The rapid and broad adoption of remote work spurred by the pandemic allowed people to work in residential space, instead of office space, at a scale unimaginable just a few years ago. This dramatically reduced the demand for office space, with particularly steep contractions in some markets. While the final depth of this demand contraction remains an outstanding question, in this X-Factor we’ll analyze how far it has progressed and how it’s affecting both renters and owners of office properties.
“Demand for office space has significantly contracted, but we won’t know the depth of the contraction until more leases expire and more tenants make decisions about how much space they really need.”
Post-Pandemic Surge in Availability Rates for Office Space
One metric that can provide a clue about the scale of demand reduction is the availability rate of office space across different cities. Availability rates are similar to vacancy rates but are considered a more comprehensive measure. In addition to vacant space, an availability rate also includes space that’s currently occupied, but is being marketed for lease (i.e. will be vacated in the near future), and space listed for sublease by an existing tenant.
Since the fourth quarter of 2019, tenants have downsized. As a result, available office space has increased in 77 out of the largest 100 cities by population (see chart 2). Cities with the greatest increase in available space compared to pre-pandemic levels tend to be large coastal cities, followed by some in the Southwest and the Sunbelt. San Francisco has had, by far, the largest increase in available office space of any city in the country, followed by Seattle, San Jose, Calif., Austin, Texas, and Denver.
Why Offices Rents Have Been “Downward Sticky” So Far…
Though demand to lease office space, as measured by availability rates, has declined in most large cities compared to pre-pandemic levels, rents for office space have only declined in a handful. Out of the largest 100 cities, office rents have only fallen in eight of them compared to the fourth quarter of 2019:
1. San Francisco (-29.9 percent)
2. San Jose, Calif. (-8.4 percent)
3. The East Bay, Calif. (-8.3 percent)
4. Seattle (-7.8 percent)
5. New York (-6.0 percent)
6. Orange County, Calif. (-3.3 percent)
7. Washington (-1.5 percent)
8. Los Angeles (-0.6 percent)
If demand to lease office space has fallen across the country, why haven’t lease prices declined in nearly as many cities? A couple of factors are at play here. First, office leases are usually long term with rent escalations built in, so leases must expire for rents to adjust downward. Second, if an office owner is forced to lower rents, and a building’s income falls as a result, then the value of that property also falls. This is a concern for owners with maturing mortgages that might soon have an outstanding loan balance greater than the value of their property. Rather than lower rents, landlords are instead trying to attract tenants by offering lease concessions, such as months of free rent or tenant improvement allowances, to shield property prices from the impact of declining rents.
This partly explains why post-pandemic office rents have, so far, been “downward sticky.” However, downward stickiness in office rents is unlikely to persist. Office properties are now regularly selling at significant discounts relative to prior purchase prices. As more buyers acquire office space at meaningfully lower prices, they will be able to better compete for tenants with lower rents. After all, even an office building that’s only 30 percent occupied can still be profitable at the right price.
…Yet Prices Have Not Been “Downward Sticky”
Though office rents have been downward sticky, office prices haven’t. Compared to pre-pandemic levels, prices for office space in cities with low or negative rent growth have been commensurately lower. Lower rents reduce an office property’s profitability, all else equal, and demand to own it as an investment falls as a result. Typically, demand to lease space drives demand to own it by impacting the rental rates that landlords can charge. But the relationship can work in the other direction if buyers first acquire properties cheaply and then compete with lower rents.
Cities in the lower right quadrant in the chart below have something interesting in common. Though rents are up in these cities compared to pre-pandemic levels, prices are down. This suggests that, in 51 of the largest 100 cities, expectations of reduced future demand to lease office space is at least partially built into prevailing prices.
A Bright Spot in the Suburban Sprawl
The transition to remote work also shifted demand for office space away from urban cores to the suburbs. Since 2020, suburban office prices have generally fared better than those in central business districts (CBD). Though suburban and CBD locations exhibited somewhat similar price movements in the first two years of the pandemic, beginning in the back half of 2022 CBD prices began to decline at a much faster pace. As of April of this year, CBD office prices are down by approximately 50 percent compared to pre-pandemic levels, whereas suburban office prices are only modestly below where they were.
So, What’s the X-Factor?
Advances in technology can change the way society uses space for different purposes. While there will always be some push and pull between employers and employees about how often they can work from home, the fact is that the normalization of remote work has allowed residential space to be used as office space to a degree that wasn’t possible before the pandemic. As a result, demand for office space has significantly contracted, but we won’t know the depth of that contraction until more leases expire and more tenants make decisions about how much space they really need.