U.S. Office Market Outlook Gloomy As Availability Hits New High

The U.S. office market turned in a dismal first quarter to start a year that many in commercial real estate see as one meant for treading water and waiting for calmer seas. Available space is at record levels, overall demand is tepid and formerly vigorous space takers, such as tech, are paring back their usage.

The outlook, especially following last week’s higher inflation numbers and the subsequent doubts that an interest rate cut is in the near future, is also bleak. Familiar beacons of hope, like return-to-office and conversion potential, are waning as debt bears down on landlords.

“There’s just no tenants right now. You have an issue with a lower group of tenants. Let’s take a service provider. So a law firm, for example, or an accounting firm. The accounting firm just needs less space. That doesn’t mean that they don’t need an office, they do. But they don’t need as much office space as they once needed,” Locke Lord partner Mark Silverman said. 

More than one-fifth of the country’s office space is available for either direct lease or sublease, with 1.2B SF up for grabs. It’s a figure that has crept up since the pandemic set in more than four years ago, and it is not likely to reverse course anytime soon, despite efforts by landlords and employers alike.

The return-to-office effort has bolstered the hopes of many in the office world, with major companies in important sectors like finance and tech announcing mandates that would require workers to come to the office for a given number of days per week. But despite a few bright spots in the trajectory of the movement, return-to-office is lacking a major component that could make it a game-changer for office usage.

“The element of return-to-office policy that has been missing is enforcement,” Avison Young U.S. President Harry Klaff said. “That would suggest that there's concern that enforcing policies could cause some type of flight risk among employees.”

Take Goldman Sachs, for instance. The finance giant’s requirement that all employees work from the office five days per week was announced in May 2022, eliciting cheers from the CRE industry. Six months later, just 65% of the firm’s employees were abiding by the rule, causing Goldman to “remind” employees of the requirement. 

Competitor Bank of America issued a requirement in October 2022 that employees be in the office at least three days per week, but the Financial Times reported in January that the company was sending out “letters of education” to noncomplying employees, threatening disciplinary action.

Return-to-office isn’t necessarily a dead letter, Klaff said, but it might take more years to happen at a scale that makes a difference to leasing and won't make an immediate impact on office markets. 

Tech companies, another of the country’s biggest office leasing drivers in the pre-pandemic years, have challenges of their own. RTO mandates in tech have met with mixed success, and some tech companies are using any resistance as a means to make determinations about layoffs, a scourge in the industry in the last two years. 

Most of the tech sector is in turmoil, culling employees brought onboard during the hiring surge in 2021 while reckoning with changes coming from within the industry in the form of artificial intelligence. Helping with layoff decisions, though, doesn’t boost office usage. 

“In my career, tech has always led to recovery of the real estate market,” Klaff said. “I don't know if it's going to happen that way this time.”

Whether in-office or not, office-using companies are poised to hire fewer people, a reflection of an uncertain economy and a bad sign for office occupancy.

Office job postings, considered a leading indicator of employment growth, were down 26.8% in the first quarter from the same period in 2022, AY reported, with tech postings dropping 60% and finance down 48%.

All of this availability, of course, means less income for landlords as debt loads encroach. Nearly $150B of office-backed mortgages are expected to mature this year, with more than $300B coming due by the end of 2026. 

At the end of 2023, office owners and commercial real estate at large had high hopes for interest rate cuts that would offer much-needed relief, but four months later, those hopes have grown dimmer with each inflation report and Federal Open Market Committee meeting.

The so-called wall of maturities is likely to spur some office sales activity this year and next, HKS Real Estate Advisors partner Michael Lee said. 

“People have been sitting on their hands for the last 24 months, basically saying unless I have to do something, I'm not going to do anything,” Lee said. “Now some of those maturities are actually starting to come due. So the world has to turn at some level, right? Transactions have to flow to some degree.”

The deals that are completed probably won’t spur the office conversion spree that many have touted as a potential partial solution to office’s challenges, Lee said.

“The likelihood of hitting on those deals is still a bit off,” Lee said. “Pricing expectations are still misaligned, and they're challenging deals in general. A lot less conversions are going to happen than people may think.”

One bright spot for the office market did continue to shine in the first quarter. The highest-quality properties, including newer Class-A and trophy assets, are attracting those companies that have been executing lease deals.

Direct availability for trophy properties stood at 17.7% nationwide in Q1 compared with total direct office availability of 20%, according to AY data. But, higher-quality properties have been the most in-demand for years now, causing their supply in many major metro areas to dwindle, impacting leasing.

“We've seen a slight decrease in trophy leasing across the U.S. in terms of the share of total leasing,” Avison Young Regional Manager for Market Intelligence Danny Mangru. “It's not really because occupiers aren't looking at the high end of the market anymore. The supply is diminishing.”

In Q1, leasing in trophy office buildings represented 20.4% of the total, while Class-A space was 38.8% of the total, according to AY data. During all of 2023, trophy leasing represented 22% of the total and Class-A nearly half, at 48.9% of the total.

Tenants who are still in the market for trophy space in gateway markets, however, are willing to sign longer leases for such space than in more average product, AY reports. Companies are willing to sign for an average of 110 months, compared to 91 months for Class-A and less for B and C. That trend will likely continue in the coming quarters.

Office investment remains stuck in neutral and financing prospects are limited, AY also reports. At $1.3B of investment sales volume for office buildings during Q1, the market is on track to have the lowest total sales volume since 2009, when sales totaled less than $10B. In peak years like 2015, the total was more than $70B.

Returns for the U.S. office sector will remain anemic in the coming years, according to the Urban Land Institute's most recent survey of economists, which forecasts an average annual return of less than 1.9% until 2026 for the sector. As hybrid work schedules persist, rents in the office sector are projected to contract by an average of 1.1% annually.

“Investors are unsure of where values are. Unsure if they are increasing, decreasing or flat,” Lee said.

That uncertainty is even impacting those investors interested in distressed debt as a way to acquire assets at a steep discount. “There's definitely interest in distressed office debt,” Lee said. “There's going to be more of it available. The problem we're seeing is the disconnect between buyers and sellers. There's a disconnect between lenders and buyers.

“Lenders are saying we're not willing to take a loss on it,” Lee said. “Buyers are saying they need a discount to make this work. Otherwise, why put themselves in that kind of position?”