Office Demand Slumps In Q2 Against Mounting Macro Headwinds

The most recent VTS Green Shoots report for the office sector was tepid, coming on the heels of two significant rate hikes by the Fed and eye-popping increases in the consumer price index. 

The national VTS Office Demand Index was 63 in June after remaining stable for several quarters, with tenant demand 6% higher year to date, year over year. But “VODI’s point drop from 68 in June put the change of new tenant requirements into the red (-3%) YTD over 2021 YTD through June,” the report notes. “Down significantly from pre-Covid averages, this month’s downtick in VODI demand puts the spotlight on the recent macro decline and calls into question the near-term direction of tenant demand.”

Demand was higher with strong net effective rent growth in Q2 in markets where employees are back in physical offices (like Houston, New York Los Angeles, and Chicago), with demand in those cities down just 24% over pre-COVID numbers and outperforming market where workers are still working from home more often than not (think Washington D.C., San Francisco Seattle, and Boston).

On an industry basis, financial firms appear to be back-to-office, with T3M counts of tenants entering the market down 30% over pre-COVID while tech and creative new tenant counts are down by -44% and -52%, respectively. But the quarter-over-quarter count of tech (-4%) and creative (-5%) tenants is only down slightly less than finance (-10%) over the same period, according to the VTS report: “in summary, the June slowdown hit the TAMI sector harder,” the report states.

VTS also continues to observe a flight to quality with premiums up 12% on average in six of the top 8 markets since the pandemic. New York tops the list.

“The top 10% of spaces continue to outperform the rest of the market, and upgrades by tenants to higher quality assets have been one primary factor in offsetting and preventing a decline in average starting rents since pre-Covid,” the report states. “The higher interest rate and softening economic environment will test the current rent premium differentials and create an uptick in distressed office asset opportunities. A further demand slowdown or continued uncertainty in the market more likely will likely maintain the trend of tenants upgrading to better assets with favorable concessions above pre-Covid norms.”

A bright spot? Los Angeles, which remains a top market performer. VODI remained flat in June at 73 and was down just 8.8% quarter over quarter. Proposal volumes were up 10.6%, TI’s were down 4.5%, and starting rents were up 2.0%.