The Office Recession is Here

John Greenman

(Hay una versión en español de este artículo aquí.)

As many of you know, we have the good fortune of being allied with John Greenman, a deep expert in U.S. commercial real estate. In today’s Timón, John shares his insights into U.S. office property.

There has been a lot of discussion in the press as to whether the U.S. economy has already had a recession, is in one now, or is about to enter into recession. But one thing is certain: the U.S. office market is in a downturn, one that looks more serious than other recent cyclical corrections.

As has been widely reported, the rate of occupancy—the proportion of total available space now under lease—is dropping. More important, however, is that in most U.S. metro areas the rate of utilization— the proportion of office space physically occupied—is down to only about half its pre-Covid level. This means that, in a market with, say, 80% occupancy, the percentage of office space physically occupied is only 40%.

The effect of such a low utilization rate on retail businesses serving daytime workers and on mass transit systems that bring commuters to the central business district has been dire. These days most offices are empty on Mondays and nearly empty on Fridays, as most companies now are either officially or de facto on a three-days-in-two-days-out schedule.

At the same time that most office buildings are struggling mightily to retain tenants, a new class of what we can call “super office” has emerged. Newly constructed and supremely well-located, it offers the latest in technology and amenities. Such assets are leasing up at record rental rates, as top-tier companies in today’s still highly competitive job market have decided to use such offices as lures for retaining employees and drawing new ones in.

Meanwhile, older office assets seem destined to go the way of older shopping malls: turn into “zombies” that can be redeveloped for another use only with great difficulty and at great expense. (The contention that converting office buildings can create much-needed residential supply is, alas, mostly wishful thinking. The floor plates of most office buildings built in the past forty years are just too big to allow a successful conversion to apartments that people actually will want to live in).

Why is the U.S. office sector so uniquely bad compared with almost all other office markets around the world, where occupancy and utilization rates have returned to their pre-Covid levels?

To begin with, the particularly rapid rise in U.S. interest rates since March 2022 has hurt asset values across all commercial real estate. For office buildings, this rapid rate escalation has fatally intersected with the supply-and-demand gap described above, wherein demand has collapsed. The collapse is a long-term phenomenon, not merely cyclical.

I see two main reasons for the collapse. First and above all, during Covid, the U.S. worker found out how much better life could be without a commute. The United States is much more reliant on single passenger auto transport to get to the office than folks anywhere else in the world. For U.S. workers, the fact that by collaborating on Zoom one can save up to an hour each way each day was a true revelation.

Second, the civil unrest that followed the George Floyd protests in the summer of 2020 hurt the downtowns of U.S. cities, where crime and homelessness rose to seed a widespread perception that central business districts are now unsafe. Although municipal authorities insist that this perception is mostly untrue, at a certain point perception becomes reality, as people learn that they can lead a completely suburban lifestyle without ever venturing downtown and forward-looking suburbs add amenities previously found in the city center alone.

So, what happens next? Pessimists worry that the scope of lender losses on office assets may be so large as to trigger a broad banking crisis, or at least curtail lending to all commercial real estate sectors (which, outside of office, have healthy fundamentals), and that this will push the economy into recession. Or, perhaps, the other way around: that a general recession may finally arrive to further weaken already anemic demand for offices and deepen losses for property owners and lenders.

Optimists point out that, if companies still expect nearly all their workers to come in to the office at least on Tuesdays through Thursdays, they still will need about the same amount of office space as before. They note, further, that, just as before Covid, growing businesses need ever more space.

Even so, most tenants will be asking their landlords to reconfigure their existing space or even shrink it a little by reducing the number of private offices and adding conference rooms of varying dimensions with the latest videoconference technology to connect to those working remotely. Such reconfigurations will be costly. Tenants will demand not only the nicest space but also amenities such as outdoor space, health and wellness facilities, and on-site food service (including the extremely popular feature that is free coffee). Only the best-capitalized landlords will be able to respond.

As noted earlier, the winners will be the “new and shiny” super office assets that will poach tenants from older buildings. And suburban properties will likely do better than downtown buildings, particularly newer properties able to incorporate some of the super-office features found in new central business district towers.

There’s an adage in the office market: “No one really wants to work at home” (the barking dog problem) “and no one wants to work an hour from home. What everyone really wants is to work five minutes from home.”

In the post-Covid U.S. office market, the adage may be coming true.