The flight-to-quality trend of office tenants seeking well-located workspaces with appealing features may be one bright spot for the struggling property type, but it doesn’t mean landlords have the upper hand when it comes to how much tenants are willing to pay.
Manhattan, the largest U.S. office market and a barometer for the rest of the country, offers a telling example. Class A office tenants signing direct new or relocation leases of at least 20,000 square feet with lease terms of at least seven years have received an “astonishing” average 24% of their total rent as concessions, which include free rent and tenant improvement allowances, since April 2020, real estate firm Avison Young said in a study. In contrast, between 2018 and March 2020, concessions were 17.1% of Class A office rents in Manhattan.
The increase was not just limited to Class A office buildings. Concessions given among trophy buildings, or properties that usually command even higher rent and more desirable amenities and other features than Class A assets, have risen to 20% of total rent from 17.2% pre-pandemic, Avison Young said. Among the lower tier Class B and Class C office buildings, the concessions also jumped to 21.2% from 15.4% in that time.
“With the current economic environment and the slowdown in leasing, landlords have been enticing tenants” with concessions, Danny Mangru, Avison Young’s New York regional manager of market intelligence, said in an interview. “We are currently in a very tenant-friendly market. Landlords have to compete. Given all the supplies in the market, they have to compete not only with direct [leases] but also sublease space. They have to lure tenants with higher concession packages. Is this sustainable? It remains to be seen. I don’t anticipate these concessions packages to drop in the next few quarters.”
Concessions nearing a quarter of total rent among Manhattan Class A office buildings are the highest level on record since Avison Young began tracking the data in the early 2000s while the citywide average is also near a record high, Mangru said.
Class A buildings are “continuing to compete against trophy properties,” which include the likes of One Vanderbilt, owned by Manhattan’s largest office landlord SL Green Realty, or Olayan Group’s redeveloped landmark 550 Madison Ave., Mangru said, adding trophy towers represent about 10% of Manhattan’s office stock while Class A office buildings another 15%. “They have to up the total concessions.”
Longer Leases
As part of the flight-to-quality trend that signals well-resourced employers seeking desirable high-end buildings, trophy buildings often command about 10-year lease terms on average, longer than those in Class A office leases, Mangru said, adding Class B and Class C buildings are “struggling.”
Class A buildings are generally the most prestigious in a market, in the most desirable locations with the best amenities, while Class B buildings are typically older with some amenities and may have had recent renovations. Class C buildings tend to be low-rise, no-frills structures away from city centers that are due for some major upgrades.
The phenomenon isn't limited to New York City. Other major cities including Atlanta, Boston, Chicago, Los Angeles, San Francisco and Washington, D.C. all saw jumps in both tenant improvement allowances and free rent periods since pre-pandemic in 2019, Avison Young data compiled for CoStar News shows.
For instance, while year-to-date tenant improvement allowances in Manhattan averaged $128 per square foot, they were even higher at $135 per square foot in both San Francisco and D.C., where security firm Kastle Systems’ keycard swipe data point to office utilization rates that are both lower than those in New York.
In another example, while Manhattan office tenants are getting 11.2 months in free rent in normalized 10-year lease terms so far this year, D.C. tenants are getting a whopping 18.2 months.
Debt Coming Due
An uncertain economic outlook and questions about office demand in light of the pandemic-led hybrid work trend aren’t the only drivers behind the increase in concessions across various building classes.
The sector bracing for major debt maturities in the next two years also means “concessions will play a big part” of deals because “landlords are going to have to hit certain base rent” to help them with refinancing and other negotiations, Mangru said.
In the next three years, a “staggering” amount of fixed-rate loans, or topping $10 billion, on the commercial mortgage-backed securities market in Manhattan will reach their maturities, with over $7 billion of loans maturing in 2025 alone, Avison Young said in a separate recent study.
It added that the market is “set to experience further distress” as more such loan maturities draw near.
Other markets are also bracing for more debt maturities and potential difficulty in refinancing. Almost $1.4 trillion of commercial mortgages are set to mature in 2023 and 2024, according to Moody’s Analytics in a study published last month.
Only 30% of $1.15 billion in fixed-rate office loans on the CMBS market that matured through April this year were paid off, the sister company to ratings firm Moody’s Investors Service said. It added that over 60% of the remaining $7.8 billion upcoming maturities in 2023 may have difficulty refinancing.
Record-High Vacancy
New York’s office vacancy rate has reached another record high of 13% while its availability rate of 16.3% topped the pre-pandemic level of 11%, according to a CoStar report, adding the amount of available sublet space in the city also recently reached an all-time high of 29.9 million square feet.
Also making the supply and demand “imbalance” worse is the fact there’s still 13.4 million square feet of office space under construction while tech companies, which have previously been among the most active tenants seeking New York office space, have laid off tens of thousands of workers across the country over the past year, the CoStar report said.
“Limited deal activity and record-high availability have created a leasing environment where tenants hold all the leverage,” according to the CoStar analysis, adding some tenants have recently been successful in achieving up to 15 months of free rent and up to $150 per square foot in tenant improvement allowance.
Concessions cut office landlords’ net operating income margin, which hovers around 60.7%, by another 23.3%, BMO analyst John Kim said in a report in March.
“We see the next two years as crucial for the office sector, pressured by rising vacancy rates and depressed demand heading into a recession,” Kim said at the time. “Landlords with high lease expirations will struggle to hold occupancy, which would impact not only earnings, but also pricing power [rent].”
The top 13 office real estate investment trusts have 21.6 million, or 9.4% of total square feet, and 30.7 million, or 11.6% of leases, set to expire in 2023 and 2024, respectively, he said.
With Manhattan having ended the first quarter with a record-high office vacancy rate, landlords are seeking to compete not just by investing in new tenant amenities or concessions, JLL said in its first-quarter market report.
For “capital-constrained” landlords in the face of higher borrowing costs and tighter access to funding, they also are coming up with “more creative and flexible lease terms,” including early termination or expansion options and access to flex space within the same building, as they “seek alternative ways of negotiating beyond traditional concessions,” JLL said.