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Coronavirus - COVID-19
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Office Markets Are Preparing for the “New Normal”

The prospect of falling occupancies and rent reductions will cause cap rates to rise.

COVID-19 has been a shock to public health and the economy. As the toll of new cases starts to subside in some states, it is becoming clear that “normal life” in the future will be different from our pre-COVID days. Changes to our work routines have been so significant that some will be permanently adopted. What does this mean for the office market in the near term, and in the long term?

Short-term impacts

Federal regulations provided tenants with an opportunity to defer rent payments. This imposed cash flow burdens on many owners. Those with federally-backed loans may be able to obtain deferral of their mortgage payments, but those with outside commercial financing are being squeezed. For tenants who remain solvent, deferred rent will be repaid over time, but a looming concern regarding owners’ cash flow focuses on the potential for tenant bankruptcies and business failures.

Judging from Integra’s national COVID-19 Impact Market Survey, conducted in April and May, 84 percent of property managers reported some increase in office rent delinquencies for April rent, with almost half reporting increases of more than 10 percent.

“Stay at home” guidelines are now easing, allowing more tenants to return to the office. During the last few months, many in the technical and professional workforce worked effectively from a home-office environment. With tools such as Zoom, BlueJeans, and Microsoft Teams, communication was maintained, and cloud-based file systems enhanced productivity. As a result, returning to the office is occurring as a measured and phased process. Many companies are offering employees the option of working from home through the end of the year.

As offices re-populate, companies and building owners are examining issues of social distancing, amenity packages, and interior design. Technology companies that relied on closely spaced open work areas with coffee bars, buffet food service, and other social amenities will face significant changes, while the stodgy, traditional configurations (think major law firms) will benefit from the social distancing that was designed into their current layouts. There will still be challenges related to conference room activities of staff meetings and depositions; these may become hybrid experiences with some participants present in person and others making a virtual appearance.

Landlords will be challenged in how they address the amenity needs of their tenants, especially on-site restaurants and retail shops. The focus in the short term will shift to providing visible expressions of personal hygiene: hand sanitizing stations; plexiglass barriers at security stations; controlling the number of people in elevators; and enforcing masks in common areas.

Long-term impacts

The respondents to Integra’s survey cited office as the third hardest hit property category from the pandemic, behind hospitality and retail. It is also third from the bottom with regard to recovery from the recession.

Reduced demand for space will come from: (1) less growth in the employment categories that generate office demand; (2) companies having fewer employees, especially if staff members can be productive working from home; and (3) demand for some common area spaces (like staff lunch rooms) dropping off. Offsetting some of this reduction is a possible need for companies to increase the square footage per employee for social distancing, but the long-term net effect is expected to be reduced overall demand.

Since most office tenants are subject to multi-year leases, impacts to long-term occupancy trends will appear gradually, as tenants use lease expirations to vacate their premises or negotiate to a downsized footprint. Early signs, however, are already appearing. Some of the companies with the biggest growth over the last few years (Facebook, Opendoor, ZipRecruiter and Nationwide), have announced a combination of layoffs, furloughs, and transitioning to a work-from-home culture that will result in a significant decline in office space needs. These shifts are affecting market fundamentals. For example, the Phoenix market reported an increase in the availability of sublease space as some office tenants have started the downsizing process. At the end of April, the amount of sublease space available jumped by 28 percent compared to availability at the end of 2019, according to CoStar.

Concerns about future financial performance is causing challenges for office properties in purchases and other recapitalizations. In Los Angeles, for example, office sales volume during March and April fell to $421 million—a 65 percent drop compared to the $1.1 billion in transactions for the same period last year, according to CoStar. Most potential buyers are staying on the sidelines, waiting for prices to drop. Sellers are sitting tight, hoping that a re-opened economy will make this a “V-shaped” recession. If that doesn’t happen quickly, there will be pressure from lenders and outside investors to force some sales at new, lower price points.

The office investment sector is facing a more segmented future. Buildings with strong credit tenants in growth industries will remain in high demand. Medical office will be fine, but properties with weaker tenant profiles are likely to suffer declines in value and long-term occupancy. The prospect of falling occupancies and rent reductions will cause cap rates to rise, which will magnify any value declines. Higher cap rates have not materialized yet, but that is something the industry is keeping a close eye on as investors evaluate the position of office properties in their portfolios.

John G. Ellis, MAI, CRE, FRICS, serves as the senior managing director of Integra Realty Resources’ Los Angeles office. He has provided real estate valuation services in Southern California for nearly 40 years.

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