Thesis Driven dives deep into emerging themes and real estate operating models. This week’s letter explores possible outcomes of the sinking office market, including alternative uses, conversions, and more.
It is hard to find silver linings in recent office data. JLL concluded that office vacancy topped 20% in Q1, the highest in recent memory. Some individual markets are far worse; for example, the San Francisco, New Jersey, and Houston office markets are all more than 25% vacant. And as we’ll discuss later in this letter, the situation is likely to get far worse as in-place leases roll.
While there is little disagreement that the office market is feeling pain, there is far less consensus on what comes next. Various alternatives are floated, as are apocalyptic renderings of abandoned city centers and prognostications of doom.
Rendering of a post-apocalyptic San Francisco from a recent Financial Times article
This week’s letter will dive into the state of the office market and make a few predictions. Specifically, we’ll tackle:
A more detailed look at the state of the market and why prices haven’t "unstuck" yet despite record vacancy;
An overview of alternative uses of traditional office space including managed / flex office, residential conversions, and other uses;
An analysis of the financial viability of alternatives;
Predictions of where the market will end up and when it might end up there;
What this all might mean for cities.
So how bad is it out there?
While the increase in office vacancy is certainly real and bad, how badit is really depends on how one asks the question.
While in-place leased occupancy is bad, it is actually the most optimistic lens through which to view the current state of the office market. Most reports show leased occupancies for most markets around 80%, and all but the worst markets are still above 75% leased office occupancy. This relatively bullish view, however, still shows a concerning trend line, as vacancy continues to trend up despite decreasing new supply.
Viewing leased occupancy gives an overly rosy picture for a few reasons. One, it lags the current state of the market; the average office lease term is approximately 100 months, so the majority of in-place leases today were signed prior to the pandemic. Looking at office absorption—the rate at which available office product is leased—gives a much more pessimistic view.
Outside of a blip in late 2021, office absorption has been strongly negative. Worse, it has been trending in the wrong direction over the past 18 months. While new, highly amenitized office towers (NYC’s Hudson Yards and One Vanderbilt, for example) have generated some positive headlines by signing marquee leases, they are almost entirely gaining occupancy by poaching tenants from older buildings and less compelling neighborhoods rather than taking advantage of nonexistent net new demand.
Other office market reports tell a similar story. According to Colliers, total office absorption was negative 25.4 million square feet in Q1 2023—meaning more space was delivered or became vacant than was signed to the tune of ten whole Empire State Buildings.
However, the most apocalyptic views of the office market come from measures of actual end-user utilization. Kastle’s back-to-work barometer—which tracks keycard swipes—is one measure of end-user office use.
While 2021 and 2022 saw a plodding return-to-office trend, this year has seen stagnant if not backwards progress toward office occupancy across markets. And unlike in prior years, there is no fundamental change on the horizon that will necessitate a turnaround in office demand like vaccines or RTO mandates. Actual end-user office occupancy rates in the 40-60% range appear to be here to stay.
But despite sagging absorption and weak utilization, asking rents remain sticky, with leasing incentives showing up in other ways. From Colliers’s May 2023 report:
Asking rates are, by and large, showing little change. However, the gap between asking and effective rents remains significant, with generous concessions on offer. For example, tenant improvement allowances of $100 per square foot or more are available in 10 of the 15 leading U.S. office markets when a tenant signs a new 10-year lease on Class A space. In a similar manner, two-thirds of the leading markets are offering 10 months or more of rent abatement on such transactions.
This is somewhat understandable behavior on the part of office owners; TIs and rent abatements can be explained away as one-time expenses. Signing long-term leases at lower rents, however, has a material impact on a building’s appraisal value, in many cases pushing it below the value of the debt on the asset. This would effectively wipe away any equity value still in place, so owners are highly incentivized to wait as long as possible before pulling that lever.
JLL takes a bit more of a perplexed view on asking rents’ stickiness, although they provide good color on the flight to quality actually leading to an increase in sticker rents for new leases being signed today:
Rental rates remain something of an enigma in today’s environment, as despite challenging conditions national asking rents continue to grow, reaching $38.96 per s.f. in Q1, an increase of 0.3% since Q4. Part of this is driven by landlords preserving asking rents through increased concessions, but the bifurcations in the office market driven by asset quality have been more influential. Although vacancy rates are reaching record levels nationally, supply-and-demand dynamics within the performing segment of the market—high-quality Class A and trophy space—is vastly different in many markets, with available space in high-quality buildings relatively scarce despite demand from migration of tenants from lower-quality buildings. Because of this, executed rents on leases signed over the past 12 months continue to climb, with base rent and effective rent increasing 16.4% and 16.5% respectively against the 12 months leading into Q1 2022.
Many office owners are hanging their hopes on a number of recent return-to-office announcements from major companies, particularly those in tech like Amazon and Facebook. The dialogue has certainly taken a pro-RTO turn in recent months, with many executives and founders lamenting the flaws of perma-work from home: coordination challenges, slow innovation, and a sneaking suspicion that employees aren’t putting in a full day’s work—or are even holding down multiple jobs.
But even if executives get their way and employees are forced back en masse, the office market is not necessarily saved. One, many companies have realized they don’t need as much space as they did prior to the pandemic, with office market analysts (e.g., Colliers) projecting 20-30% office downsizes even when companies are planning to return to the office. And for many companies, "return to office" still just means three days per week, depressing end-user occupancies and justifying office downsizing.
But perhaps more importantly, the office market was not going swimmingly until the pandemic hit and the music stopped. As this WSJ article outlines, an oversupply of office space—particularly suburban product—had been looming prior to COVID, with new deliveries of Class A space largely succeeding by poaching tenants from aging properties rather than taking advantage of net new demand.
So office owners are going to increasingly look for alternative uses. But what alternatives are out there and are they viable?
The Plan Bs
With office demand not returning, what might happen to all that vacant space? In this section we’ll tackle some of the major alternatives that have been floated as well as the economic viability of each.
Alternative #1: Managed / Flex Office Space
While some may argue it isn’t an "alternative" per se, managed and flex office space reflects a very different approach to the leasing, use, and financing of commercial square footage. It also likely taps into an end user base underserved by current office options.
Thesis Driven did a deep dive into managed and flex office providers earlier this year, and we found that they were doing quite well—particularly in the suburban locations feeling the most pain from a long-term leasing standpoint. Flex office companies like Industrious and Serendipity Labs are seeing success in wealthy suburban locations like Sandy Springs, Georgia and Fairfield County, Connecticut by opening up where key employees live, giving employers a plug-and-play solution to entice workers out of their homes.
An Industrious location in Sandy Springs, Georgia
It may seem contradictory that flex office providers are succeeding in the very locations that are struggling in the broader market. But flex office users are fundamentally different than major tenants looking to sign long-term leases—and in fact, these office users are likely inversely correlated. As large companies are less willing to sign long-term leases for big space, more individual end users or small teams may look to sign small, short-term commitments to get out of the house for a few hours or host clients. The success of this model supports the notion that the problem isn’t the office but the commute.
While it’s not difficult to generate pro forma models that significantly increase the NOI of office square footage through flex space conversions—many operators charge their end users gross rents well in excess of $100 per square foot per year—the challenge comes from lenders, all of whom view flex space revenue has lower-quality and less predictable than long-term leases. I was recently on a panel with the CEO of a major flex space operator who cautioned building owners to keep the percentage flex space in their assets "under 20%" to avoid raising lender concerns and driving down an asset’s LTV. We’ll talk more about how lenders may approach this going forward later in the letter.
Alternative #2: Residential Conversion
Thesis Driven’s very first letter—back in September 2022—tackled the question of office-to-residential conversions by profiling a handful of developers who have actually executed on them. Since then, much more has been published on the feasibility—or lack thereof—of converting vacant offices into apartments.
Any office owner—or prospective distressed office buyer—considering a residential conversion must address a number of challenges, including:
Zoning. In many jurisdictions, office buildings cannot be converted into residential apartments without a change of use. Depending on the jurisdiction, this could be anything from a trivial administrative task to close to impossible. Zoning also isn’t the same for every office building within the same city; in New York, for example, some commercial zones (e.g., many in the Financial District) allow apartments while others do not.
Unlit Cores. Office floor plans are often much "fatter" than those of residential buildings, leaving a large unlit core in the center of the building that is not reached by natural light. In general, conversions approach this problem in one of three ways: (1) accept a much higher loss factor, perhaps putting extra amenity or storage space into the unlit core, (2) building long, thin units with lots of windowless bedrooms, or (3) changing the floor plan, often by blowing a light well into the middle of the building. Each of these routes has its own costs and challenges.
Utilities. Offices buildings have fundamentally different needs than apartment buildings in pretty much every utility category: water, sewer, HVAC, and electrical. Office buildings typically have utility runs in the central core—where the bathrooms often sit—which need to be distributed throughout the building to serve each individual apartment unit. The building’s HVAC system will also need to be fully reworked.
Together, all of these drive cost, uncertainty, and delay. And in many cases, they mean that attempting to convert an office building to a residential apartment is less feasible than simply scraping the site and building from scratch.
This is not to say that office-to-residential conversions aren’t happening. Older, pre-war office buildings with thinner floor plates and historic charm—and the potential to earn historic tax credits—often make good candidates, as do buildings with unique land use situations that make conversion viable. Nathan Berman’s Metroloft, for example, targets midcentury office buildings in New York City’s Financial District that are "overbuilt"—that is, they are built to a higher FAR than current zoning would allow—for luxury condo conversions. By converting rather than demolishing the existing structures, Berman is allowed to conserve the grandfathered square footage.
Top-down view of 180 Water, an office-to-residential conversion by Metroloft in New York City. Note the lightwell punched into the middle of the building.
Berman also benefits from high Manhattan rents and condo prices. His favored solution to the "unlit core" problem is to punch a lightwell into the middle of his buildings, a costly and structurally complicated solution that makes sense when studio apartments at 180 Water (a prior Metroloft conversion) start at $3,300 per month.
Residential conversions make sense for certain buildings as well as markets with high apartment rents and the right zoning. They’ll happen, but they’re unlikely to consume a significant percentage of the vacant office space coming to market.
Alternative #3: Industrial and Logistics
As the office market has crumbled, demand for industrial and logistics space has soared with the steady rise of e-commerce and increasing demand for storage and distribution space. Might there be a time soon that it makes sense to convert vacant offices to warehouses, light industrial facilities, and distribution centers?
To an extent, this is already happening. Many last-mile logistics providers are signing commercial leases in dense urban hubs at far higher rents than traditional logistics companies could stomach. We wrote about this trend in a letter earlier this year and featured several of the last mile operators signing leases at rents competitive with retail tenants and other commercial users.
A Getir "dark store" storefront in New York
While the rise of last-mile logistics operators and e-commerce distribution centers may be a boon to some retail owners, it is unlikely to be a savior of the office market. One, the aggregate square footage need of these last-mile facilities is still small; the majority of last-mile companies take leases on spaces smaller than 5,000 square feet. Two, logistics companies often struggle with higher-floor space without access to a loading dock, and even the ugliest Class C office building is unlikely to want a tenant constantly hauling pallets up and down the freight elevator.
The price disparity on unspecialized industrial square footage is also too wide; general light industrial space generally rents in the $10-30 per square foot range depending on the market. This is well below the level that would be viable for most comparably-located office buildings. Industrial and logistics use may have an impact on some low-rise buildings at the lower end of the office market, but it is unlikely to be a savior.
Alternative #4: Community, Education, Recreation, and More
There is more to life than sleeping and working. And there’s more to commercial real estate than offices and apartments. Schools, recreation facilities, maker studios, play spaces, event venues, and more have significant demands for urban space—but usually can’t afford to pay top-dollar office rents. If office rents come unstuck, alternative uses like these will likely increase their urban real estate footprints, and marginal uses today may become viable at lower rents.
My bullishness on this alternative comes partly from personal experience. In 2010, I co-founded General Assembly, a brick-and-mortar school teaching technology and design skills. Over the following eight years, we leased hundreds of thousands of square feet of office space to transform into "urban campuses" with classrooms, collaboration and working space.
A lounge in a General Assembly campus
During our rapid growth from 2010 to 2015, we took advantage of relatively depressed office rents; our first campus at 902 Broadway in Manhattan was signed at $29 per square foot. In 2019, similar space would rent for upwards of $75. Beyond my own experience, there are a few trends that make me more optimistic about this route:
One, consumers are increasingly placing a high value on experiences, and experience-based businesses have seen outsized growth over the past 10 years. From escape rooms to Instagram-able "museums" to foreign language schools and pickleball courts, studies have increasingly shown that experiences are capturing wallet share from goods, increasing the demand for experiential space.
Two, while office-heavy "central business districts" have performed poorly, downtown areas with a strong residential footprints and a mix of uses have done well, speaking to consumers’ continued demand for dense, walkable neighborhoods. That is, when downtown is an inviting place for people to live and play rather than simply work, consumers respond enthusiastically.
Many of these alternative uses act as "shadow demand" today—they don’t make economic sense at current office rents but stand ready to grab space should rents fall below a certain level. Previous generations, after all, saw a far wider variety of uses in "commercial" square footage than white collar office work. New York City’s Garment District—now filled with poorly-performing Class B and C office buildings—got its name from the textile manufacturing happening in those very buildings. While I doubt we will return to rows of Singer machines, we could very well see more 3D printers and robotics.
And there are surely wilder ideas that we are not even considering. China, for example, is building a 26-story urban pig farm, perhaps an appropriate path for a spiteful office owner denied a residential variance.
Alternative #5: Office, But Cheaper
Our final (and least interesting) alternative is that the vast majority of current office space will remain office space—just rented at a lower price point than it was in 2019.
This alternative hinges on the elasticity of demand for office space. Clearly, the office market is "stuck" right now; owners are refusing to lower face rents despite increasing vacancy and steeply negative absorption. But what happens when rents come "unstuck"? Is there a significant amount of office demand simply waiting to sign leases at 10%, 20%, 30% below current market rates? Alternatively, would the corporate tenants with rolling leases currently planning to cut their office space by 20-30% do so if they could pay the same amount of rent but for more space?
Unfortunately no one really knows, and I could find no meaningful research on the elasticity of office space demand—although I’m certainly not the only one thinking about the implications of increasing price elasticity in the office market. Regardless, it’s not hard to imagine scenarios in which companies choose to retain a majority of their office footprint if the cost of doing so were significantly lower.
So this path seems like the safe—and most likely—bet, especially as executives look for more creative ways to bring employees back to the office. Unlike the other alternatives outlined here, there are no hard costs involved in converting offices to into cheaper offices—only asset owner pain that is likely to materialize one way or another.
The Great Unsticking
Of course, any of these alternatives would require office rents to actually come down. While there are some signs that lower office rents are manifesting through increased concessions or TIs, face rents remain stubbornly high.
Unsticking the market, unfortunately, will likely require a capitulation event on the part of owners, an admission that they have no equity left in their assets and those buildings are effectively wards of their senior lenders. Lenders, of course, have little desire to inherit a wave of distressed office properties and the regulatory scrutiny that would accompany a mass capitulation event, particularly in the wake of recent bank failures. So lenders continue to roll their notes and push the wall of maturities a little further out.
But things eventually have to break. In the best-case scenario, lenders will exert enough pressure on borrowers to drop rents to a market-clearing price, avoiding outright default. And some owners may be forced to sell to buyers of distressed assets, who will then recapitalize those buildings with far lower rents underwritten. The current situation—high asking rents maintained in an environment of dramatically increasing vacancy and negative absorption, with no obvious demand driver on the horizon—is unsustainable. When the Great Unsticking happens—and whether it happens gradually over 18-36 months or suddenly as lenders get tough—is impossible to know.
It is important to remember that all of this office distress is happening during a fairly strong macro environment. While certain high-profile sectors—such as technology and media—are feeling pain and cutting back, unemployment remains at record lows and job growth continues apace. A renewed Fed commitment to rate hikes in the coming months could be cataclysmic for office owners already teetering, pushing us closer to capitulation and the Great Unsticking.
For whatever reason, Americans are uniquely obsessed with the End Times, something I’ve always attributed to our Great Awakening roots. Regardless, the past three years’ weak office demand and resulting slow recovery of American central business districts has been grist for the mill of apocalyptic predictions of secular decline, societal decay, and general millenarianism regarding cities.
Another rendering of a post-apocalyptic SF from the Financial Times
Without a doubt, office owners are in deep trouble. I don’t know if this means that the worst quartile of office assets (by measure of performance and capitalization) will hand the keys back to their lenders or only the only best 10% of assets will retain possession when all is said and done, but office equity—and plenty of lenders—are in for serious pain.
But I don’t believe this means that cities themselves are doomed. That is, we should not conflate the fates of influential office owners with those of cities themselves.
For one, the model of segregated uses—in which people live outside the city and commute in and out every day to work—has been fundamentally broken for some time and was already in decline. Segregation of uses leads to sad central business districts dead after 6pm on weekdays and socially isolated suburbanites, and for good reason it has fallen out of favor among city planners, major employers, and elected officials alike. New city master plans and zoning regimes increasingly embrace a mix of uses and activated ground-floor space. In many ways, the pandemic and the rise of remote work is the final nail in the coffin of segregated uses—and that’s unambiguously a good thing for cities.
Cities also aren’t as dependent on commercial property taxes as many pundits would have you believe. New York City, for example, gets 30% of its revenue from property taxes. Of that, approximately a fifth comes from commercial property taxes. So even if all commercial property taxes go to zero—which they won’t—NYC will only face a 6% drop in total revenue. While this kind of shortfall would result in some painful cuts, it would hardly doom the City—especially since NYC’s budget has risen by more than a third over the past decade.
Finally, as commercial rents come unstuck, alternative uses will arise to bring more people back to city centers. At least three of our five alternative uses we discussed earlier would draw more people back to central business districts than traditional offices; community, education, and recreation use in particular could easily make urban centers more vibrant than the offices they would replace, drawing a wider variety of people to urban spaces at more varied times of day, making it easier to support retail businesses and other amenities.
To be clear, I don’t think one alternative use will be the "winner" of declining office rents. If anything, the majority of current office space will remain office albeit at a lower price point, with some alternatives—a handful of residential conversions and a lot of new, creative uses—scooping up lower-priced space in distressed Class B and C buildings. The degree to which those alternatives proliferate depends on the eventual market-clearing price; a 20% decline in rents will see fewer creative uses than a 50% decline would foster.
For cities, the Great Unsticking cannot come soon enough. Lower rents unlock the creativity of entrepreneurs to do interesting things with space, and that’s unquestionably a good thing for cities.