As we begin the 2023 year in Commercial Real Estate and look back on the fourth quarter, it has become obvious that we are right in the middle of a recession. Whether leases are being signed or buildings are being sold, transaction volume has dropped, specifically in the Office sector. There are several factors that play into the drop in volume. The obvious factors to consider are economic factors such as inflation and rising interest rates in addition to a slow post-pandemic recovery. A less discussed factor is a significant gap in expectations between Landlords and Tenants and Sellers and Buyers.
2022 showed a negative absorption of 592,000 SF in office. Vacancy rates didn’t drop much in 2022 as expected and seem to have plateaued at 14.9%. However, an incredible amount of sublease space hit the market in 2022 – There is currently 6.3 million square feet of sublease, nearly double the amount seen at the start of the pandemic. Downtown Denver suffers the most. Many of the Tech companies that were large absorbing users of office space have recently listed hundreds of thousands of square feet. Not only has the “remote work” model affected the occupancy and users of office, but the expectation of price from a tenant or buyer’s perspective has been significantly lower than that of a landlord or seller. Of the office tenants and buyers looking for and needing office space, many tenants and buyers in the marketplace have been under the assumption that pricing should be 50-75% of pre-pandemic pricing. Meanwhile, landlords and sellers have only dropped rates and/or pricing by less than 10%, if at all. When it comes to leasing, certainly concessions have grown, such as free rent or tenant improvement allowances, but overall rates have not declined. In fact, rental rates grew .7% on average in 2022 over year 2021. As for sales, sellers are reluctant to drop pricing and instead just either pull it off the market and/or just continue to be patient to get the price they want. Sales of office averaged $265/SF and a 6.1% cap rate with an average of 13% vacancy at the time of sale in 2022.
So, the question is why are the expectations of buyers and tenants so different than that of landlords and sellers? Buyers and tenants assume that owners are “bleeding” due to the pandemic. They believe buildings are 50% occupied. Unfortunately, they haven’t considered that the commercial real estate market, inclusive of office, has been very strong for quite a long period of time. Rent growth, value add investments overperforming and tremendously low interest loans have provided landlords the “patience” to land the right tenant that will pay the rate they expect. As for sellers, similarly, many own with very strong financing in place if not owned debt free. Until the fall of 2022, tenant and buyers that ultimately needed or wanted space would ultimately be the party that “lost” the negotiation, especially in high quality, class A suburban space. In late 2022, we started to see some tenants get more favorable deals and rates. Since interest rates have climbed and inflation experienced, a new development from the buyer and tenant side is emerging – capability. Once a buyer and/or tenant no longer has the capability to purchase or lease at the market rates, only one thing can happen, prices must come down.
The reality is that we are in the middle of the expectation gap diminishing. Landlords will only be able to sit on vacancy for so long and sellers will ultimately understand that market pricing will drop. We have already seen some tremendously low sales prices in Denver, such as the Denver Club building downtown selling for $52.80/SF in November 2022. That price is the lowest an office building has fetched in many years. So, is 2023 the start of distressed sales beginning to occur? Is 2023 the year that loans are called on commercial office buildings? Are we quickly moving into a Buyer/Tenant market? I believe so. Rising interest rates, increased vacancy and low demand are all in full force when it comes to office space, there is no denying it.
Fortunately, as we all know, it will be temporary. Real Estate has always been and will always be on a growth pattern. Each valley is still better than the previous and each peak is also better than the previous. Trust in appreciation of value and trust in the market we live and work in. Colorado continues to be a place where many out of state investors and businesses continue to be bullish about. Attractive rental rates and increased vacancy will afford many out of state and local businesses the ability now that they have been wanting in recent years. 2023 and 2024 appear to be years where perhaps we don’t call it a recession, but more of a correction. Deals will continue to occur, both leasing and selling, they are merely changing. Deals will take more time again. They will take more creativity and more strategy. A much more cautious approach will be taken from all parties. Be prepared and educated in real estate transactions. Real estate is a long-term investment. Allow the experts at NavPoint Real Estate Group with long-term experience to help you in your real estate endeavors.
Written by Matt Kulbe