Sizing Up Office Space Risk

The office space sector is struggling, and there appears to be little relief in sight. Office attendance in major urban areas is still roughly half of what it was pre-pandemic. And vacancy rates in office buildings are reaching critical levels, with the national average now at 13.3%, according to CoStar Risk Analytics in Boston—that’s the highest number they’ve seen since 2000 (other firms have the vacancy rate even higher). A recent Bloomberg survey of nearly 1,000 investors paints a somber picture: Two-thirds believe the U.S. office market will only rebound after a severe collapse, with commercial real estate prices not expected to hit bottom until the latter half of 2024, or beyond.   

The hard times are projected to continue through 2026, and lenders will have to sift through myriad details about individual properties to properly assess risk, says Joseph Biasi, head of capital markets research at CoStar. Biasi recently spoke with RMA about the factors driving office property values, pockets of the office sector that are performing better than others, and factors banks can consider when evaluating office-related assets and lending.  

What’s causing the stress in the office real estate market?  

The post-pandemic work-from-home trend is still the main culprit for the office real estate decline, Biasi explained, but high interest rates have exacerbated the issue. Office vacancy rates have risen to record levels, while transactions have stagnated, and values have declined. 

On the interest rate front, inflation has gone down, and rates have gone up, but the Federal Reserve has made it clear that it will not declare victory until it is sure that inflation has dropped to a 2% target.  

The interest rate decision has become more complicated as the economy has continued to perform well. The labor market has been strong and GDP growth has continued. “All of this means that the Fed can feel comfortable keeping interest rates higher for longer,” Biasi said. 

While the overall percentage of remote worker days has dropped since the pandemic, it still sits well above where it was in 2019. A recent Harvard Business Review survey showed that CEOs expect the percentage of fully on-site workers to continue to drop in the next couple of years, going from 76% today to 73% in 2028. The number was 92% as recently as 2018, according to HBR. 

“This [timeframe] is a concern for office, because this is really what’s affecting demand,” Biasi said. 

How does office space compare with other commercial real estate categories? 

According to Biasi, office is the category of commercial real estate experiencing the most dramatic decline. But it’s a complex picture. Before the pandemic, values of different types of commercial real estate grew in concert. Today, projections show industrial real estate continuing to do well, while retail and multifamily property values are flattening out, however lenders are concerned about multifamily due to decreasing occupancy.  

Fewer commercial mortgage-backed securities are being issued, as commercial real estate has been pinpointed as a source of concern for the economy. Office CMBS that enter maturity defaults are more likely to go to foreclosure now than they were even during the Global Financial Crisis. This has been mainly due to declining values and declining demand. Extensions and modifications to avoid foreclosure have been easier to work out in other CRE categories. 

Office demand has fallen significantly below its pre-pandemic trend. There is a gap of 250 million square feet between actual demand for office space and where that demand would base on pre-pandemic numbers. 

Vacancy rates for office space have increased by about 3.8% from 2019 and won’t peak for another two years, according to CoStar projections. Projected drops in value from 2023 to 2026 vary by market. Northeastern and Western markets tend to look worse. Southern markets look better. Some of the worst-performing Southern markets are in areas with tech and highly educated workers, who are more likely to work from home. 

What factors should be considered in evaluating risk for an office property? 

Economic downturns not only increase expected losses, Biasi said, they also widen the distribution of losses across multiple factors. To properly assess where risk lies in the market, lenders need to evaluate vast amounts of detail on age, location, quality, tenant, lease turnover, and type. “They all matter and they’re all factors that are interconnected,” he said. 

There are some pockets where office space is performing better, such as medical office and owner-occupied office. There has been some flight to quality, with five-star office properties performing better as a whole, but even higher performing office assets with amenities are having problems. At each level ofstar rating, vacancy rates are better for properties younger than 20 years than for older. Also, central business district vacancy rates have gone up a lot faster than suburban vacancy rates.  

Among all the leases that were active in January 2020, only 45% have expired, which means 55% of lessees have yet to decide whether to renew, to downsize, or to move. 

“What we’re worried about for lenders and risk is renewals,” Biasi said, adding that renewals are down 50% since 2019. 

“Tenants are moving and shrinking: They’re moving out of their current space that might be pretty expensive and they’re shopping for deals and they’re getting a smaller space,” he said. “Or in the case that they’re working fully remote, they’re getting no space.” 

Bank regulators recently released guidance on CRE loan accommodations and workouts, and two office property risk factors they identified were work-from-home propensity and lease turnover. The type of office tenant is another factor to consider. For example, information and finance sector companies have the greatest percentage of remote and hybrid workers, while hospitality and retail companies have the lowest. 

“It really is an asset-by-asset type of risk management right now where you can’t just assume based on one or two factors how a building is going to perform,” Biasi said. 

What’s the outlook for office? 

The office real estate market will likely experience “significant stress” in the next few years, Biasi said. As occupancies continue to decline, values are expected to decline as well. This will be at the same magnitude as during the Global Financial Crisis, but will take place over a much longer period. “That’s a concern when you think about how many [interest-only] loans have been originated in the last couple of years,” Biasi said—refinance risk is a huge issue and will continue to be going forward. 

Regulators have asked lenders to work with borrowers when they can, but the regulators also recognize the risks and are asking lenders to differentiate risk factors, which can be difficult and time-consuming without granular and well-organized information. 

“If our projection plays out, we see extended value losses through 2026. It’s going to be difficult to do loan workouts,” Biasi said. “We’ve already begun to see an increasing share of loans with maturity defaults entering [lender-owned status] and foreclosure in the office sector.”