New Office Product Continues To Outperform Even As Sector Shifts

Despite a rise in hybrid work arrangements, the physical office is here to stay – and data captured over the course of the pandemic reveal that occupiers are choosing newer, better Class A product as they decide where to put down stakes. 

“The physical office will continue to have some role to play in the future of work,” Cushman & Wakefield economist Rebecca Rockey says in a new report outlining the future of the sector across the country. “And although there are a myriad of occupiers with vastly different needs, we know that newer, better quality office product, which usually outperforms, did so to a greater degree during the pandemic. And that trend is expected to stick.”

Historically, Class A office product has outperformed, whether during expansions or recessions or within CBD or suburban submarkets. And during prior expansions, Rockey says, Class A office product accounted for a “disproportionate amount” of absorption relative to other product types, clocking in at a growth rate of 1.7 times its share of inventory. After the Dot Com bust, Class A office accounted for 61.6% of all absorption and 35.7% of the inventory and after the Great Financial Crisis (GFC), these shares were 78.4% and 45.0% respectively, she says.

But when demand is negative, Class A office accounts for a lower proportion of net absorption: “in other words, it outperforms during recessions,” Rockey says. During the last three recessions, Class A office averaged 38.5% of negative absorption versus 42.7% of inventory. 

“Since net absorption accounts for move-outs, these figures demonstrate clear demand outperformance,” she writes. “This is made possible by a historic average of 55.5% of all new leasing activity occurring in Class A assets, a 13-percentage point spread above the historic share of overall office inventory that is Class A (42.5%).”

And within Class A, newer assets outperform. Pre-COVID comps Rockey cites in her research show that the premium paid in achieved rents in new Class A assets was 16.4% nationwide, and the premium was wider in suburban markets, at 33.1%, versus in CBDs (4.1%).

Enter the pandemic: while fundamentals have taken a hit, “many of the same demand trends that existed pre-COVID-19 remain true,” Rockey says. Class A product wasn’t hit as hard as other product types, accounting for 40% of negative absorption and half of all office stock in 2020 and 50% of negative absorption in this year.

“Historically this ‘proportionate’ impact has happened in each recession (in 2002 and in 2009) just prior to a pick-up in absorption that is driven by Class A demand specifically,” she says. “Given the unique aspects of COVID-19, while the timing of a pick-up in absorption is less certain than usual, it is clear that Class A will outpace the overall market as it has in early stages of prior expansions.”

More than half of all new leases signed during the pandemic have been concentrated in Class A offices, and the premium for newer assets is 35.2%, more than twice pre-COVID figures.  Rockey also notes that rents in CBDs have tended to move more sharply than suburban rents, and says that “these findings are consistent with anecdotes of a flight to quality and intense competition among occupiers for the very best space. They are also consistent with the reality that older and lower quality office stock will bear the brunt of current market conditions.”

Of course, these findings are coming up against another trend in the office space: the push to remote work and the lessening demand overall for office. However, recent signs suggest this is a temporary blip.

The most recently released VTS Office Demand Index (VODI) shows that new demand for office space rose to a 15-month high in August and is now just 13 percent below pre-COVID-19 levels. 

“When the pandemic first hit and the world came to a halt, there was a clear correlation between rising COVID-19 cases and falling demand for office space—as cases went up, demand went down,” said VTS CEO, Nick Romito, in prepared comments. “Now, even as cases have risen exponentially over the past few months due to the Delta variant, we’re not seeing the same correlation.

“While it may be a bit premature to say that there will not ever be a material impact on new demand and office-using employment as of right now, we’re not seeing it. Companies, even if delayed, are making plans to get their employees back in the office and that bodes well for the office space market.”