The pandemic and its aftermath created profound shocks to every commercial property type, but arguably the most complex and profound effects have occurred in the office sector.
While the uncertainty surrounding the future of the office is now dissipating, confusing and conflicting signals remain. In light of this, CoStar’s national director of office analytics, Phil Mobley, recently asked insight leaders at three major commercial real estate services firms to share their thoughts on what lies ahead for the U.S. office sector.
Participating were Aaron Jodka, national director of capital markets research for Colliers, David C. Smith, vice president and global head of occupier insights at Cushman & Wakefield, and Julie Whelan, global head of occupier thought leadership at CBRE. In a wide-ranging discussion, the three shared their outlooks on hybrid work, the so-called “flight to quality,” the future of central business districts and more.
CoStar: Perhaps the most pressing issue facing the office sector is the degree to which hybrid workstyles will affect long-term demand among organizations that have traditionally leased office space for most of their employees. Has there been a permanent structural shift, or do you expect demand will soon revert to its pre-pandemic pattern?
Whelan: Office demand is experiencing a structural shift right now. Office-using employment rebounded higher than anybody would have expected [at this point in the pandemic], and unemployment is still below the natural rate. Yet net absorption has been muted. Sublease availability is very high, and that is a challenge. And square footage per employee is at historical lows. So clearly, organizations are planning for a structural shift, and they're changing their leasing patterns accordingly.
Smith: Our workplace consulting team has surveyed tens of thousands of office-using employees about what they want, and what we see in that data is a desire for choice. Even among employees who want to be in the office pretty regularly, they still want some control over when they're in the office and when they're not. I don't think that is something that's going to change all of a sudden. The pendulum might swing back and forth over the coming years as companies try different things, but hybrid work is going to be here for the long term.
We did a study early in the pandemic that forecast somewhere around a 15% to 20% drop in demand because of the increase in remote and hybrid work. That doesn’t mean a direct increase in vacancy, but if in the past we were going to see 100 million square feet, we might now see 85 million square feet of demand moving forward.
Jodka: We've seen certain industries that have been slower to return to office than others, and we've seen a shift to hybrid working, which we do believe will be here to stay for the long term. That's a structural change. That is something that is far more prevalent today than it ever was pre-pandemic. So that will cause some changes in how space is used and how work is done.
If there is a true structural shift, it will have multifaceted implications. This includes changing when occupiers use offices, as well as what they expect employees to do when they are using them.
Smith: As we track usage patterns and foot traffic, it's not a steady stream throughout the week. Peak days may have a 30 to 50% higher traffic load than Fridays, for example. So, it’s not the case that if you have 20 percent of your people working hybrid, you can cut your space by 20 percent.
Whelan: I don't want to talk about “return to office” at all in 2023. Talking about “luring” employees back is looking at it the wrong way. What we need to do is create an environment where they naturally want to come into the office. First, the location needs to be good. It needs to suit employees in their life patterns. Second, there needs to be clarity about what interactions employees are going to have in the office, so they understand why and when to come to the office. Third, it's the esthetic and design. If the location and the deliberate interactions and the guidance are there, then if the design is good, that's going to be a place that keeps them happy, makes them engaged and sustains their return in the long term.
CoStar: Related to the question of the highest and best use of time at the office is the question of the best use of the building itself. Given the change in demand, is there much discussion of converting existing office buildings to other uses?
Jodka: There is an appetite for conversion activity. The challenge is the pricing. You can buy an office and expect a higher aggregate rent from a life science transaction, assuming that the building is converted and leased. On the multifamily side, some pricing adjustment needs to take place first.
Generally speaking, a bank will not lend more money to convert a mostly vacant office building into a multifamily property. That valuation needs to reset so that the next investor can come in at a cost basis that makes financial sense to convert it. Converting also depends on the asset itself. Certain buildings with deep floor plates are not conducive to being converted into residential or hotels, for example. You need window lines; you need space that these deep floor plates don't necessarily allow for. Not every building will be convertible.
CoStar: Another implication of hybrid work is the disproportionate impact on central business districts, especially in major markets. But does that necessarily mean the death of downtowns?
Whelan: The suburban office market has been more resilient throughout the pandemic. The vacancy hasn’t increased as fast. Rents have held steadier, and there hasn't been as much downsizing. However, we do not believe that that is going to be a long-term trend. We believe in agglomeration and that the density of people in businesses and places is important. We are still very bullish about the urban markets and their recovery.
Jodka: An amazing statistic that we've seen is that suburban vacancies have fallen below CBDs [or central busness districts.] It’s the first time we've seen such an inversion. But even though the suburban office markets have relatively outperformed so far, the amenity factors within a city — the culture, parks, activities, and sports — will lure people back.
Gateway cities have more prominent CBD markets, whereas your next 10- or 20-largest markets may have downtowns, they may or may not be the city's dominant office submarket. Think of a place like Dallas. Historically, the CBD of Dallas has not been the driver of office activity. So that dynamic is still at play in some of these cities. But at the end of the day, Boston, New York, Washington, D.C., Los Angeles and San Francisco have all been longstanding downtown markets with tremendous amounts of capital and investment. We don't think that changes.
Smith: If you define "hub-and-spoke" as a centralized HQ-type office downtown with a bunch of landing spots in the suburbs, we've seen occupiers who have thought about it and even talked about it, but not taken a lot of action. They’ve been consolidating and trying to reduce the number of leases they might have, whether CBD or suburban.
CoStar: The shift in the marketplace is not only about how much space tenants need or where it should be located; it is also about what kind of office they want. Economic cycles often see a flight to quality, but there are important nuances for investors to note this time around, correct?
Smith: Across the 90 markets we track in the U.S., we saw about 189 million square feet of negative net absorption during the pandemic. But looking just at the buildings built in the last eight years, there has been 105 million square feet of positive net absorption. So there are definitely “haves” and “have-nots” right now. Talking about A versus B versus C is probably not enough granularity as we move forward. There are going to be several levels of Class A, with trophy buildings at the top that are automatically desirable, and then more of a Commodity Class A, a nice building, perfectly functional, but maybe not a lot of wow factor or experience options for employees around it.
Whelan: Flight to quality is happening, but what organizations are after right now is what I consider a “pursuit of happiness.” They are defining what the office means in that pursuit. And once they do that, then they can understand what type of quality they're looking for. In that context, “quality” typically ends up being about the type of technology that's in the space, the location of the space and the wellness amenities, services and programming the space offers. But how that all comes together for each company depends on what they have decided is going to keep their organization happy.
Jodka: There's still a record amount of investment capital sitting on the sidelines, and investors will be looking for well-leased assets that have [environmental, social and governance] policies — in particular LEED Platinum certification — and low energy consumption. Those assets will be highly liquid. The challenge is that there aren't a lot of them for sale. On the other end, vacant assets that are trading at substantial discounts to replacement cost could offer some interesting investment opportunities.
CoStar: As leasing activity stabilized in 2022, tenants began to show how they are adapting to their changing needs. Skyrocketing sublease inventory forms a key part of the backdrop, but aren’t there also other patterns suggesting tenants are taking more decisive action in managing their footprints?
Whelan: We have seen a change in lease sizes very clearly in 2022 versus 2019. We track leases over 10,000 square feet, and among those, we have seen a drop of just under 20% in the average size of the lease. It has been a clear driver of the market, and it was not a surprise to us because we know that most of our clients and most tenants are in that right-sizing mode right now.
Smith: We saw a shortening of lease terms. New leases dropped by an average of about nine months early in the pandemic. Since then, they've gained about half of that back. On renewals, we saw much shorter lease terms. They dropped by about 15 months, from just over six years to under five years. More recently they’ve added back about four or five of those months.
CoStar: Looking to the year ahead, how much will the slowing economy and higher cost of borrowing further challenge the office sector?
Jodka: We're facing headwinds. The biggest challenge is interest rates. More so than anything else, the rise in borrowing costs has put investment sales activity at a relative standstill. Office leasing has generally been stabilizing, but investment sales activity has dropped off.
A recession or additional layoffs will only add to the challenges. Longer term, there will be some repricing. It will depend on occupancy, on the durability of leases, and on location. The likelihood of renewal and the percentage of space that will be renewed are factors that investors will be looking at in their underwriting.
Smith: Our perspective is, if there is a recession, it will be relatively mild. We might see some job losses in the office-using sectors, but I think some of the slowdown demand is already baked into what we've experienced in the last couple of years in the slow recovery in leasing relative to employment.
Whelan: With a looming recession ahead of us, many organizations are looking at their real estate and being even more cautious, which is going to be a double whammy in this whole equation.
Once that is past us, we could end up in a place where some organizations have overcorrected, and we could see some demand come back because of that. There is a theory that tenants have already dropped the space that they can. Hybrid work gives them a failsafe for their space needs, and they can calibrate their real estate as a result. Whereas they used to take space in advance of actually needing it, now that equation has somewhat reversed.