Why It Would Take a Lot for the Most Pessimistic Office Outcomes to Happen
It is easy to fall into deep pessimism. But in practical terms that can be as hard to achieve as wild optimism.
Office is a disaster. Just look at the headlines, listen to the people recite the numbers. As Moody’s Analytics CRE said in a new analysis by Matt Reidy and Kevin Fagan, “A common prediction we hear among the most pessimistic market prognosticators is that office property values could see a peak-to-trough decline of up to 40%.”
But, as they add, it takes “a lot” for an office platform to lose 40% of its value, and that’s also completely different from anyone saying that office overall would lose 40% of its value.
The argument is a progression of percentages: how far have things fallen, how much more would it have to go, and how likely is that?
Currently, according to the National Council of Real Estate Investment Fiduciaries (NCREIF) property index for office, “the appreciation component of the index shows office values fell 12.7% from their peak in Q1 2022 to their current Q1 2023 level.” A full 40% drop would mean an additional 27.3% drop from peak, or a 31.3% decline from current values. Not impossible, but a heftier fall than has already happened even with the continued increase of interest rates likely limited.
Four key metrics — occupancy rates, rents, expenses, and cap rates — would all have to meet significant criteria to bring an office value crashing down. Working with a hypothetical example of a 100,000 square-foot office building, the authors started with the following conditions: 81% occupancy rate; effective rent per square foot of $28.14; a 55% operating margin/NOI; and a cap rate of 6.75%.
To create a 24.5% decline in NOI would require occupancy to fall to 77.2%, effective rent to slide to $26.06; and an operating margin drop to 47.1%, creating an NOI of $947,113. That 77.2% occupancy rate “would be more than 3% lower than any point in the 45 years of Moody’s Analytics occupancy history.” Then, to get the 31.3% decline to cause the 40% loss of value from peak, the cap rate would have to climb another 100 basis points to 7.5%, reaching an overall 32% value loss.
The number of changes needed to reach that 40% loss from peak has, in the opinion of the authors, a 4% likelihood of occurring.
As they write, yes, it could happen and might at many properties. But to have that occur broadly does seem highly unlikely.