Despite Office-Demand Challenges, There’s No Sense of Panic

Despite the daily chatter – mostly positive – about return-to-office trends – new demand for office space fell for the third consecutive month in August, according to data from VTS.

That streak could end in September, as more companies are firmly establishing their return-to-office policies, although some employees are rebuffing those directions. Meanwhile, lenders sit back and wait.

Adam S. Finkel, CCIM, principal and co-founder of Tower Capital, tells GlobeSt.com that lenders are hesitant to embrace office just yet until there’s more clarity about back to work plans, how long that will take and what the office of the future will look like.

“The supply demand drivers underlying real estate assets are still strong despite the volatility of increased interest rates, though that’s been an artificial way to dampen demand. Uncertainty remains, though the industry will muddle through the coming market.”

Finkel said that today, there’s no sense of panic in the market despite the challenges.

“Most recognize we’re coming off a high point and are on the other side of the hill,” he said. “They are trying to adjust to a new environment and figure out the uncertainty of rates. Once we’re on the other side of this, I believe it will be a very strong market and activity will increase.

“For now, as rates increase it will be a challenging time. We will see more growth in secondary financing, like preferred equity, mezzanine debt and other creative financing solutions to help sponsors with their capital stack.”

‘Looming’ Recession Hasn’t Yet Had an Impact

Steve Quick, CEO, Unispace, tells GlobeSt.com that he’s seeing more employees return to the office after summer, with about a 5% increase since Labor Day.

“The looming recession has not yet had an impact, but it’s important to remember that real estate is a late-cycle industry,” Quick said.

“I expect the office market to continue to recover in Q4 as we continue to see more employees return to the office on a hybrid basis. We continue to be optimistic about the future of offices because we believe that flexibility is here to stay.

“Long term, companies are rethinking their workplace strategy and creating office ‘experiences’ employees can’t get by working remotely.”

Employers ‘Hoping for a Recession’ to Get Employees Back

John Drachman, co-founder, Waterford Property Company, tells GlobeSt.com that the demand for office space has never come back during the pandemic “and in many markets has fallen off a cliff.

“It is so bad within the office industry that many are now hoping for a recession to give employers more leverage to get employees back into the office,” Drachman said.

“Traditionally there is nothing worse than a recession for the office industry, but that might be its saving grace. This is the potential apocalypse for office values as some have speculated you could see $453 billion in valuation loss across office assets in the US as rising vacancies, lack of demand, mixed with rising interest rates creates an untenable situation.”

He said that for urban environments like Downtown Seattle, LA, San Diego or San Francisco, the demand for office space has been cut dramatically and “I don’t know when it’s coming back.

“Only truly class A+ highly-amenitized projects and quality suburban properties will do well in the coming years. With that said, it will lead to opportunities for smart operators to take advantage of, but again it will be tough sledding in the near term.”

An ‘Incredibly Wide’ Bid-Ask Spread

Eric Enloe, senior managing director, Chicago-based Partner Valuation Advisors, tells GlobeSt.com that tenants are still working out how many employees will be back in offices, and the balance with work from home.

“There is an incredibly wide bid-ask spread for large multi-tenant office assets,” he said. “Sellers may believe a multi-tenant office property is worth X, while a buyer thinks it is worth Y.

“Part of what is driving that gap is interest rates because they affect the perception of value, and another aspect is demand. Today, there is uncertainty about tenant demand.

“It is vital to know if a tenant plans to renew a 50,000-square-foot lease, reduce their footprint to 25,000 square feet or is looking to expand. Until tenants have conviction about how much space they need, there will be a spread between buyer and seller expectations as it relates to value.”

He said that these continued interest hikes impact the cost of capital for borrowers, namely it puts pressure on underwriting, as well as how investors look at rents, and ultimately how they look at values.

Rising Interest Rates’ Impact on Values Uneven

“Rising interest rates impacts yields and the rate of return,” Enloe said. “The impact on values is not evenly distributed across all property types though.

“Multifamily and industrial are still favored amongst investors, but the return requirements for investors are different for those asset types compared to office or retail properties.

“Overall, they are viewed differently from a risk perspective. It can be different within the classes too— a single-tenant office asset trades at a much different value compared to a large, multi-tenant office building.

“A grocery anchored retail center will trade differently than a regional mall. Borrowing costs are increasing because of rising interest rates and that is creating uncertainty on values, especially for office and retail properties.”