When I was a mortgage trader, I recall a wag on the trading desk who would often shake his head forlornly and mutter in abject despair that “we just don’t have good numbers“ to assess the state of the economy. Now let’s fast forward a few years (or decades) to the present day, and the same problem applies when analyzing the office market. The world has changed tremendously and commercial real estate has as well. While there’s a surprisingly easy fix to provide better analytics, the solution to the underlying problem of office vacancy will be far more challenging. Let me explain.
According to a recent Wall Street Journal article, the largest amount of office space since data has been collected is hitting the market in the United States in 2022 due to a jump in lease expirations. More specifically, the leases for 243 million square feet of US office space representing about 11% of the nation’s overall leased office space are set to expire this year.
This is a major concern here in NYC as the office vacancy rate is currently an eye-popping 23% and likely to increase as more leases conclude in 2022. To date, some tenants have been taking short-term leases when their leases expire, thus allowing them to defer long-term real estate decisions. However, the current period of relative calm will not last forever as tenants have become more comfortable in a hybrid work environment and vacancy rates continue to rise.
In the next couple of years, we will reach an inflection point as even more leases come off the books, which will likely drive the office vacancy rate higher. This trend will make the rent rolls and thus the buildings extremely unattractive to prospective investors. Even high-quality buildings may suffer. As debt service coverage ratios (net income divided by debt service) plummet, there will be more foreclosures and loan defaults. And even if there is no foreclosure or landlords are not yet ready to give up the ghost and turn back the keys, lenders will be more reluctant to lend to buildings with high vacancy rates and will demand steep terms.
Here’s another relevant data point. As of April 27, there was an employee attendance rate of just 37% in New York City as measured by the widely followed Kastle Systems back-to-work barometer. So, I think you get my point by now. If that percentage doesn’t move up significantly, foreclosures and bankruptcies may soon follow.
Accordingly, we need new metrics to measure the real state of office buildings. It is no longer sufficient to evaluate the rent roll as so many tenants have low rates of employee attendance. Obviously, the lower the office attendance for a particular tenant, the more likely the tenant is considering either taking less space or getting rid of the lease entirely at the end of the lease term. As a result, lenders and landlords must have access to statistics that provide visibility into the employee attendance rates of individual tenants as well as overall occupancy rates.
Compounding the problem of high rates of office vacancy, many of the spaces are very expensive to convert to alternative use. However, if they are not economically viable as office buildings, landlords will not want to put the substantial expense needed to upgrade the buildings to updated environmental and market standards necessary to attract tenants. Throw higher interest rates and the tug of war between employer and employee on returning to the office into the mix, and you have a witches’ brew of pending problems in the short term (of course John Maynard Keynes famously said that in the long run, we are all dead).
The silver lining in this scenario is the lower rents that tenants will have on offer. In addition, some tenants are recommitting to cities. That is welcome news, but unless business is booming, tenants are often recommitting at lower square footage. This downsizing is better than abandonment, but it is the future. We are already seeing that some companies will be downsizing anywhere from 25% to 50% when leases come due, which is a sure sign that turbulence lies ahead.
As a result, we predict there will be significant turmoil in the office ecosystem in the next few years other than at the upper end of the bifurcated market (which is a term we are starting to tire of using). At a minimum, we will need some better Covid news on the horizon. But that may not be sufficient to forestall a glut of foreclosures and delinquencies as the Darwinian process of natural selection is well underway. As with baseball before analytics, the real estate Moneyball needs new and better tools to keep accurate score of what is most definitely not a game. Unfortunately, even with a sharper focus there are still open questions regarding how to keep all the players including commercial backed securities investors on the field. Where is Brad Pitt (or Billy Beane) when you need him to come up with a new paradigm? Watch this space.