Good news and bad news. The revival of the office market is finally in sight, but things are probably going to get a bit worse before they get better. 2024 is shaping up to be a turning point, driven by a complex interplay of various factors. Here are the main forces at play:
- The Return-to-Work Dilemma: Companies are grappling with how to bring employees back to the office
- Wasted Space Solutions: Growing call for office space conversions and more efficient utilization
- Quality Over Quantity: Tenants are prioritizing high-quality office environments over vast square footage
- Interest Rates and Motivation: Evolving financial landscapes are discouraging investors
This mix of forces hints at a (not so distant) future in which office stock is tightening, which would be somewhat miraculous considering average occupancy rates still linger around 50%. So, let’s dive into why this may be a possible fate and what it means for your position as a tenant.
And in the meantime, it's crucial to stay informed about the latest trends and developments that could impact your role as a corporate tenant. To ensure you stay ahead of the curve, subscribe to our blog to stay informed, stay prepared, and stay in control!
Office Stock May Tighten
The AIA/Deltek Architecture Billings Index serves as a forward-looking indicator for the demand for nonresidential construction activity, encompassing both commercial and industrial buildings. It aims to forecast construction trends in the next nine to twelve months.
The index plummeted to 44.8 in September, marking the lowest score since December 2020, a period at the height of the COVID-19 pandemic. A score below 50 indicates deteriorating business conditions, reflecting an increasing number of architecture firms experiencing reduced billings.
And this significant decline in business for architecture firms in September raises concerns about the potential slowdown in construction and a tightening of supply in the commercial real estate market over the next year.
Is Return-to-Work Upon Us?
The office market has been kicked while it’s down. On top of a troubling and indefinite period of low demand for office space due to remote work, high interest rates have grinded any other developments to a halt. There is no motivation for investors to enter a market marked by so many red flags.
Now, chronic oversupply has initiated a slew of suggested solutions for the concentrated office stock. And as we adapt to the new normal, many are pointing out the adaptive reuse potential of empty office skeletons. Because of this, we are seeing more office to residential projects in the pipeline than ever before.
And even though it’s a complicated and slow-moving process, no one really seems to have any better ideas than to wait and see what happens.
The other dynamic at play is whether or not large-scale return-to-office edicts will be implemented. Many have returned regular commutes to the office, and although not immediate, this will continue to provide steady demand for office space.
“A persistent wave of companies” with hybrid office attendance policies are shifting in favor of office attendance, the report said. In the third quarter, 30 different companies issued return-to-work directives for over 900,000 office-based workers.”
Companies limiting remote collaboration and either bumping up the expectation for office visits or removing the possibility of remote work entirely include:
- Goldman Sachs
On top of this are calls from government bodies for returning to physical collaboration on a more regular basis. Even President Biden asked cabinet workers to return-to-office, hopefully to set a precedent for the country at large.
A new wave of in-person attendees will limit businesses’ ability to downsize their footprints further.
Meanwhile, like discussed, new office construction has experienced a sharp decline. The root causes are multifaceted, driven by the combination of poor investor confidence and the weight of high financing costs. Investors are showing reluctance to commit to new projects, thereby hampering the growth of office space supply.
The slowdown in architecture activity further underscores the impending turning point. It signifies what many have already recognized: the commercial real estate landscape is on the cusp of transformation.
While we anticipate a potential tightening of office stock in the future, as evidenced by these prevailing trends, it may not materialize for at least another year. The dynamics of the office market are indeed evolving, and businesses are navigating these shifting tides with a careful eye on the road ahead. Because as demand evolves, so will the leverage you have at the negotiation table.
Interest in Higher-Quality Buildings May Spill into Lower-Class Properties
Even as demand in the overall office category has hit record lows, there are properties garnering new interest. As companies downsized, the trend became fine-tuned footprints in premium environments. CRE spending was overwhelmingly devoted to nicer buildings that encourage a return-to-office, and thus the Flight to Quality emerged.
Interest in Class A and AA buildings has kept the office market alive (albeit barely breathing). In fact, any rent growth experienced in the last few years is due to an increase in more expensive leases, disguising the effects from low leasing volume.
“Best-in-class product has seen rising base rents and effective rents over the course of the pandemic.”
And as older, less interesting properties are devalued, owners are encouraged to hand them over for redevelopment.
So even though there are certain subcategories over-performing right now, continued demand for premium properties and construction that can’t keep up will limit their supply in the near future. As a result, the lower-class properties that survive the initial defaults and/or conversions will eventually see some payoff.
“As supply constraints in high-end product become more acute, not only will rental rates in new and Trophy offices begin to experience upward pressure, but landlords of non-trophy properties may begin to see spillover demand as availability declines.”
Good News: Time is Now for Better Deals
As demand tightens, balance will return among corporate tenants and landlords. Up until now (and for the near future), power has been inordinately placed in the hands of the tenants. This power will likely grow stronger until conversions, high interest rates, and return-to-office catch up, causing office stock to dwindle. And when the supply eventually swings back in favor of the corporate landlord, tenants will gradually lose the immense leverage that they have had.
Acting now can secure a once-in-a-lifetime deal for your corporate real estate. Even tenants in existing leases have opportunities to create more advantageous agreements.
Approaching early renewals or renegotiations with your landlord while the market is still tenant-favored could unlock impressive savings and relief on your EBITDA. You have the ability to negotiate for the best terms, price, and concessions for your company. But the time for prospective tenants to act is now, while there is still a glut of unused office space.
The revival of the office market isn’t only good for landlords seeking new business. A healthier CRE industry will inspire confidence in developers, tenants, investors, and landlords alike. And in this ever-changing office market environment, you should always be working with a True Tenant Rep™. Their expertise can prove critical to juggling trends and trusted measures that will secure your most advantageous lease.
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