Uncertainty Continues to Haunt the Office Market

The office market continues to be challenged by return-to-office uncertainties, with vacancies expected to crest over the next few years. 

Office vacancies dropped faster in the second half of last year than many experts predicted, falling by 30 basis points in the third quarter and by another 10 basis points in Q4. The national vacancy rate ended the year at 18.1% and is now 40 basis points lower than what Moody’s Analytics analysts say “may well be” the pandemic peak of 18.5% recorded in Q2 2021.

“Asking and effective rents were basically unchanged at the national level,” Moody’s Kevin Fagan and Xiaodi Li write in a new analysis, and ended the fourth quarter at $34.46 PSF and $27.74 PSF, respectively. Meanwhile, “year-over-year asking and effective rent growth rates of -0.2% and -0.8% paint the picture of a tumultuous period, with both types of rent posting positive (if marginal) increases in the middle of the year,” the pair note. 

Distress was more noticeable at the individual market level, with spikes of 210+ basis points observed in urban centers. But “by most counts, pandemic-induced distress did not reach anywhere near what the market originally expected during March through June of 2020, the time of peak uncertainty,” Fagan and Li note, adding that in mid-2020, the IMF projected US GDP would fall by 8% over the course of the year. The actual number was closer to 3.5%.

But “perhaps the wolf that the boy cried about is still coming,” Fagan and Li predict, as more employers engage in very short term leases. Since the onset of the pandemic, they say, the average lease term has fallen from five to three years. While this has been driven by small-space tenants, “it is still indicative of how firms are thinking through (or rethinking) commitments for the next few years,” they say.

“There has been distress in the office sector, with vacancies rising through the middle of 2021, and five straight quarters of negative effective rent growth,” Fagan and Li say. “Performance metrics are probably best characterized as ‘having stabilized’ in the latter half of 2021, though pessimists are still waiting for the so-called other shoe to drop, when they would argue that employers will decide to shed substantial office space because of continually low physical utilization percentages.”

The pair predict “more conflicting signals” over the next few years as the sector recovers. 

“Employment growth has been slowing down; the effect of the Omicron variant has yet to be determined: will it peak in a few weeks and barely cause a disturbance in economic activity? Or will it weigh down first and second quarter figures for overall GDP growth?” they said. “With uncertainty around boosts from fiscal policy, like whether or not (and in what form) the Build Back Better program will be approved, 2022 US GDP growth forecasts are likely to be lowered as well.”