There was a time when millions of office workers throughout the U.S. would commute each workday morning from home to an office building for work. Along came the Covid pandemic which changed everything. To maintain social distancing offices were closed, and office workers worked remotely from workstations at home. As the pandemic winds down, will the empty office space in large urban downtowns again be occupied?
The slow migration back to the office building: Companies that required work from home are slowly unwinding that requirement by bringing office workers back to the office at least partially during the workweek. In early May, 2021, only 5% of the office buildings in the U.S. had as much as a 10% occupancy rate. Whereas in Europe and Africa over 30% had at least a 10% occupancy rate, and in Asia the percentage is 50%.
Inducements to bring back office workers: The post Covid return to the office has increased the demand for newer buildings with better overall facilities and more useful amenities. The main draw to attract new tenants includes lower overall rent, with improved ventilation, more natural lighting, and access to outdoor space. The trend toward quality office space is further impacted by a trend towards a greener work environment, and cleaner air plus more efficient energy systems are crucial to this end. Providing wellness and fitness facilities has gone from being optional to mandatory. The number of prospective tenants considering relocating to New York City seeking top quality office space has increased from 38% before Covid, to 50% plus as the pandemic winds down.
Older buildings are being left behind: The push to quality office surroundings is leaving older buildings behind. Manhattan’s largest office landlord, SL Green, reports that rents in the older buildings of its portfolio are down 10%. Making the picture gloomier is the shrinking demand for downtown office space owing to the amount of office workers who will continue to work at home. In some cases, the older buildings will be undergoing renovations to make them more useful and/or more attractive to prospective tenants. As an example, AIG, an insurance company, is moving to a renovated office building in downtown Manhattan and converting their thirty plus year old current office building into apartments.
It’s a lessee’s market place: The most important issue remains that the supply of office space will continue to be greater than the demand making it a buyer’s or lessee’s market place. Corporate planning is beginning to shift course away from pre-pandemic norms and taking newer approaches to their office needs, resulting in downsizing or delaying moves. The forecast is for as much as 20% of all U.S. downtown office buildings to be completely empty by the end of 2022. Rents are expected to fall by 7.5% overall with acute drops in places like downtown San Francisco.
Rent collection is holding up: Currently, rental collection by Real Estate Investment Trusts (REIT’s) has held up fairly well for nearly empty office buildings, being above 90% throughout North America for the previous twelve months. The worldwide average is 98%. This is in contrast to the high delinquency rates for retail space primarily in shopping malls and plazas. One reason might be that the average office building tenant is more likely to be a major corporation, whereas the average mall tenant is more likely to be a sole proprietor shopkeeper or a smaller chain of stores.
The uncertain future: The future for the downtown office building is nonetheless uncertain as the number of companies that will continue to require their office workers to work at home is not known. The postponement of office planning coupled with sellers’ unwillingness to sell buildings for lower prices means a significant decrease in sales volume that makes the current price of office space unreliable as a market tool. Since the downtown office building relies considerably on debt financing, a major downturn could send shock waves through the financial system. Banks are in deep with the financing of major downtown office real estate to the tune of about $2 trillion in the aggregate, or as much as 20% of all bank lending. The bellwether for the future could be the vacancy rate. Many downtown office buildings need a certain vacancy rate in order to remain open. This rate must be even higher for the building to make a profit. Continued low vacancy rates could result in buildings closing sending tremors not only to financial markets but also to municipal and state governments as tax bases will be smaller and collections more difficult.
Conclusions: Currently I own several REIT’s some of which apply to downtown office buildings. I further own another group of capital companies, and also one small bank. So far, they all have held up paying their dividends with only two notable exceptions: one that is mall based, and another that is a hybrid of malls and downtown office buildings. Naturally I’m concerned about the viability of all these real estate investments; the future appears to be bright in the short run, but could take a nasty turn for the worse down the road.
Sources: Shaky Foundations, The Economist, June 5th, 2021.