It’s a transformational time for the office market. Increased remote work options following the pandemic added downward pressure on employee utilization rates in offices. Data from Green Street shows that office values fell precipitously by 28% (as of May 2023) from their peak in March 2020 and are trending below 2014 levels.14 This, as reported by CoStar data, has translated into an outlook for stagnated rent growth and absorption within the next two years. The bleak outlook for office suggests that values will continue to decline for the foreseeable future, driven in part by the next wave of office loan maturities, especially for lower class office products.
Source: Office, United States, CoStar Data, as of May 2023.
Although loan maturities within the next few years are a looming risk for some of the major asset classes, the risk is typically higher for the office sector because of low probability that refinancing requirements will be adequately met. Roughly $130 billion of office loans are scheduled to mature in 2023 and 2024, according to MSCI Real Capital Analytics. Considering that the capital markets are almost completely frozen for office loans, the market dynamic seems to foreshadow more loan defaults. This could lead to more distress and further downward movement in prices.
“Five to 10 office towers each month join the list of properties at risk of defaulting because of low occupancy, expiring leases or maturing debt that would have to be refinanced at a higher rate,” according to Connect CRE.
With that said, office distress is not equally distributed. The top 15% of office inventory have registered over 100 million square feet of positive absorption since the pandemic and will remain highly desirable until 2030, according to a Cushman & Wakefield report titled “Obsolescence Equals Opportunity.”
As the post-pandemic office use saga drags on, office obsolescence is becoming a serious issue. With relatively high vacancy rates and a tepid forecast for demand, data suggests that offices will lose at least, if not more than, 39% of their market value within the next decade as compared to 2019 levels. Roughly 25% of the total inventory will be rendered functionally obsolete, requiring repositioning or repurposing to achieve high occupancy.
From a strategic standpoint, our perspective is that there are potentially two ways to approach the office sector in 2023. First, tuning into the “flight-to-quality” trend in the office market which is a trend where tenants are increasingly disqualifying older and functionally obsolete projects while opting into newer or repositioned projects that offer modern amenities to uplift the office experience.
We believe that high-quality office assets with strong tenants, long weighted average lease terms (five to 10 years), and priced at a going in yield that fits the current state of the market, could enable investors to ride out the current storm and possibly exit later this decade when greater certainty for the sector may return.
Our second strategy centers on creatively restructuring distressed assets that are deeply discounted relative to their 2019 values. Despite a negative outlook for the office sector, the level of emerging distress suggests some office projects may be mispriced, which will reset the basis to a lower bar.
Investors can approach distressed office deals in two ways, either by purchasing the real estate directly from a seller or by acquiring through alternative routes such as bank foreclosures or discounted note purchases. Such transactions by nature could present high risk going in but we believe there is potential that this strategy could translate into upside scenarios later this decade when the office sector exits its recession.
14 Commercial Property Price Index, Green Street, May 2023.