In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi discuss how office space utilization has shifted during and after the pandemic, and what that means for office space supply in the near future with special guest Senior Commercial Real Estate Economist Xander Snyder.
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“Higher quality class-A office buildings, especially new and best-in-market assets, will have a better chance to weather the new workplace reality. Class-A properties are able to offer the sorts of amenities that tenants and tenant's employees want, whereas older buildings, such as class-B and class-C offices might not be able to.” – Xander Snyder, senior commercial real estate economist at First American
Odeta Kushi - Hello and welcome to episode 58 of the REconomy podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American.
Mark Fleming - Hi Odeta. Guess what? We have a guest on the show today. Joining us is Xander Snyder, First American Senior Commercial Real Estate Economist to discuss trends in the commercial real estate market. Are we excited? I am. And this is his first time on the podcast, but certainly not the last. And I would also point out not the first time on a podcast. Welcome, Xander.
Xander Snyder - Thanks so much. Hi, Mark. Hi, Odeta. Excited to join you both on REconomy today.
Odeta Kushi - Welcome, Xander. Now, as our regular listeners know, we tend to focus on economic trends that affect residential housing, which was meaningfully impacted by the pandemic. But housing hasn't been the only type of real estate impacted by the pandemic. And you have the job of tracking what's going on in all commercial real estate asset classes, office, retail, multifamily, industrial, and I could go on, but I think we're just going to cover one asset class in particular today, right Xander?
Xander Snyder - That's right, Odeta. Office buildings in particular had been really impacted by the broad adoption of remote work technology and culture. So, consequently, residential space has become a substitute good of sorts for office space, since both office and residential space can now be used in similar ways. And that is to do work.
Mark Fleming - Oh, hold on, hold on. I just gotta say, the voice, the voice. I mean, you are made for this stuff. And wait a second. We can't just throw out phrases like substitute good without an explanation. Please explain your jargon, Xander.
Xander Snyder - What would a good Econ podcast be without some good Econ jargon. So, okay, a substitute good or service is something that can be used in place of some other good or service. So, before the pandemic, in the case of office space, there weren't many available substitutes for office space since the vast majority of people didn't work remotely. Now, though, many people work from home. And it seems highly likely that, at the very least, hybrid work remains a feature of our work culture for the foreseeable future. This has decreased the demand for office space and increased the demand for residential space. Since residential space can now be used as a substitute for office space.
Mark Fleming - Yes, as substitutes. So, my spare bedroom, gym, TV room, office from which I'm doing this podcast episode. So many substitutions.
Odeta Kushi - So many substitutions. That makes sense. More people want to work remotely now, then pre-pandemic. I'm looking at the both of you from your screen right now. So, certainly, the three of us fall into the work from home category. And that ability to work from home has increased the demand for residential space, which now has this dual, or more, use. But how much has that demand shifted? Is there a way to measure how much people are substituting residential space for office space?
Xander Snyder - Well, one way would be to measure how vacant, or how underused, office space currently is. Since the outbreak of the pandemic, there is a data vendor called Kastle Systems that has emerged as sort of the go-to-source for physical office occupancy. And they collect data based on card swipes. So, you go into an office building, you swipe your card to get in, and they use that card swipe data. They use that card swipe data to calculate the current physical occupancy of office buildings. And then they compare that number to pre-pandemic benchmark rates.
Mark Fleming - So, more simply, Kastle Systems is measuring how much emptier office buildings are today than they used to be. I guess that really raises the question of, well, how empty are they?
Xander Snyder - Right? Kastle Systems publishes data on 10 different cities. And the average across those cities in the latest reading for the week ending February 1 was 46%. So that means that office buildings are less than half as occupied as they were pre-pandemic, it's still a fairly substantial number.
Odeta Kushi - Wow, tough not to see the glass half-empty with numbers like that, huh?
Mark Fleming - I think my bad jokes are finally rubbing off on you, Odeta.
Odeta Kushi - Much to my dismay, yes. So, over 50% emptier than pre-pandemic. How does that compare to trends through 2022?
Xander Snyder - As it turns out, the prior release of Kastle's data, so for the week ending January 25, of this year, was the first time that average physical occupancy in these 10 cities climbed above 50% And has since fallen down to 46%, but it was above 50% for the first time since the onset of the pandemic. So, some people were looking at that number and we're treating this return to 50% as a milestone of sorts, saying perhaps the tide might finally be turning in favor of employers and the return-to-office push. But even 50% occupancy leaves a big open question mark for what happens with that other 50% of unoccupied office space.
Odeta Kushi - Right. So, office buildings are certainly emptier than they were. But different things can contribute to office physical vacancy, right?
Mark Fleming - For example, I can imagine two situations that could lead to higher physical vacancy rates. A tenant might have a lease that doesn't expire for another two years, but their employers are working remotely. I think that's sort of what we think of it as. That would result in leased office space being underutilized as measured by this data. But a decrease in physical occupancy can also be caused by tenants letting their leases expire, which would result in truly empty offices, and a higher leased vacancy rate as well as physical vacancy rate. Do we have a sense of what portion of physical vacancy rates are in offices due to under-utilization of the space as compared with literally not leasing the space?
Xander Snyder - Yeah, that really is the crux of the question. We try to measure that under-utilization to get a sense of how much vacant office space is, quote, in the shadows, which can hit the market as more leases expire. So, the result of this metric, we call the u-shadow vacancy rate, and here the U is just the letter U and stands for under-utilization. So, the u-shadow vacancy rate tells us how much of the decrease in office physical occupancy as reported by Kastle is due to under-utilization of space, as opposed to those lease expirations. It's calculated as...
Mark Fleming - Hang on, hang on, before we get into any fancy math, maybe we should first mention why we call it shadow vacancy in the first place, and where that term comes from comes from.
Xander Snyder - Yes, definitely without a shadow of a doubt.
Odeta Kushi - Oh, Xander, it didn't take you long to pick up on Mark's humor.
Mark Fleming - Are we all doing a collective eyeroll right now?
Odeta Kushi - Yep.
Mark Fleming - We are, indeed. So, this idea of shadow vacancy is borrowed from the phrase shadow inventory, which was a term used regularly during the Great Financial Crisis, particularly between 2008 and 2009 to describe homes that were not yet listed for sale, but that would be in the near future. For example, bank-owned homes in the process of foreclosure, or homes that were soon to be vacated. That's what was meant by shadow inventory - that which hasn't yet hit the market, so it isn't fully reflected in some of the more traditional metrics used to measure housing supply.
Odeta Kushi - Okay, so using that logic, we could say that for office buildings, shadow vacancy refers to space that isn't vacated yet, but it's likely going to be soon. Is that correct?
Xander Snyder - Yes, that's exactly right. Now, it's worth mentioning that shadow vacancy already has a specific meaning in the world of commercial real estate jargon. So, traditionally, shadow vacancy refers to the difference in what’s called the availability rate and the vacancy rate for a building. And the vacancy rate is just a percentage of unleased square footage in the building. The availability rate is this vacancy rate, so all vacant square footage, plus any other square footage in the building that's listed for sub-lease, or sale, or is about to be vacated by a tenant with an expiring lease. So, essentially, the availability rate is a measure of total rentable space in a building, whereas the vacancy rate only captures unleased space in a building, and shadow vacancy, when traditionally used, means the difference between these two metrics.
Odeta Kushi - Got it, that makes a lot of sense. So, shadow vacancy in the traditional sense means the difference between the total rentable square foot and the total leased square feet. That seems a little different from the concept of under-utilization that we mentioned a couple of minutes ago.
Xander Snyder - That's right. So, since the free shadow vacancy already exists, and is used to describe what's a fairly common situation in the world of commercial real estate, we wanted to measure and differentiate the under-utilization of office space, hence the U in u-shadow vacancy.
Mark Fleming - Alright, so now we've got a handle on the distinction and why the name. You may now proceed with the math.
Xander Snyder - Yes, the fun part.
Mark Fleming - Fun for sum. S-U-M, get it?
Xander Snyder - Sum-what. Anybody?
Odeta Kushi - Oh, I get it.
Xander Snyder - Bueller? So, to calculate u-shadow vacancy rates, we first measure the difference in availability rates between the fourth quarter of 2019 and today. So, we take some pre-pandemic benchmark and measure the change. That measures how much leased, sub-leased, and for-sale space has changed over the last several years. We subtract this change in availability rate from the current physical vacancy rates published by Kastle Systems. The result is the amount of empty space that is directly related to under-utilization, rather than leasing or sales activity. So, we call that the u-shadow vacancy rate.
Mark Fleming - Okay, I think I follow here, but there are a few moving parts. Can you give us an example of how to calculate u-shadow vacancy for a city and what it implies for the office supply in that market?
Xander Snyder - Sure, let's look at Austin, which has the highest physical occupancy rate out of the 10 cities covered by Kastle Systems at about 40%. Since the fourth quarter of 2019, the availability rate in Austin increased by 7%. So that implies a 33% - that's 40% minus 7% - so it implies that 33% of the decline in physical occupancy in Austin is due to under-utilization of space and is, therefore, quote, u-shadow vacant space that will likely come to market in the future, either as a sub-lease, lease or sale.
Odeta Kushi - Okay, so now that we know what u-shadow vacancy is, let's see how it compares across markets. And, if you're a fan of charts like I am, you can check out Zander's Twitter, it's @XanderSnyderX, where he has published the latest chart. You can also visit our website at firstam.com/economics to learn more about u-shadow vacancy rates. Okay, so the U.S. shadow vacancy is currently highest in San Jose at 61%. And the lowest, as Xander just mentioned, is in Austin at around 33%. Cities in Texas tend to have lower u-shadow vacancy rates than coastal cities, which implies that in the least empty markets, nearly a third of existing inventory is still going unused or underused. So, what's going to come of all of that underutilized office space when office leases expire?
Xander Snyder - I think that's the question everyone in the market is really asking themselves right now. Higher quality class-A office buildings, especially new and best-in-market assets, will have a better chance to weather the new workplace reality. Class-A properties are able to offer the sorts of amenities that tenants and tenant's employees want, whereas older buildings, such as class-B and class-C offices might not be able to. So, what's going to happen to the space? Some office-to-apartment conversions are happening. And, in fact, there's a private equity company called Silverstein group. They're a New York-based developer and they just raised a $1.5 billion fund dedicated to doing exactly this office-to-apartment conversions, but these sorts conversions are costly. And often the investment doesn't work out for the developer, unless they can buy the office building at a steeper discount than the current class-B or class-C office owners may be willing to accept.
Mark Fleming - So, I get it that office-to-apartment conversions are happening. But there are meaningful barriers to them happening at a great enough scale to really make a big difference. Seems like that still leaves a fair amount of ambiguity in office's future, especially for those class-B and class-C buildings.
Odeta Kushi - It's certainly an asset class we'll be keeping our eyes on as the year progresses. Alright, well, that's all the time we've got for today. To our listeners, if you want up-to-date information on what's going on in commercial real estate, I highly suggest giving Xander a follow on his Twitter or LinkedIn. He also regularly publishes blog posts on our Economic Center. So, Xander, thank you so much for joining us today on the REconomy podcast.
Mark Fleming - Thanks, Xander. See you back again soon.
Xander Snyder - My pleasure. Thanks for having me.
Odeta Kushi - And thank you all for joining us on this episode of the REconomy podcast. If you have an economics-related question you'd like us to feature on a future episode, you can email us at economics@firstam.com. We love to hear from our listeners. And, as always, if you can't wait for the next episode, you can follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark and @XanderSnyderX. Until next time.
This transcript has been edited for clarity.