In Light of Current Office Market Conditions
For all companies, the effective utilization of real estate is an important factor in determining business success. As both a cost of doing business and an operational asset, real estate ultimately impacts the achievement of business objectives and the performance of business units.
A sluggish recovery of the U.S. office market is expected as we emerge from an unprecedented Pandemic where work-from-home and hybrid work models were accelerated combined with a forthcoming expected economic downturn not seen since the Global Financial Crisis.
Up until now, most companies have been preoccupied with seeing how the labor market responds to return-to-office initiatives and where the economy is headed. The consensus opinion is for the U.S. to fall into a recession in 2023. The question remains on the duration of a recession and how severe it might be. Preservation of capital and short-term lease commitments have been the norm for most office tenants waiting on a better picture of where their business environment and the economy are headed before addressing long-term real estate plans.
Corporate America is starting to get more clarity on its hybrid work models going forward and a better picture of how much space it will maintain in its overall office footprint.
A recent survey conducted by Colliers and CoreNet Global found that more than 71% of corporate real estate professionals expect hybrid work models to result in at least a 20% reduction in office footprints. Another 19% expect to shrink footprints by 40% and 7% indicated hybrid work will not impact their expected office space demand.
These are challenging times for office building owners
There is considerable debate and speculation regarding the future of the U.S. office sector. The U.S. office vacancy rate stands at 15.4%, an increase of 30 basis points in the third quarter and 50 basis points year-over-year. Sublease space on the market is at a record high. However, vacancy is still below the peak of 16.3%, seen at the height of the Global Financial Crisis.
Asking rates are, by and large, still holding firm. However, the gap between asking and effective rents remains significant due to generous concessions on offer. Since the onset of the Pandemic only the very top-tier trophy office properties have been able to sustain any leasing momentum.
Historically the office leasing market typically responds to changes in the economy with a lag of 2-3 quarters. As a result, it could be mid – 2024 at best or early 2025 before the market plays out and we begin to see a significant increase in office leasing activity. The $64,000 question is do hybrid work models sustain, accelerate, or diminish over time. There is a valid premise for all three scenarios. I personally believe work-from-home privileges will slowly diminish over time as it proves to be a drain on productivity, but the five days in the office work week is a thing of the past for most employees.
We are increasingly starting to see announcements of job cuts, particularly in the technology industry which has been the primary driver of office leasing activity over the last 10 years. Ironically it has been the technology sector that has been the most accommodating of work-from-home scenarios for their employees so far creating somewhat of a double whammy, particularly in tech-centric office markets such as San Francisco.
How particular individual major office markets react to these external forces will vary from market to market based on varying dynamics but no matter what metro you are in with very few exceptions it will remain a tenant-friendly office market for at least the next 12-24 months or potentially even longer.
Currently, landlords suffering from anemic leasing activity and declining or flatlining rental revenues are getting much more aggressive with their economic packages to retain existing tenants and lure new tenants to their projects. Tenant concessions of lower rents, significant periods of abated rent, and tenant improvement allowances are becoming increasingly more substantial.
“Tenant improvement allowances of $100 per square foot or more plus 12 to 15 months of rent abatement are available in several major markets when a tenant signs a new 10-year lease on Class A space.”
For many forward-thinking companies, these current market conditions create the opportunity to:
- Reduce office real estate costs and offset rising costs in other facility categories such as industrial operations
- Lock in attractive lease rates for the long-term
- Most importantly, align real estate that is complimentary with changes in business practices aimed at improving the employee experience.
Real Estate plays a major role in three important business drivers:
Finance: Real estate impacts cash flow, operating expenses, profitability, financial ratios and metrics, liquidity, debt, and financial reporting
Operational Flexibility and Control: the ability of a company to move expeditiously to expand, contract or take a new product to market is either enhanced or limited by real estate
Productivity: Real estate impacts productivity in terms of the promotion of employee collaboration, morale, privacy, access to resources, employee comfort, health, safety, recruitment, and reflecting the desired company culture.
The office market is clearly in favor of occupiers. Companies with leases expiring in the next 24-36 months should begin to investigate the possibilities today while this window of opportunity presents itself. There are several important reasons not to delay this evaluation:
- The real estate transaction process takes more time than most people realize. As much as 12-24 months depending on the size of your company can be required to: (1) develop the project criteria to ensure real estate use is aligned with business operations; (2) identify potential matches in the market; (3) perform due diligence on qualified alternatives; (4) establish negotiating positions with landlords; (5) negotiate a lease; (6) review legal documents; (6) execute a lease; (7) complete a space plan; (8) build-out or retrofit a space; (9) coordinate relocation; (10) occupy
- Even if your lease does not expire for 24-36 months, it does not necessarily mean your real estate situation can’t be improved. Many landlords are amenable to listening to blend and extend scenarios. When all factors are considered re-negotiating or relocating before expiration may be economically attractive.
- While nobody is suggesting a quick market recovery; any improvement in the market will make negotiating the most tenant-favorable lease more difficult and the liberal landlord concessions will begin to diminish. The ability to execute a transaction in the next 12-18 months because the groundwork has been completed will provide the ability to react accordingly as we get a clearer picture of economic conditions.
Taking advantage of current real estate market conditions is prudent for the forward-thinking company. Start the real estate process early and utilize a qualified tenant representation team. Position your company for improved performance by making real estate a primary contributor to your business success, rather than just a place to do business and a cost of doing business.