To say there’s uncertainty in the office market is an enormous understatement. Companies and landlords are beginning to get more clarity as hybrid work models firm up and workers slowly trickle back to offices. But vacancy rates remain stubbornly high, and there’s been a vast difference in occupancy for newer and older buildings. The speculation about the future of work and the office market is endless. And one increasing question is whether or not a large swathe of office buildings faces obsolescence.
When something becomes “obsolete,” it has lost its function or desirability due to changing technologies, requirements, or market preferences. Eight-track tapes were the primary music delivery device from the mid-1960s to the mid-70s. Then, technological advances replaced the eight-track, giving way to cassette tapes, the compact disc, and eventually digital files like MP3s and streaming services like Spotify. Each tech shift made the previous era’s listening devices obsolete, tossing them into the dust bin of history.
The same thing can happen to buildings. Economical, functional, and physical factors can render buildings obsolete. The obsolescence can be curable or incurable, depending on the severity. Some factors like a traffic pattern shift or neighborhood zoning could be terminal because it’s outside the control of investors and building owners. They can lobby city officials for changes, but the decision is up to someone else. Other factors, like the physical aspects of a building, can sometimes be fixed as long as they can be resolved quickly and at a reasonable cost.
For the office market right now, the pandemic has accelerated the flight to quality and created conditions for possible obsolescence that may or may not be curable for some buildings. It may be hard to motivate employees to return to a 1970s-era office that’s not compelling and doesn’t have all the dazzling amenities that many corporate occupiers are investing in right now. Plus, there’s the sustainability aspect. More regulations from state and local jurisdictions on lowering carbon emissions, such as New York City’s Local Law 97, push expensive energy efficiency upgrades on office buildings, making inefficient older buildings much less attractive to corporate tenants.
Out with the old
The process of auditing building portfolios for obsolescence has already begun, according to Lonnie Hendry, Head of CRE & Advisory at Trepp, a provider of commercial real estate data and analytics. “Property owners are identifying buildings with red flags,” Hendry said. “We won’t see historical price drops in Class B and C offices tomorrow, but it’ll happen soon.” Hendry said an excellent example of the obsolescence trend is what happened at 1740 Broadway in NYC’s Midtown West. Blackstone lost two large tenants at the 600,000 square foot office and then handed the keys back to the special servicer on its $308 million commercial mortgage-backed security.
Blackstone has extensive Manhattan office holdings, and giving up on the 1740 Broadway property was a “one-off occurrence,” a source told CommercialObserver. The real estate firm said the building had a “unique set of challenges.” While Blackstone said it was a one-off occurrence, Hendry told me the loss was “indicative of what we’ll be seeing” in the office market. “When tenants move out, owners may start bailing on older properties,” Hendry said.
The challenging thing for investors and building owners is that with interest rates rising, they may not be able to refinance loans at favorable rates, putting more pressure on underperforming assets. Though, owners of Class B and C offices do have options besides foreclosure. Most of them can reinvest their capital in upgrades to make buildings into solid B-plus or A-minus offices and still develop a stronghold depending on pricing. But another challenge is how building owners will pass all these improvement costs to tenants. There’s still a lot of downward pressure on office rents, and tenants have leverage in today’s market, leading to situations where owners may be forced to sell due to insufficient cash flow.
Institutional owners will be better able to absorb a drop in prices and rents, but it may be more challenging for individual owners to hold on. Something similar happened with hotels throughout the pandemic, as big operators withstood the impact of high vacancy rates, but smaller owners were forced to sell at a loss. “Institutional office owners can probably survive and pivot,” Hendry said, “but smaller owners will see significant cap rate increases and could fare much worse.”
Re-pricing on the horizon?
A new report from Zisler Capital Associates, a commercial real estate consultancy, delved into office market obsolescence. They estimate that as much as 70 percent of existing office stock will suffer from accelerating obsolescence. The report says the re-pricing of space and assets will require office owners and investors to decide which to hold, renovate, or sell. The effects of COVID and sustainability standards have created an increasingly bifurcated office market. Energy-efficient and healthy offices are in high demand, while older buildings are becoming obsolete with aging systems, poor energy performance, and a failure to recognize changing tenant demands and government standards. “Regardless of the number of people returning to the office, many will demand updated, sustainable, healthy space, as demonstrated by large tech firms signing mega leases during the pandemic,” the report said.
The report estimates that of older and smaller office buildings, prices could decline on average by at least 20 percent over the next 3 to 5 years based, in part, on historical cap rates and building quality ratings. “If local governments don’t require changes for energy efficiency, firms and workers will discriminate in building selection, and that’ll manifest in pricing,” said Randall Zisler, Chairman of Zisler Capital Associates and a former Executive Director of Real Estate Research at Goldman Sachs. “There will be a big sorting in the market. There could be a lot of office buildings sold at a loss.” Zisler said his firm used CoStar data and looked at more than 220,000 square feet of office buildings for the study’s methodology.
The popularity of hybrid work is one of many factors contributing to office obsolescence. If hybrid is indeed the future of work, companies will likely need on a per-employee basis 9 percent less space, according to Stefan Weiss, Senior Economist at CBRE. This could easily lead to higher vacancy rates for lower-quality buildings. “Owners may have to severely drop rents or invest money back into the building,” Weiss said. “Or they could make a case for conversion.” Landlords and owners are also repositioning office buildings with an eye toward 2050 and reaching reduced carbon emissions targets. Higher-end offices will come with a so-called ‘green premium,’ while lower-end, energy-hog buildings could have a ‘brown discount.’
As for office conversions, Weiss thinks some landlords could make the case to adapt Class B and C properties. “If floor plates are conducive, office to multifamily conversions make sense,” Weiss said. Converting to lab space could work, too, given that life sciences is a hot market right now, even though it’s still a minimal share of U.S. office inventory.
Change isn’t easy
Not everyone agrees that office conversions will catch on. “We’re not scoffing at the idea of office to multifamily conversion, but we think it doesn’t pencil out most of the time,” said Kevin Fagan, Head of CRE Economic Analysis at Moody’s Analytics. Moody’s studied office to multifamily conversions in the New York City metro area and discovered that only about 3 percent (or 35 of the nearly 1,100 NYC office buildings they track) would meet what they consider characteristics of a potentially viable apartment conversion. Even in a down year for offices when multifamily has thrived, the report says not many office properties have transacted deep enough discounts to warrant profitable conversions.
There’s also the matter of the size and shape of typical office buildings, which limits potential conversions. Offices usually have deep floor plates and little natural light for interior offices and storage rooms. And natural light is essential for apartments. Much of an office building may be rendered unusable or very low value because of floor plates up to 120 feet wide. “The office-to-apartment conversion trend will likely be minor unless office values and rents see some major, permanent decline after the pandemic,” Moody’s report concludes. Outside of New York, a less economically diversified market may pose more conversion opportunities.
Besides conversions, Fagan also doesn’t think the office market is in dire straits as some make it out to be. Commercial mortgage-backed securities (CMBS) loan defaults are about 2 to 3 percent for offices. That’s a far cry from the last down cycle during the Financial Crisis of 2008, when loan defaults were about 10 percent. There has been a national dip in many leading office market indicators, but there are indications of recovery. “People forecasting major declines for the office are speculating,” Fagan said.
Fagan said that the reality of reducing office footprints is complicated and plays out over a long period. Typically, only about 4 percent of most corporate occupiers’ revenue is spent on real estate, while the highest cost is 20 to 30 percent on people and the labor force. Companies are trying to figure out what’s best for their workforce right now. Some firms will shrink office footprints, but others will expand, as evidenced by Big Tech companies gobbling up office space recently. “It’s not an apocalypse for the office,” Fagan continued. “Real estate costs aren’t killing the average company.”
There’s a potential that lower office occupancy rates could remain, but Fagan thinks we could be back to the pre-pandemic normal about 3 to 5 years from now. There are anecdotes of good and bad in the office market, andd the data doesn’t support all doom and gloom. For instance, there has been much speculation about shorter lease terms, but Fagan said shorter leases signed during the pandemic mainly were isolated to smaller companies. Small firms were inclined sometimes to sign “bridge leases” of less than a year while they figured out the implications of the pandemic. But larger and mid-sized companies were still signing leases during the pandemic for 9 to 12 years.
Uncertain times for offices
The road ahead for the office market is still hazy for now. The office is maybe in last place among the 5 major commercial real estate asset classes, according to Huber Bongolan, Director of Capital Markets & Underwriting at StackSource. Hospitality and office took the biggest hits from the pandemic, but lenders are starting to see the light at the end of the tunnel for hotels. Bongolan explained that the same narrative isn’t there for the office yet, even though people are beginning to return to their desks. “Many investors really don’t like Class B and C suburban offices; they’re very tough to get financing for,” he said. “There’s less incentive to maintain a building unless it’s Class A.”
The claims that a vast swathe of buildings will face alarming re-pricing or worse may just be speculation. The study by Zisler Capital Associates estimates that about 30 percent of office buildings can be categorized as “endangered,” being all but obsolete and incurable. This is an alarmingly big number, so big that it is somewhat hard to believe. “That seems like an awfully broad number,” Bongolan said, adding “an old real estate professor of mine always used to say drill the number down as much as possible to get specific.”
The flight to quality is very real, leading to a bifurcated market with Class B and C properties having difficulty catching up. Tenant demands and improvements will likely increase, given regulations for carbon reduction and the push to get employees back in buildings. Tenants may leave older offices for newer properties, leaving owners with large vacancies and insufficient cash flow. Obsolescence audits can help property owners know if the worst comes to pass but no matter how much market analysis is done the uncertainty around the future of office buildings will remain, and so will the speculation about what will happen next.