The U.S. economy has been going through a rough patch, as economies are prone to do now and then. Last year, it met the informal threshold of a recession with two consecutive quarters of negative gross domestic product growth. But despite that, the National Bureau of Economic Research has not officially declared a recession yet. Typically, it takes them about a year to make that call as a recession is based on a broad range of economic factors. Usually, it is long after a recession is widely recognized that the commercial real estate industry feels it. Leases typically don’t expire until after these slowdowns happen. But this time, commercial properties had largely been the early indicator of the storm brewing. Occupiers were already in a holding pattern trying to understand the true scope of the return to work.
As much doom and gloom as I read about struggling properties, I am not too concerned about the industry as a whole. Commercial real estate owners are in it for the long haul. This is an industry with some of the longest time horizons regarding investment thinking. My guess is that they will likely see a mild recession as just a speed bump, not a roadblock. If anything, this will probably push the industry to be more innovative in the way it operates and make it even more resilient for inevitable future recessions.
Economists have predicted that the 2023 recession would be more of a white-collar recession, which means it could hit the office market pretty hard. We’re already seeing companies announcing hiring freezes and layoffs, which inevitably affect office building owners’ bottom lines and could lead to credit losses. Some properties are dropping into special servicing and even foreclosures. The stress points in commercial property are expected to be at either end of the market: older buildings where the occupier has moved out, and developments that have yet to reach completion.
Despite all of this, U.S. office real estate has historically been a pretty stable and resilient asset class. During the recession in the early 2000s, there was a slowdown in office space demand, leading to lower rental rates and more vacancies. But things bounced back quickly as the economy recovered. The Great Recession of 2008-2009 had a much more severe impact on commercial real estate. Many businesses closed or scaled back operations, leading to a significant increase in vacancies. It was a tough time, but the market eventually recovered thanks to a number of factors, like a rebounding economy, lower interest rates, and a general lack of new construction.
A 2023 recession will lead to some softening in fundamentals and net operating income. We may also see a slowdown in investment sales and development activity. Despite that, some well-capitalized office owners may actually thrive in this environment by focusing on distressed assets or value-add investments. For example, they could acquire older office buildings in prime locations that are currently underutilized or underperforming and renovate them to make them more attractive to tenants. Updating common areas and building systems and repositioning the property to appeal to a different type of tenant can make all the difference. For instance, an older office building in a high-tech district could be repositioned as a creative office space.
Some niche markets, such as co-working spaces or flexible office space, are more resilient during a recession. They often have lower occupancy costs and more flexible lease terms than traditional office space, which could make them more attractive to downsizing businesses.
Make no mistake, occupiers are still shedding space. Although roughly 1 million office jobs have been added over the past two years, there is still significant negative net absorption. According to CoStar, sublease space is at record levels, and net absorption has been negative for the past two years, losing around 120 million square feet of leased space. CoStar also claims a whopping 230 million square feet of sublease space is currently available. That’s almost a 90 percent increase compared to the end of 2019. But the good news is that the market is expected to stabilize this year, as tenants approaching lease expirations have already decided how much space they need.
So what do those space decisions look like? The last VTS Office Demand Index analysis found that new demand for office space has decreased quite a bit. In December, it fell 20.7 percent year-over-year. This means that new demand for office space flowed in at 46 percent of its average in 2018-2019, the pre-pandemic benchmark. While Class A office buildings with a wide range of amenities are still doing well with limited vacancies, conventional wisdom would say that employers might look to B and C properties as a cost-saving opportunity in a recession. But according to Cushman & Wakefield, the premium for new construction office space almost doubled from 21.2 to 39.0 percent during the pandemic.
Despite the overall negative absorption since the beginning of 2020, there have been about 100 million square feet of positive absorption in high-quality, well-located office assets that have been built or renovated in the past eight years—however, this highly coveted space accounts for less than a fifth of current inventory.
Investing in an improved employee experience with technology and amenities could make a huge difference in the market’s future. Companies are moving towards smaller but better quality offices that can accommodate a hybrid work model for the long term. This approach could create new issues if tenants prioritize trends that emerged during the pandemic rather than focusing on how people actually work. The challenge will be creating an office space suitable for both group and individual work.
Even if we face an official recession this year, the modern commercial real estate industry tends to think outside the box. Once we have a better idea of what the future holds, we’ll see people start planning for the other side of it. This industry is great at adapting and looking ahead, so investors and developers will likely continue to make decisions based on long-term strategies, even in a recession. Although the office market may experience some short-term difficulties, more people will return to the office over time, and the market will eventually stabilize.
