Newsletter – May 2023
In Q1 of 2023, the Office sector has continued to struggle. Vacancy rates are high, shadow vacancy is speculated to be significant, and looming loan maturities threaten to stress the office product type even further. It is important to understand the challenges facing the office market in the coming year to better understand what kind of creativity will be required to continue building wealth in this difficult economy.
Bloomberg estimates that $92 Billion of Office mortgages will come to maturity in 2023. This means that Office owners will either have to sell their building to offload their underperforming asset, or they will need to refinance. All else held equal, a simple refinance at a time like this will turn the owners upside down in their investments the day they sign the new loans. However, if owners decide not to sell, they may consider repurposing some of their square footage to retail or multifamily to offset the challenging vacancy numbers and higher interest rates.
With investors selling assets out of necessity, the question must be asked, who will buy these buildings? Vacancy is at 14.2%, but shadow vacancy is much higher. Tenants who have 30,000 SF of space might only have 5 employees coming to the office everyday. These underutilized spaces signal disaster for the Landlords when leases expire and tenants who want to resign take a quarter of the space they currently occupy. Think of shadow vacancy as impending vacancy. For short term tenants, these vacancies will be realized soon. However, Landlords may discover their longer term tenants wish to renegotiate their lease terms, using the threat of default as their negotiation leg to stand on.
Another factor in the demise of the office sector is the number of SF under construction compared to demolitions. In 2023, Net deliveries are roughly -985,000 SF. This means that almost 100K SF more Office space has been demolished than has been delivered. And while net absorption was high in Q1 2023, the expectation for the end of the year proves difficult with predictions estimating a negative net absorption of almost 5 million SF.
As Office continues to struggle, developers are seeing fewer and fewer opportunities in the product type and tenants are fleeing the high rates set by landlords. The trend for new office development is in steep decline and with vacant buildings becoming the new norm, Office has a challenging road ahead.
Office defaults are expected to increase in 2023. Vacancy rates are increasing, and they don’t factor in the shadow vacancy. Landlords and investors need to devise a plan to extricate themselves from the office sector in 2023 or get creative with how they utilize their assets to produce the best return. Repurposing buildings to retail and multifamily may become the norm. Regardless, creativity will be required to turn office buildings into high performing assets in this post-pandemic environment. While the forecast looks bleak, Office will never be decimated. Small minds breed small ideas, and in the words of Albert Einstein, “If you always do what you always did, then you will always get what you always got.” Stay creative, and devise ways for your assets to work for you!