Real Estate

Some Real Estate Professionals Say US Office Market May Still Have Room to Fall

While Waiting for the ‘Bottom,’ Uncertainty Threatens Broader Consequences

According to some commercial real estate experts, the uncertainty surrounding the national office market is likely to persist into 2024. They are struggling to determine when demand for office space will reach its lowest point. The vacancy rate is currently at a record high, and there is an excess of unwanted office space available for sublease. This has led stakeholders to predict that there will be more challenges this year as the value of properties falls. Landlords may struggle to cope with empty office buildings and smaller lease sizes, especially those facing maturing mortgage loans. Corporate job cuts, persistent inflation, and signs of slower consumer spending at the beginning of this year have raised concerns about the state of demand in the office market and its potential to affect other parts of the economy.

According to Richard Barkham, global chief economist for Dallas-based brokerage CBRE, the changes happening in the office market are similar to what happened with regional malls in the past seven to eight years. In both cases, the digital economy has affected real estate usage. For regional malls, it was about goods going directly to consumers. At the same time, in the U.S. office market, technology has enabled remote work, allowing people to get more of their day back.

Barkham believes it will take nearly eight years for the office market to recover, just as it did for regional malls after institutional investors stopped investing in them around 2016. However, he thinks the office market will fully recover but with a smaller footprint. Barkham said that it will be an arduous and lengthy process, but over the next 10, 15, or even 20 years, some office buildings will be demolished, some will be repurposed, and some will be redeveloped.

Close to Bottom

According to Phil Mobley, CoStar Group’s national director of market analytics, the current outlook in the industry suggests that although the market has not yet reached its lowest point, we are getting closer to it. There is still a lot of uncertainty, and things could change. However, based on what we have seen in the last four years and particularly the last year, it is unlikely that the market will see any immediate and dramatic return to pre-COVID levels.

Mobley explains that office attendance rates have fallen and plateaued at approximately half of what they were before the pandemic. This reflects the viewpoint that the market has not yet reached the bottom. As a result, companies have started to close offices, reduce their real estate use, and redesign their remaining space to cater to a more flexible working environment.

These changes are being made as economic concerns are fueled by softening consumer spending and persistent inflation. This has been complicated by uncertainty over how quickly the Federal Reserve could begin lowering interest rates. Retail sales in the United States dropped by 0.8% in January compared to the previous month, which was a larger-than-expected drop that raises new questions about the durability of the nation’s economy.

Many job cuts have been announced since the start of the year, leading to more uncertainty as employers try to respond to slower growth and the need to cut costs. Tech companies alone have cut over 34,000 positions in 2024; other big corporations, such as United Parcel Service and Nike, have also made cuts.

According to CoStar data, outstanding office loans in the US amounted to over $2.7 billion by the end of last year. However, the delinquency rate increased from 1.4% at the end of 2022 to 7.3%. Within the past two years, office values have decreased by as much as 15%.

US Treasury Secretary Janet Yellen expressed concern about commercial real estate at a Senate Banking Committee hearing, stating, “Valuations are falling. And so it’s obvious that stress and losses will be associated with this. I hope this will not be a systemic risk to the banking system. The exposure of the largest banks is quite low, but these developments may stress smaller banks.”

CoStar News spoke to real estate industry professionals to get their opinions on the office market and what to expect in the year ahead.

Risk Awaits

In general, the value of real estate reflects the economic conditions rather than the other way around. Anthony Graziano, the CEO of Integra Realty Resources, stated that the decline in office building values is not necessarily hurting the economy. However, coupled with rising interest rates, it has “frozen” the real estate trading market. Graziano also stated that in 2023, bankers, mortgage brokers, appraisers, real estate brokers, asset managers, and property managers all experienced recession conditions in their respective industries. Most commercial brokerages had revenue declines of 50% or more last year, which translates to a significant decrease in income.

This situation directly impacts individual consumers, affecting their daily habits and the broader economy. Graziano further explained that many individuals with a 401(k) or pensions have a stake in institutional funds invested in significant office buildings. Therefore, broad declines in the fundamental demand for office spaces and the values upon which those funds are based could negatively affect the performance of retirement and pension accounts. The more considerable impact on individuals and the public is the negative economic impact on neighborhoods and cities.

Office buildings are not just spaces for work; they also drive economic activity in the surrounding area. Office workers in a neighborhood can support local businesses like restaurants, nail salons, and dry cleaners. Ground-floor spaces in office buildings can help activate a street block and attract foot traffic. All of this helps to increase demand for properties and support property values in the area where jobs are located.

However, when office buildings struggle to attract tenants and occupancies fall dramatically, it negatively impacts the local economy. This has already occurred in Silicon Valley in California, where remote work and job losses have affected the local economy. The drop in daily office use is connected to the deterioration of values in the real estate market.

According to Alexander Quinn, the director of research for Northern California at real estate firm JLL, adopting remote and other flexible work policies may impact the competitiveness of innovation cities. This is because some essential cultural drivers that fuel an innovation spirit get lost in remote-friendly work environments. If the core principles of the creative economy are undermined by remote work, we could lose some of the secret sauce that made the Bay Area so productive. It is uncertain if this trend will endure, but it is essential to consider the long-term effects of remote work on the economy.

Opportunities on the Table

According to Greg Friedman, the CEO and managing principal of Peachtree Group, a real estate investment firm in Atlanta, the commercial real estate market contributes around one-tenth to the national gross domestic product, with office space accounting for approximately 15% of that economic activity. As a result, any challenges within the sector will have wider effects on the broader financial market.

According to Friedman, a shock to this sector would be material in size and ripple through the economy, although it would not be a death knell. He believes that while the office sector may never recover in value to pre-COVID levels, it should be rebalanced, similar to the changes that regional malls faced several years ago. The office sector’s redevelopment into other uses presents a significant investment opportunity to help grow the economy.

Despite the uncertainty, the office market will eventually adapt as it moves through the subsequent stages of recovery and expansion. However, Friedman notes that a new set of economic, technological, or consumer changes could hit, and the market may again be forced to transform.

Investors have been hesitant to invest in office deals due to a decline in sales volume, which fell by nearly 60% last year compared to the levels in 2022, according to CoStar data. However, some buyers are optimistic and are looking beyond the sinking valuations and rising interest rates; instead, they are trying to take advantage of the limited competition and score deals they wouldn’t be able to entertain otherwise.

South Florida’s Morning Calm Management and San Diego-based commercial real estate finance company, Reven Office REIT, are seeing some silver linings in the current market downturn. They both plan to invest in trophy properties in top-tier markets across the country by taking advantage of the rising number of office defaults and depressed pricing.

Delinquencies for Fitch-rated office loans sold on the commercial mortgage-backed securities market are projected to increase from 3.3% at year-end 2023 to 8.1% in 2024, and 9.9% in 2025 as maturity defaults rise from expected refinancing challenges.

“A decline in the value of office buildings or a broader weakness in commercial real estate could lead to a liquidity crisis for the banking sector and possibly a solvency issue for some banks, especially smaller regional banks that are more exposed to commercial real estate loans,” said Mukang Cho, CEO of Morning Calm Management.” If the weakness in the banking sector persists, it could result in a slowdown in the economy, which will affect everyone.”

However, this weakening market could create opportunities for investors ready and willing to invest. As lenders look to make up for their losses and offload properties quickly, there will be openings for investors.

Chad Carpenter, founder of Reven Capital, emphasized the importance of understanding the actual state of the office market and which buildings are viable for survival to navigate the market with precision. He added that lenders could see up to 110% losses on some distressed office building loans.

According to Carpenter, Reven Office REIT is trying to raise $1 billion for financing deals when banks have ceased mainly lending.

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