Obsolescence Could Trigger a Massive Downward Repricing in Office Space

Pointing to “alarming obsolescence,” Zisler Capital Associates released a report of a new economic analysis stating that “as much as 70% of the total inventory faces an alarming period of repricing due to fast-paced obsolescence, accelerated by COVID but exacerbated by evolving environmental and health standards.” The report also suggests that for 30% of the existing office stock, retrofitting and upgrades may be economically unfeasible.

The report continues to note that “strict new government standards for energy efficiency and growing tenant demands for healthy, safe, and energy efficient office environments with ample modern amenities” will grow over time, adding pressure to office properties.

Author of the study Dr. Randall Zisler wrote, “Obsolescence already has created a ‘green’ premium of 6% for leases in sustainable buildings that can meet government energy standards and achieve carbon neutrality. In addition, tenants are now willing to pay a ‘health’ premium, significantly pushing rental rates up over other office space, separate and apart from the green premium.”

Coretrust Capital Partners, a “vertically integrated office investor reinventing large assets to serve today’s tenants” that “acquires outdated trophy office properties in prime urban locations and reinvents those assets to meet the needs of modern tenants” as the firm describes itself on its website, commissioned the study.

The report suggests investors have third parties perform obsolescence audits so owners can decide whether to hold, sell, or retrofit.

While the report focuses on the problem of maintaining viable premises, it does not address a potential major result: the impact on financing.

Obsolescence can have a significant effect on valuations and rent rates. The concern about office spaces and obsolescence has existed for years. CRE investors already see ESG as a crucial consideration, with “sustainability no longer a ‘nice to have,’” according to Colliers. 

As the Securities and Exchange Commission looks into ESG disclosure requirements, public companies will have to look at the implications of real estate, whose performance in the area will play a significant factor. The combination will likely drive companies into seeking spaces that can deliver better compliance, causing rent rates to drop in non-compliant property.

If rent rates drop as tenants, already questioning after the pandemic how much daily floorspace they actually need, gravitate elsewhere, there are multiple impacts on financing. Valuations will fall with rents. That could affect loan covenants on such areas as loan-to-value, debt service coverage ratio, and occupancy rates. Banks might also write down property valuations, with an impact on owners’ portfolios.