Will 2024 Mark a Turning Point for Office?

The drumbeat of bad news from the office sector has been so pervasive over the past years that it has almost become a fact of life. But a new report from JLL suggests that 2024 could mark a turning point — with the possibility in a few years that demand for office space will exceed supply.

Several factors underlie this optimistic view. A growing number of companies have imposed return to office mandates, as have several government agencies. As this happens, there will be fewer opportunities for companies to downsize. At the same time, a number of office buildings are being converted to residential or other uses. And new office construction has fallen sharply as a result of poor investor confidence and high financing costs.

“As supply constraints in high-end product become more acute, not only will rental rates in new and Trophy offices begin to experience upward pressure, but landlords of non-trophy properties may begin to see spillover demand as availability declines,” according to JLL’s Q3 2023 office market report.

“A persistent wave of companies” with hybrid office attendance policies are shifting in favor of office attendance, the report said. In the third quarter, 30 different companies issued return to work directives for over 900,000 office-based workers, and over one million workers had already been affected by similar orders that went into effect in September. Law firms led the way, with many of the largest adopting four-day in-office workweeks. Technology companies varied, with some more open to hybrid or remote work than others. A call-back by some federal agencies has been met, however, with union resistance, especially for hard-to-fill positions. The return-to-office mandates have already led to record post-pandemic attendance rates, JLL reported, citing data from Kastle badge swipes. Based on that data, attendance is expected to keep rising through the rest of the year, with average rates around 55% and peak-day attendance of 65%. That data set, however, is limited to 2% of national office inventory. Data from the Partnership for New York City found a 72% return to pre-pandemic in-office levels. “The prospect of most of the white-collar labor force returning to regular attendance in office buildings is becoming more of a certainty,” JLL noted, adding that companies are also pivoting away from fully remote hiring.

The implications of this trend for office leasing are significant. JLL noted that as companies have expanded hiring but cut their office portfolios, some have found they now lack the space they need. It found active tenant requirements have grown 2.6% quarter-over-quarter in gateway markets and 8% in secondary markets, though the recovery remains “disjointed.”

The report also found that the decline in volume of office leasing is concentrated in a few sectors “that have seen more intense cyclical headwinds in recent quarters, while a large segment of office market demand has reached or is exceeding pre-pandemic averages over the past year.” Those which have pulled back on leasing the most were technology tenants and flexible office providers. Together, they account for almost half the decline in office market leasing compared to 2019. The situation has not been helped by a lack of transactions over 100,000 SF in the past year. However, leasing of space below that amount is 6.3% higher than 2019 levels.

Sublease activity has also been affected by these trends. Sublease vacancy reaching 5.1 million SF contributed to the negative net absorption of 18.6 million SF in Q3. However, “more than 60 percent of U.S. office vacancy is concentrated in just 10 percent of buildings, predominantly large-scale campuses and towers developed in the 1980s and 1990s, and 40 percent of office buildings have no vacancy at all,” the report stated.

Meanwhile, the high-quality segment of the office market has continued to perform strongly and even outperform pre-pandemic trends in many markets since the pandemic, JLL observed, especially in newer product and differentiated offices, generating over 120 million SF of positive net absorption. While there has been over 230 million SF of negative net absorption since Q2 2020, occupancy losses are concentrated in a relatively small subset of underperforming assets. “Best-in-class product has seen rising base rents and effective rents over the course of the pandemic, with more than 80% of JLL’s tracked markets setting record rental rates from 2021-2022,” the report stated.

As new product comes on the market and older offices are removed for redevelopment or conversion, asking rents have risen marginally — driven more by the quality of new buildings than organic rent growth for existing buildings. Tenant improvement allowances have shrunk. Shifts in the development pipeline could intensify the flight to quality. However, the slump in new construction suggests that the industry will face severe supply constraints beginning in 2024.