U.S. Office Fundamentals Soften as 2022 Closes
Key Takeaways
- U.S. office vacancy increased at a faster rate in the second half of 2022.
- Net absorption turned negative in Q4 2022, offsetting the occupancy gains earlier in 2022.
- Asking rents are mostly holding firm, but generous concessions remain on offer.
- Sublease space continues to rise and is at record levels.
- Supply-side risks are limited as construction activity continues to decline.
- Office occupancy levels are slowly increasing, with most firms adopting a hybrid work model.
- Annual sales volume fell in 2022, as investors recast their office strategies.
- The U.S. economic outlook remains subdued.
The U.S. office vacancy rate stands at 15.7%, an increase of 30 basis points in the fourth quarter. Vacancy is still below the prior peak of 16.3%, seen at the height of the Global Financial Crisis, but will equal this level by mid-2023 if the current pace of vacancy increases is sustained.
Net absorption, which measures the change in occupied office inventory, was positive in 43% of the metro office markets tracked in our national survey, down from 52% in the third quarter. National office absorption totaled negative 14.1 million square feet, more than offsetting the modest gains seen earlier in the year resulting in an annual net absorption total of negative 8.6 million square feet.
Reflecting this shift in fortunes, 12 metro markets posted negative absorption above 500,000 square feet. Occupancy losses in the fourth quarter were led by New York City (negative 4.3 million square feet), Greater Los Angeles (negative 1.8 million square feet) and Minneapolis (1.5 million square feet). Conversely, positive absorption was led by Baltimore, Orlando and Salt Lake City.
There is a record 242.8 million square feet of sublease space available across the U.S. office market, up from 232.8 million square feet in Q3 2022, and significantly higher than the prior cycle’s peak of 143.3 million square feet seen in Q2 2009. As firms continue to evaluate their post-COVID real estate needs, sublease space will remain a cost competitive, short-term option until there is greater clarity on business direction. Construction activity continues to slow. Currently, 100.6 million square feet are underway, which is down 39% from this cycle’s peak of 164 million square feet in Q3 2020.
The New York metro area has by far the largest amount of ongoing construction, at 15.3 million square feet, followed by the San Francisco Bay Area with 10.7 million square feet, which is mostly focused on Silicon Valley, and Seattle with 7.6 million square feet.
Asking rates are, by and large, showing little change. However, the gap between asking and effective rents remains significant due to generous concessions on offer. For example, tenant improvement allowances of $100 per square foot or more, plus 12 months of rent abatement, are available in several major markets when a tenant signs a new 10-year lease on Class A space.
There is considerable debate and speculation regarding the future of the U.S. office sector. The return to the office remains slow. Most tenants are adopting hybrid working with a minimum of three days in the office per week, emerging as the common standard.
Is a market correction ahead? Firms continue to recast their property strategies, focusing on how much space will be needed going forward and where it should be located. Evidence of tenant downsizing is increasing, with space reductions of at least 20% to 30% being implemented by large occupiers. Uncertainty in the economy continues to cloud the picture, further impacting the timing of such decisions. In addition, existing lease commitments will restrict the ability to implement change.
Pending a resurgence in demand, vacancy rates and sublease availability are set to continue to rise over the year ahead, placing increased pressure on rents. In addition, retrenchment in the tech sector, which has been a key driver of leasing volume, could compound this trend.
Where are the opportunities? Performance and demand differentials are expected to widen. This should be most evident between space class, but will also be seen between and within markets, and different business sectors. Quality will win out as firms seek the optimal work experience to retain and attract the best talent and bring employees back to the office. Environment, Social, and Governancem(ESG) initiatives offer owners an additional opportunity to differentiate their assets from the pack.
Key Observations
Vacancy Increases
- The U.S. office vacancy rate stands at 15.7%, up 30 basis points from the third quarter.
- Despite this uptick, vacancy in this cycle remains below the record peak of 16.3%, seen at the height of the GFC.
- Central business district (CBD) vacancy rates rose by 20 basis points in Q4 2022 to 16.2%, while suburban levels increased by 40 basis points to 15.4%.
- South Florida has the lowest metro vacancy rate outside of the tertiary markets at 10.2%, followed by Jacksonville (10.6%) and Kansas City (11.6%).
- Houston has the highest metro vacancy rate at 23.2%, followed by Chicago (21.3%) and Austin (20.2%).
Asking Rates Show Little Change
- Average Class A full-service office asking rates fell by 0.3%in 2022 to $41.16 per square foot in the fourth quarter.
- Class A asking rates in CBD markets average $52.59 per square foot, down by 0.2% over the year. Average Class A suburban asking rates stand at $33.96 per square foot following a 0.2% annual decline.
- The gap between asking and effective rates remains significant. Tenant improvement allowances of $100 per square foot or more, accompanied by up to 12 to 18 months of rent abatement, are available for Class A space in several leading metros.
- Despite these generous concessions, the continued rise in construction and material costs requires some tenants to contribute a portion of improvement expenses. In addition, fit-out periods are becoming longer due to a shortage of skilled labor and supply chain issues.
Absorption Turns Negative
- U.S. office absorption totaled negative 14.1 million square feet in Q4 2022, compared with 0.5 million square feet in Q3 2022.
- Less than half (43%) of markets tracked in our survey saw positive absorption in the fourth quarter, down from 52% in Q3 2022.
- Salt Lake City saw the greatest amount of positive absorption at a metro level in Q4 2022 at 681,297 square feet, followed by Baltimore (512,714 square feet) and Orlando (463,309 square feet).
- On the downside, 12 metro markets posted over 0.5 million square feet of negative absorption in Q4 2022, led by New York City (negative 4.3 million square feet), Los Angeles (negative 1.8 million square feet), and Minneapolis (negative 1.5 million square feet).
- The hardest hit markets over the year were San Francisco (negative 4.3 million square feet), Chicago (negative 2.9 million square feet), plus Los Angeles and Minneapolis (both at negative 2.4 million square feet).
- Metros with the greatest occupancy gains in 2022 were led by South Florida (2.2 million square feet), Orlando (two million square feet) and Salt Lake City (1.7 million square feet).
Construction Activity Continues to Close
- The amount of office space under construction in the U.S. stands at 100.6 million square feet, falling 39% from this cycle’s peak of 162.6 million square feet in Q3 2020. The amount of space completed in Q4 2022 was 5.9 million square feet.
- CBD markets account for 54.1 million square feet underway, with 46.5 million square feet taking place in the suburbs. In addition, the pace of construction in CBD markets is greater, equating to 2.6% of inventory compared with 1.1% in the suburbs. The national level is 1.6%.
- The New York City metro has by far the greatest amount of construction underway at 15.3 million square feet, followed by the San Francisco Bay Area (10.8 million square feet) and Seattle (7.5 million square feet).
Sublease Space at a Record High
- Total sublease space available at a national level increased by 10 million square feet in the fourth quarter to 242.8 million square feet.
- San Francisco still has the highest sublease availability rate among the top 10 markets, by a fair margin, at 8.9%. Seattle is next, at 4.9%, followed by Los Angeles at 4.3%. The average across the 10 markets is 3.8%.
- In an analysis of rental discounts for Class A sublease space over Class A direct space across the top 10 office markets, the average discount is 27.7%. Houston leads all markets with a 49.1% discount, followed by Chicago at 43.7% and Manhattan at 29.2%.
Return to the Office Remains Gradual
- Office return dates continue to be a moving target. Initial plans were stalled by the Delta and Omicron variants in turn. Most firms are adopting hybrid working, but the details are still being determined.
- Current office occupancy stands at 50.4%, as tracked by Kastle Systems across 10 U.S. office metros. This compares with 47.9% at the end of Q3 2022.
- Office utilization is highest in suburban, principally car-borne cities, as opposed to denser CBDs where there is a greater reliance on public transportation.
- Occupancy ranges from 54% to 68% in the leading Texas metros of Austin, Dallas and Houston. By contrast, levels are just above 45% in metro Chicago, New York and San Francisco, with even lower levels in their CBDs.
Investment Activity Slows
- Total office sales volume in Q4 2022 was $19.6 billion, down from $26.9 billion in Q3 2022.
- Total office investment in 2022 was $110.5 billion, down by 25% from 2021.
- Suburban properties continue to attract the most capital, with buyers placing $14.5 billion in such assets in Q4 2022 compared with $5 billion in CBD locations.
- Average pricing in Q4 2022 was $250 per square foot, with levels at $323 per square foot in CBD markets and $233 per square foot in the suburbs. Average cap rates stand at 6.4%, up by 40 basis points from Q3 2022. Further increases are expected in the face of higher interest rates and, in some cases, asset repricing.
- The most active sales markets by volume in 2022 were Manhattan, with $10.4 billion, followed by Dallas ($6.2 billion) and Boston ($5.6 billion).
