Remember during the height of the pandemic in 2020 when everybody was working from their living rooms? For a lot of people, that reality seems to have never changed. While unemployment sits near all-time lows, office vacancy rates are at all-time highs. Per Moody’s, in the fourth quarter of 2023, 19.6% of office space was unleased in major U.S. cities, the highest such level since they began tracking the data in the late 1970s. This figure is up from 18.8% in the third quarter and eclipses the previous high of 19.3% hit in 1986 and 1991.
So, the question is, how can employment be as robust as it is with this many empty offices? It would seem logical to pin the blame on the rise of work-from-home, which was popularized during the pandemic. But, while work-from-home certainly played a role in higher vacancies, a trend of rising empty office space has been in place since the 1980s. It began with years of easy lending policies through much of the 1970s. This lending led to overinvestment in construction of office spaces, and when recession hit in the 1980s, vacancies surged. Vacancy rates fell precipitously throughout the 1990s as the economy recovered, dropping from 19.3% in 1991 to 7.9% by 2000. But, as recession struck again in 2001, vacancy rates climbed back up, hitting 17% again by 2003. They never fell back to the lows of the beginning of the millennium and have been in double-digit territory since. Further, to cut costs, many businesses have opted to occupy open-air offices with cubicles as opposed to those with several private offices, allowing them to save on space. In short, a supply glut is the true driver behind the high vacancy rates of U.S. office spaces, but work-from-home did accelerate this trend in 2020.
This time is different from the last couple of cycles, though. With the ease and popularity of work-from-home today, we didn’t see the kind of sharp drop in vacancies we saw in the 1990s when the economy recovered. Some areas, such as the Miami metropolitan area, are seeing less pain than others and are even in the midst of another construction boom as developers look to build hurricane-proof buildings for the recent surge in demand in the area. Other cities, like those in the San Francisco Bay area, are seeing the most pain as the high concentration of tech firms in that region have more readily embraced work-from-home compared to other industries. Ultimately, the high level of vacant office space does not reflect employment pain for Americans the same way it did in the past, as this cycle isn’t a result of corporate downsizing. Rather, technological innovation allowing work-from-home to flourish has sped up the trend of increasing office vacancies that a supply glut started decades ago. What happens to these vacant properties remains to be seen. In some places like New York City, proposals have been put forward to adjust zoning laws to allow old offices to be converted into residential buildings to address the housing shortage. Other cities are seeing buildings being sold off at discounts to where they were purchased by the property managers. Whatever the outcome is, one thing is clear: employment and office vacancies are no longer reliable measures of one another.
Among the biggest impacts of the empty office space is the pain being felt by small, regional banks. Compared to big, national banks, regional banks have an outsized exposure to commercial real estate via their lending book. Per a JPMorgan study, small banks hold 4.4 times as much exposure to commercial real estate when compared to their large bank counterparts. This is especially problematic, with delinquency rates on office loans in Commercial Mortgage-Backed Securities (CMBSs) rising to over 5.8% versus below 1% pre-pandemic per Trepp. Regional bank stress has been widely covered by the media and has been largely priced into markets. Stress at smaller banks may accelerate a trend of consolidation by larger players in the banking industry.
One silver lining to problems within the office segment is distressed real estate investors will have a rich opportunity set. Investors in distressed and value-add real estate investors can play an important role in repurposing buildings to meet shifting real estate demand. Risk and opportunity go hand in hand. How will investors, developers, owners, and city governments come together to find the opportunities represented by the shift in real estate demand?
Written by: Brian Sawyer