The Class A Office Pipeline Offers Lifeline to Asset Class

The US office clearly has its headwinds, starting with delayed returns and accelerated virtual working trends. And as the return-to-work landscape evolves⁠—with the average US employee spending less time working in the office⁠—companies are likely to dial back on traditional private space and increase the amount of their collaborative, support, and amenity space. 

However, it’s not all bad news in the office space segment. While Morningstar expects the oncoming new supply and continuing weakened demand to increase the vacancy rate over the next year, the construction pipeline is heavily laden with Class A projects that will support an ongoing flight to quality. 

The trend of developing higher-quality space with careful attention to providing the building amenities that tenants demand is likely to buoy the performance of these newer Class A properties, which could further widen the performance gap between them Class B and C properties, which tend to be older, lower-quality assets.

Amount of Subleasable Space Continues to Shrink

Several factors suggest that, on a national level, the US  office market is likely to see a rebound from the coronavirus pandemic-induced recession even as net absorption has underperformed. 

CBRE Econometric Advisors reports that the overall US office market recorded 6.6 million square feet of negative net absorption in Q2 2021, bringing the total for the trailing four quarters to 95.1 million sf of negative net absorption, a level not seen since the record 97.0 million sf of negative absorption in 2001.

Further, net completions are running slightly ahead of pre-pandemic levels with 15.4 million sf delivered in Q2 2021 and another 111.1 million sf underway and expected to be delivered in the next two years. Because of this, the overall office vacancy rate increased to 16.5% in Q2 2021, up 3.5 percentage points year over year (YOY). 

Cause for Optimism

Going into the coronavirus-related downturn, asking rents were only slightly above the long-term average trend and not unsustainably high as they were in previous cycles, according to CBRE. Because of this, there’s less cyclical pressure on rents to return to trend beyond the supply/demand imbalance, with pre-pandemic rent levels expected to be reached by Q2 2022.

Accelerated virtual working trends may affect office demand less than commonly thought. Although employees may spend less time in the office, the need to accommodate peak office attendance limits the amount of potential reductions in space. While these decisions will play out over time as existing leases expire and office attendance levels are assessed, high-tech sectors and markets with costly commutes likely will have more employees working virtually. Acquisition and lending volumes have increased. 

The Mortgage Bankers Association reports that YOY transaction volumes for office properties rebounded in the second quarter, soaring 149%, and outpaced the total market increase of 106%. Office loan originations fell YOY in each of the prior four quarters, according to the Mortgage Bankers Association. 

The volume of commercial mortgage-backed security office-backed loans with balances greater than $100 million grew by 53% over 2019 levels, even as the volume of loans with balances less than $50 million fell 68%. These large loans boast an average loan-to-value (LTV) ratio of 57% and tend to be secured by premium assets with strong sponsorship and superior locations. In contrast, for more standard loans, originators have pulled back, as volume is down, and underwriting has become more stringent. Average LTV worsened for each of the past three years, to 59% percent in 2019 from 61% percent in 2016. 

The Top and Bottom Markets 

Unlike many previous real estate market cycles, today’s downturn in the commercial real estate market is driven more by lack of demand than too much supply. 

Cities best positioned to succeed in such a challenging market are the ones where demand for office space is growing faster than the supply. 

More secondary markets made the top 15, buoyed by a combination of strong in-migration, a relatively lower cost of doing business, and limited new construction, while the bottom 15 has more large urban markets, which are poised to see more remote work because of higher commuting costs and a greater percentage of remote work-friendly occupations.

Petra Durnin, Head of Market Analytics, Raise, tells GlobeSt, “There was an uptick in activity at the end of the summer from pent-up demand after the Delta pause during the summer. The slight downturn in September is the counterbalance to that.”

Currently, tenants in the market total 3 million square feet of demand in the pipeline into 2022 “and typically the last quarter of the year is the most active so leasing activity should pick back up,” Durnin said.

“Tenants are evaluating employee needs and working to create experiential offices to attract and retain top talent. They are becoming more intentional about their space, which is a longer process than it was previously.”