Zombie Office Buildings Set to Invade Many Gateway Cities

Not unexpectedly, one consequence of the work-from-home and hybrid work schedule phenomenon is a growing wave of so-called Zombie office buildings whose utilization rate is 50% or less. And also not surprisingly, their numbers are growing as return to work initiatives seem to bounce off employees determined to stay remote.

A recent report by the Boston Consulting Group found that, on average, vacancy rates have increased from 12% to 17%, and utilization has dropped from 70% to 42%.

An earlier report from Avison Young backed into this trend, finding that no more than two-thirds of the current office stock will be necessary.

And as we have chronicled many times in GlobeSt.com lately, slippage in office demand has led to lower valuations, while rising interest rates has caused “some owners to owe more than their buildings are worth; this, in turn, could lead to a wave of defaults that suddenly turn lenders into the owners and managers of office buildings,” according to BCG.

Perhaps worse, a self-reinforcing vicious cycle is emerging, it says. “Lower office utilization leads to decreased spending at surrounding businesses and, as leases turn over, less rent revenue. This reduces the capital available for investment in building improvements, which further decreases building values and capital for investment. As utilization stays down, surrounding businesses that cater to office workers close or relocate, creating more vacancies and often raising public-safety concerns that cities struggle to combat with fewer financial resources.”

These trends will only worsen, BCG finds. During and coming out of the pandemic, tenants were seeking shorter lease terms of less than five years and 60% of those will expire in the next three years.

BCG said it expects building values to drop by about 40% from pre-pandemic levels over the next 12 to 36 months.

Given that buildings are, on average, 60% leveraged, a 40% decline in value means many will be worth less than the debt owed.

Upon lease expiration, BCG said landlords are left with five considerations: Remain, renovate, repurpose, redevelop, or relinquish. Perhaps the most popular, at least among many cities’ mayors, is the redevelopment option, especially for residential housing which most cities sorely need.

Residential conversion is tricky, though, given buildings’ structure, age, location, and surrounding amenities.

The New York Times recently wrote that such conversion must solve for local rules about what defines a bedroom, and account for structural columns and elevator shafts that shape where walls go and provide sunlight to each unit.

Also, such conversions will likely pencil in as luxury projects and not the affordable housing that is so needed.

Zombie buildings are most likely to be found in Gateway cities with a higher concentration of office buildings than residential and retail. Areas that are remote-work friendly will bear the brunt of economic decline.

As for lenders, they will need to incorporate risk management strategies, build internal capabilities to restructure loans near or in default, and develop marketplaces to sell those loans, BCG said.