securities market are projected to increase from 3.3% at year-end 2023 to 8.1% in 2024 and 9.9% in 2025 as maturity defaults rise from expected refinancing challenges.

“A decline in office building values or broader weakness in commercial real estate as a whole could create a liquidity crisis for the banking sector and potentially a solvency issue for certain banks, especially the smaller, more regional banks that are generally more exposed to [commercial real estate] loans,” said Morning Calm Management CEO Mukang Cho. “If the weakness in the banking sector is pronounced and protracted, this could lead to a broader slowdown in the economy, which will consequently affect everyone.”

And that weakening market will create openings for investors ready and willing to open their wallets, especially as lenders scramble to make up for widening losses and look to offload properties as quickly as possible.

“Knowing how bad the office market really is and which buildings will be viable for survival is critical to navigating the market with precision," Reven Capital founder Chad Carpenter said, adding that lenders could see losses of up to 110% on some distressed office building loans.

He said that's the strategy Reven Office REIT is taking in trying to raise up to $1 billion for financing deals at a time when banks have largely paused lending.