Overview

Early in 2023, the U.S. office market remains in a state of apprehension. Net absorption was negative in 2022 for the third consecutive year, and vacancy is now well over 300 basis points higher than it was entering 2020. The forecast does not appear brighter, as our baseline scenario calls for a mild recession later in 2023, leading to more negative absorption and further vacancy increases. As the three-year anniversary of the COVID19 pandemic’s onset approaches, it is worth taking stock of what has become a persistent negative demand shock. Comparisons with the fallout from the Great Recession are useful in calibrating both the character and magnitude of the current office recession. In both cases, office-using employment declined by roughly 2.5 million office-using jobs, resulting in millions of square feet in negative net absorption. But the subsequent recoveries have been markedly different. In the recovery from the Great Recession, it took nearly six years for all the jobs to return. By contrast, the employment recovery that began in mid-2020 brought all the jobs back in less than 20 months, and it is still surging. Through January of 2023, office-using employment was nearly 6% above where it was at the end of 2019, above the level it would have been had long-term growth trends prevailed. With this level of employment growth, historical patterns suggest that demand for office space would have rebounded by now. Indeed, it was at about this point in time following the Financial Crisis of 2008—which marked approximately when absorption turned negative—that occupancy returned to its pre-recession level, even though employment had yet to fully recover. But instead of showing sings of a robust recovery, today’s market remains extremely soft, with occupancy still near the trough it reached in early 2021. And that trough itself, relative to total inventory, is nearly three times deeper than the one resulting from the Great Recession. Early in 2023, the U.S. office market remains in a state of apprehension. Net absorption was negative in 2022 for the third consecutive year, and vacancy is now well over 300 basis points higher than it was entering 2020. The forecast does not appear brighter, as our baseline scenario calls for a mild recession later in 2023, leading to more negative absorption and further vacancy increases. As the three-year anniversary of the COVID19 pandemic’s onset approaches, it is worth taking stock of what has become a persistent negative demand shock. Comparisons with the fallout from the Great Recession are useful in calibrating both the character and magnitude of the current office recession. In both cases, office-using employment declined by roughly 2.5 million office-using jobs, resulting in millions of square feet in negative net absorption. But the subsequent recoveries have been markedly different. In the recovery from the Great Recession, it took nearly six years for all the jobs to return. By contrast, the employment recovery that began in mid-2020 brought all the jobs back in less than 20 months, and it is still surging. Through January of 2023, office-using employment was nearly 6% above where it was at the end of 2019, above the level it would have been had long-term growth trends prevailed. With this level of employment growth, historical patterns suggest that demand for office space would have rebounded by now. Indeed, it was at about this point in time following the Financial Crisis of 2008—which marked approximately when absorption turned negative—that occupancy returned to its pre-recession level, even though employment had yet to fully recover. But instead of showing sings of a robust recovery, today’s market remains extremely soft, with occupancy still near the trough it reached in early 2021. And that trough itself, relative to total inventory, is nearly three times deeper than the one resulting from the Great Recession.

Leasing

After rebounding somewhat in the second half of 2021 and early 2022, the leasing market slowed considerably in the second half of 2022, especially in Q4. For the year, volume on new leases was approximately 10% below the annual average from 2015-2019, with Q4 volume 20% below the quarterly average during that same period. Net absorption was marginally negative (- 2.5 million SF) for the year as tenants continued to adjust their occupancy strategies in response to persistently low utilization in the COVID era. With many of these same companies now bracing for recession, cyclical pressures are contributing to further weakness in demand. Our forecast now calls for a fourth-consecutive year of negative net absorption in 2023, with much of it occurring in Q1. In the aggregate, occupancy is down 2% since 20Q1 and another 2% from where it would have been had long term growth trends prevailed. The total amount of this “missing” occupancy now exceeds 300 million SF, which has driven vacancy up to a near-record 13.0%, the highest since the Great Recession more than a decade ago. The market does not appear to have bottomed out just yet. Our current baseline forecast, informed by the likelihood of a recession later in 2023, calls for vacancy to reach an unprecedented 13.8% by mid-2024. Nowhere is weakness in the sector more evident than in the sublease market. There are currently 212 million SF available for sublease, more than double the amount at the end off 2019. The impact is particularly acute in markets like San Francisco, which has over 11 million SF available for sublease, representing 5.8% of its inventory. Similarly, New York has nearly 30 million SF of sublease availability, representing 3% of inventory. The sublease wave is impacting broadly. It is affecting markets large and small; CBD, urban, and suburban submarkets; and properties of all quality ratings. Given the flood of sublease inventory and tenant reluctance to renew the same amount of space, the availability rate is probably a better indicator than the vacancy rate of the true state of play. Overall availability stands at a record 16.4%, exceeding the previous peak that occurred in 2010. Sublease space has combined with recent deliveries, which tend to enter at the top end of the market, to push availability even higher at 4- & 5-Star properties, where it is now 23.0%. Despite this gloomy backdrop, demand has held up relatively well in some segments of the market. At recent-vintage properties — those completed since 2010 — net absorption has been positive each quarter, even during the height of the pandemic. Since the beginning of 2020, these properties have seen an average of just under 20 million SF of positive net absorption per quarter. While this is down more than 20% from the quarterly average in 2015–2019, newer properties have performed dramatically better than older ones. But even these newer properties are not immune from the surge in sublease inventory, as they have seen similar increases to those at properties of older vintage. In other cases, local market dynamics have propped up demand for office space. Vacancy is lower now than it was entering 2020 in Las Vegas and the Inland Empire. And while it has increased in Boston, demand for lab space in the red-hot life sciences sector has helped the market weather conditions well compared to other gateway cities. The overall outlook for office leasing, however, remains challenging. The specter of layoffs, which have been elevated for several months in the technology sector, will not help demand for office space. Generally weak fundamentals are thus likely to persist for some time.

Rent

Though office rents have recovered somewhat since a pandemic-induced dip, outsized sublease availability — which in some markets is being offered at discounts of 30-50% to direct rates — has put downward pressure on growth. At $35.00 per SF, national average rent is on par with what it was entering 2020. The current economic context of elevated inflation is an important factor in evaluating office rent growth. In the five years prior to the pandemic, office rents grew at a year-over-year rate of 2%-3%, slightly above inflation as measured by the Consumer Price Index (CPI). Since the end of 2019, however, office rents have remained essentially flat; meanwhile, consumer prices advanced 7% in 2021 and another 6.5% in 2022 according to the Consumer Price Index (CPI). Furthermore, higher interest rates have increased yield expectations. While the 10-year treasury yield has pulled back from its autumn high, it remains near 4.0%, more than twice what it was at the beginning of 2022 and well above its average in the 2010s. Thus, real market rents have been in steady decline. The competitive reality currently facing landlords is another consideration in interpreting rent growth. For many months, payers in the market have been reporting generous concession packages, including longer periods of free rent (a common rule of thumb in many markets is one month of free rent for every year of term) and higher tenant improvement allowances intended to attract tenants and help them adapt to rising build-out costs. In this environment, even nominal effective rents are almost certainly falling for most properties in most markets. There are important exceptions to this trend, however. Industry insiders report that real, effective growth remains positive at premium properties — specifically, new and trophy assets in highly desirable submarkets. This comports with the resilience of demand in buildings matching this same description, as noted above, and provides further evidence of a bifurcation in the market as occupiers adapt their workplaces to the post-pandemic world.

Construction

Last year saw 42.9 million SF in net deliveries, the lowest since 2014, but still enough to put pressure on vacancy in an environment of flat-to-falling absorption. Another nearly 70 million SF in expected deliveries in 2023 — the majority of which are expected in the first half of the year — will contribute further to softening fundamentals. Construction starts, however, have slowed quickly. At just over 10 million SF, starts in 22Q4 were the lowest in the past 10 year, less than half the 20.7 million quarterly average from 2015-2019. With tighter financing conditions and general economic headwinds now facing developers, construction activity looks to slow further this year. Still, there are 135 million SF currently under development, which will add in the coming years to the glut of high-quality space from which tenants in the market will be able to choose well within the typical range in each. The overall picture is one of steady supply growth in line with historical trends, a pattern that would have been unremarkable before 2020. On the one hand, this offers another indication that softness in the leasing market is primarily a demand-side phenomenon. On the other hand, it also suggests that development activity has not yet moderated sufficiently to adapt to the change. As would be expected, much of this pipeline is concentrated in markets where demand has so far been comparatively resilient. Together, San Jose and Seattle have over 20 million SF in the pipeline, putting them at some risk given the employment outlook in the key technology sector (though much of this space has been commissioned by large tech firms and is thus currently spoken for). Life sciences hubs Boston and San Diego also have relatively large development pipelines, as do Sun Belt metros such as Austin, Nashville, Miami, and Charlotte. Gateway cities New York, Washington, D.C., and Los Angeles remain perennial leaders in construction activity, though the volume is well within the typical range in each. The overall picture is one of development activity that has moderated already and could slow even more abruptly in response to changing economic and financing realities.

Sales

A much-anticipated slowdown in transaction volume finally began to materialize in 22Q4, which plummeted to $13.7 billion – the lowest figure for the final quarter of a year since 2009. For the year, the $81.8 billion in sales volume recorded was lower than any year in the past decade barring 2020’s $69.8 billion. Market pricing managed to climb slowly (about 3%) during the year, but this was influenced by a smaller number of deals concentrated among well-leased assets. Both the financing environment and the challenging outlook for fundamentals have created a bid-ask spread in the capital markets for office buildings. While capital to invest in real estate is still abundant, much of it will move to the sidelines until a repricing occurs. There are already signals that such a repricing could be imminent. The market capitalization of public office REITs would imply that cap rates have risen approximately 180 basis points in the past year, suggesting a corresponding decline in asset values of about 20%. It should be noted though that the portfolios owned by these firms are not generally representative of the larger market. Speaking privately, industry insiders suggest a downward adjustment in values of 20-25% from peak is likely, which would be similar to the drop that occurred in the aftermath of the Great Financial Crisis. Several factors could combine to realize a correction this year. Many properties likely will face elevated lease rollover risk in the coming year, with organic long-term leases expiring alongside short-term extensions executed during the pandemic. Given the conditions prevailing in the leasing market, renewal rates are likely to be lower than historical norms would suggest, especially at older properties. Among those tenants who do renew, many are likely to reduce their footprints if they follow a trend that became visible in 2022. This will put pressure on NOI, which combined with higher interest rates, will make it more difficult for owners to meet standard debt service coverage ratio requirements. A wave of loans maturing amid weak fundamentals and a difficult borrowing environment could trigger distressed transactions and reset the market, presenting opportunities to all-cash buyers and other well capitalized investors.

Economy

The U.S. economy is still expanding, but signs of slowing are proliferating as the Federal Reserve boosts interest rates to tackle inflation that is still stubbornly high. Many analysts are now expecting the economy to tip into recession this year on a pullback of consumer spending and business investment, which are reacting to higher borrowing costs and weakening demand. Pandemic-related supply chain disruptions and stimulus fueled consumer demand led to decades-high inflation last year, which was exacerbated by the war in Europe. In response, the Federal Reserve has tightened monetary policy, raising its overnight lending rate by 450 basis points since March 2022, including four unusually large increases of 75 basis points. Despite recent turmoil in the banking sector, more hikes are expected, with perhaps 50 basis points added by mid-year, pushing the target rate past 5%. The central bank is also shrinking its bloated balance sheet. More than $300 billion of assets were allowed to mature without reinvestment last year, removing liquidity from the market and shrinking the monetary base. The Fed intends to draw down $1 trillion in 2023. Federal Reserve Chairman Jerome Powell has repeatedly stressed that the committee is focused on its price stability mandate and will push rates higher until inflation abates, even at the risk of triggering job losses and an economic slowdown. So far, inflation as measured by the consumer price index (CPI) has eased from its peak of 9.1% reached last June to 6.0% in February. However, core CPI, which excludes food and energy prices, has been slower to retreat, with services being especially persistent. Rising prices and recession fears have weighed heavily on consumer sentiment, yet households continue to open their wallets. Consumer spending has been supported by stimulus payments that were sent to households during the pandemic, much of which was saved. But robust spending on physical goods such as automobiles, computers, and furniture during the pandemic (and now on services such as travel and entertainment) has seen households drawing down their excess savings and turning to borrowing. With relief payments in the rearview mirror, personal incomes are set to cool, which suggests that spending will also moderate, becoming a drag on economic growth. Real personal outlays fell in November and December, and income has stagnated on a per capita basis and remains below pre-pandemic levels. The personal savings rate was 4.7% in January, inching higher since the middle of last year but still below pre-pandemic rates as spending outpaces incomes and households dip into savings accounts. Economic momentum had already flagged in 2022 after a robust rebound in growth the prior year. The first two quarters experienced negative growth, often seen as the definition of a recession, on a resurgence of COVID infections. However, the year saw GDP expand by 2.1% overall. Recent data confirm a slowdown in activity. Announcements of hiring freezes and impending layoffs are widespread, suggesting that the labor market will slow in coming days. Business investment is at risk, as factories report new orders for their products are slowing, leading to a contraction in factory activity. And with mortgage rates still at levels not seen in years and housing prices still uncomfortably high, affordability has eroded, leading to a sharp turnaround in what had been a red-hot housing market. Sales of existing homes have fallen for 12 consecutive months, while builders are clearing their inventories of new homes by offering buyers incentives, such as rate buydowns. Moreover, while the labor market remains sturdy, job gains slowed over the second half of last year. The monthly average of gains in the fourth quarter fell to 291,000, from 561,000 in the first quarter of 2022. The January blowout jobs report followed by February’s hefty gains showed more than 800,000 jobs added in the first two months of the year, but expectations are for sizable gains to end. Labor participation remains somewhat weak and is still below its pre-pandemic rate, as older workers chose to retire early during the pandemic and others continue to cite COVID fears and a lack of family care options as reasons to remain on the sidelines. Analysts suggest that many of these former workers will not return to the labor market.