Downtown Office Sales Should Accelerate in Second Half, But at Slower Pace Than Suburban

COVID-19 has accelerated many pre-pandemic trends among commercial real estate investors – especially in the office market – as, increasingly, suburban locales have outperformed urban office markets, both in terms of invested capital and associated returns.

Since the recovery from the Great Financial Crisis began, there has been a fairly steady increase in suburban markets’ total share of overall office sales. At the onset of the pandemic, investors contributed more capital toward suburban office assets than to properties located in central business districts (CBDs).

This trend accelerated through 2020 and into the first half of 2021, with the suburban share of office sales now exceeding its long-term average for 17 consecutive quarters. Compared with a low point below 50% a decade ago, suburban office transactions now represent a staggering two thirds of all office sales. 

Uncertainty relating to the future of urban workplaces is one factor contributing to this ongoing shift in investor preference. But perhaps a greater driver is the momentum in valuation increases in suburban office properties.  In the year ending July 2021, suburban office assets increased in value by 7.7%, whereas CBD office assets declined by 2.4%.

The divergence in value increase in suburban versus urban properties has never been greater.  Between 2002 and 2019, suburban office value increases trailed CBD office by an average of 236 basis points. 

Over the trailing 12 months from July 2021, this trend has reversed, with suburban office assets outperforming CBD office assets by more than 1,000 basis points. This reversal represents an anomalous event, exceeding three standard deviations relative to the long-term average.

How long will this anomaly continue? Investors are patiently monitoring property fundamentals in CBD office markets. Return-to-work plans, organic demand for lease expansion, effective rental rates, and tenant improvement allowances are all leading indicators of future performance of these assets. 

Office-using employment is rebounding unevenly across the United States. Austin, Tampa, and Phoenix represent the top-performing metropolitan statistical areas (MSAs) in the country for employment rebound, while New York City, Los Angeles and San Francisco lag their peer set. 

Given the uneven pace of employment recovery across different MSAs, it is not surprising to witness deviating returns among suburban and urban submarkets within those MSAs. 

Markets such as Oakland/East Bay, Austin, Seattle, Dallas, and San Jose are benefitting from robust innovation and/or employment expansion and are experiencing higher outperformance in suburban submarkets accordingly.

With unprecedented capital allocations to the real estate sector, “repositioning” oriented investors have record value-add and opportunistic dry powder. Relative value and anticipation of improving tenant fundamentals in CBDs should continue to draw investment capital from these investors. 

For this reason, we expect the industry to continue to see CBD office transaction velocity accelerate in the second half of 2021, albeit at a slower pace than in suburban markets. We expect the long-term balance of investment in suburban and urban locations will normalize by the end of 2023.

Jimmy Hinton is Head of Investor Strategies and Executive Vice President at Newmark, the global commercial real estate services firm. 

Daniel Littman is an Associate Director in Newmark’s Capital Markets Research group.