Office Appraisers Find Their Job Increasingly Complex

Ask any professional in the commercial real estate industry which asset class is most ripe for correction, and most discussions will quickly arrive at the future of the traditional office. 

Pandemic-induced volatility afflicting the demand side of the office market is raising numerous concerns about whether or not this sector will ever return to pre-pandemic levels. Office stakeholders are eagerly reading the tea leaves, but reviews are mixed and no one has reached anything approaching a consensus. National brokerages remain cautiously optimistic about the speedy recovery of office, while the sector’s fundamentals continue to suggest that a recovery is far on the horizon. What’s more, sweeping concerns about the aggressive spread of the new omicron variant has renewed worldwide concerns about the permanence of remote work. 

Currently there is still more office space being vacated than actively leased, and net absorption is in the red, according to Colliers’ Office Market report. In addition, office landlords are increasingly offering generous concessions such as reduced rents and tenant improvement allowances in hopes of inking more deals and securing long-term leases, according to an Avison Young US Office Market Report. 

From the perspective of commercial real estate appraisers, a realistic viewpoint is a multi-year recovery. In a recent study surveying more than 75 commercial appraisers – all of whom have worked in the industry for more than 10 years and value every type of commercial asset on a national scale – more than one-third of appraisers said it will take between two to three years before occupancy rates push rents back up to pre-pandemic levels. Fifty-six percent of those surveyed said they are unclear whether they would label the market healthy versus unhealthy, while 30 percent were firm in their view that the office market is in fact unhealthy.

In times of uncertainty, appraisers are often in high demand and tasked to investigate the marketplace to determine both the current and the future outlook of a specific asset-class or submarket, as a way to assign value to particular assets.

One of the primary factors appraisers take into account when valuing office assets is building occupancy and vacancy within the market — which is a reflection of overall supply/demand conditions. What is considered normal or stabilized vacancy in one geographic market is not the same in another, as vacancy and credit loss deductions are market-specific –  making it even more challenging to make sweeping claims about the state of a given sector on a national level.

For example, Downtown Los Angeles has historically had greater than10 percent office vacancy for the last 10 to 15 years with it being even higher in recent years, while typical office vacancy in other markets might historically hover around five percent. When completing an appraisal in DTLA, valuers may factor in 10 percent market vacancy, which translates to a 5 percent hit to the projected net operating income relative to substitute assets in competing markets that have lower stabilized vacancy levels.

In the current environment, you might see valuers using a higher vacancy factor to build in some of the risk of the market and the asset not being able to perform to historic norms, or to account for the uncertainty we’re experiencing. Alternatively, if the vacancy assumption is held consistent with historic norms, then valuers  might consider additional ways to discount the property for current conditions, such as higher capitalization rates.

Additionally, certain submarkets of office are performing differently within the same market. For instance, the medical and personal service office sub-sectors are largely unscathed by current conditions for a number of factors, including insurance requirements and the in-person nature of these businesses. Thus, vacancy rates, rental values and other value determinants including capitalization rates point to relatively strong fundamentals for these assets. In certain markets, we have seen a flight from downtown CBDs to suburban markets largely because of secondary impacts of the pandemic, such as civil unrest and deteriorating conditions.

A Coming Correction? 

It remains to be seen whether flexible work-from-home policies trending among office occupying companies will remain post-pandemic and how they will impact long-term leasing activity.

In its Midyear 2021 Economic Outlook report, Nareit said the office sector is facing a long road to recovery due to permanent shifts in how offices are being utilized as a result of remote work policies.

“There is greater uncertainty about the longer-term impacts of work from home on the demand for office space, as none of the prior office market downturns had such a dramatic shift in how and where employees got their work done,” the report states. “… tensions between forces driving return-to-office versus work-from-home will not be resolved in the immediate future.”

Office REITs experienced a 12.5 percent decline in funds from operation in the first quarter of the year, and returns have dropped by 11.7 percent through May. These circumstances point both to the decline of investor confidence and the decreased performance of the office market.

Some valuers posit there could be a very dynamic shakeup on the horizon in the office market as leases expire and business contracts come due in the next three to five years. The potential for downsizing or right-sizing for companies’ new office needs and non-renewals are a realistic outcome. This is especially true in more suburban markets where people have bigger living spaces and are more comfortable working from home. Urban centers and major cities like New York City are very much an outlier and have their own unique set of circumstances.

If a correction is near, we can take comfort in the fact that history suggests the market will inevitably stabilize.  Real estate is a cyclical asset that, historically, has always bounced back from its lulls and appreciated in value over time. The dot.com era as well as the financial crisis during the Great Recession impacted office sector values to varying degrees, yet the sector recovered from both disruptions in due time. The question for now is a matter of when?

The fact remains that volatility in the office sector has led to higher vacancy in many markets and depressed building rental rates – all of which ultimately can lower property values. Appraisers assigning opinions of value to office assets in today’s unprecedented climate have a challenging road ahead.

Lucas Rotter is the co-founder and CEO of Valcre, an appraisal software application for the commercial real estate industry. Prior to founding Valcre in 2016, Rotter spent eight years working with global real estate brokerage and professional services firm Colliers International, as a member of its Valuation & Advisory Services group.