KBRA’s Secular Office Trends: Negative News Unavoidable

Recent negative news regarding the office sector is inescapable, according to a new report from KBRA.

“CRE Secular Trends: A Long-Term Transformation for Office?” explains that the prevalence and persistence of hybrid work arrangements, along with rising interest rates, a surge in technology layoffs, and a murky economic outlook, present significant headwinds for the office sector in the short term.

Employers are seeking higher-quality space with modern amenities and improved safety features, which results in weakening demand and lower valuations for older, lower-quality buildings.

No wonder property valuations for offices also are down 14% over the last 12 months according to Green Street’s CPPI.

Some landlords will opt to convert aging assets to other uses, KBRA said.

“However, repurposing older buildings comes with its own challenges, the cost being just one of them. At least in the short term, downward pressure on rents and demand will persist, especially for lower-quality buildings.”

Another dagger, potentially, is that the CMBS sector is likely to see a meaningful rise in office delinquency rates and transfers to special servicing.

Cyclicals Only Partly Explain the Downturn

CBRE’s 2023 U.S. Lender Intentions Survey showed that attitudes toward office have soured considerably. KBRA said the negative office outlook can only partly be explained by cyclical factors.

Survey respondents, most of whom are employed at insurance companies (48%) and banks (22%), said they will continue to favor industrial/logistics and multifamily properties in 2023, which is no surprise given the strong underlying fundamentals and outlook.

Furthermore, Boston Properties and SL Green “may be hedging their bets” on the sector. The Wall Street Journal stated that both firms are looking to diversify their real estate portfolios by adding apartments or other property types.

WSJ also reported that top office landlords such as Vornado Realty Trust, Hines, and Brookfield Asset Management were postponing major projects or “losing their appetite for new developments” due to challenges in the sector.

Many companies have reduced their office footprints where possible or subleased office space. The national vacancy rate was above 18.5% in 2022, up from less than 17% in 2019.

Hybrid work schedules’ popularity post-pandemic has also dented office demand.

“A meaningful percentage of office workers are saying that five days in the office is undesirable and might be willing to change jobs to maintain flexibility,” KBRA’s report said.

One other remedy is office conversions. “However, conversions are costly and not all buildings are readily alterable to another use; in fact, some buildings may not be suitable for any type of conversion,” KBRA said.