US Office Market Imbalance Could Mean 330 Million Square Feet of Opportunity

Article originally posted on CoStar on March 16, 2023

Too Much Space Is Ill-Suited for Modern-Day Priorities, Cushman & Wakefield Says

The U.S. office market could be saddled with 330 million square feet of obsolete space by the end of the decade that would need to be repositioned lest vacancy rates rise to undesirable levels, according to a new analysis by Cushman & Wakefield.

The real estate services giant projects much of that property — the equivalent of all the office space in Atlanta, the nation’s eighth-largest office market — is ill-suited to meet the demands of hybrid working and environmental priorities.

“We want to sound the alert right now that there are opportunities here in the sector and for property owners to think about if the space they are in now is the space they want to be in long term,” said David Smith, global head of occupier insights for Cushman & Wakefield. “If not, they can focus on the value play or if they want to upgrade their space into what occupiers really want to work in.”

About 70% of the nation’s office buildings were developed before 1990 and don’t meet the demands of tenants today, the firm found in its analysis, with more tenants seeking higher quality space as leases expire and companies seek to entice workers back to the office. As companies trade up to higher-quality office buildings, they also tend to get more efficient with their footprint, leaving more empty space, he said.

Unused office space is highly concentrated in the United States, with more than 50% of office vacancy being located in only about 7% of office markets in the nation, highlighting how the flight to quality is affecting older buildings, according to Cushman & Wakefield.

In the next year or so, Smith said, office vacancy is projected to rise before coming down slowly through 2030. At that rate, the office market would have a vacancy rate of 18% — mirroring where it is today — by the end of the decade, surpassing what is estimated to be a healthy vacancy rate of 13%, Smith said. Those five percentage points into unhealthy vacancy territory represents about 330 million square feet of office space, Smith said.

“Real estate and office move relatively slowly and there are a lot of narratives, but [the narratives] really fall into two extremes,” Smith said in an interview with CoStar News. “The first one is ‘there’s nothing to see here’ and the other extreme is that we’ve gone from roughly 13% vacancy to 18% vacancy, and we are on our way to 25% or 30% vacancy, which is a ‘sky is falling’ perspective. We dug into the data and neither one is true.”

Reassessing Space

Like the retail sector 15 years ago, Smith said office space isn’t going away, but it has to fundamentally shift to support tenants’ evolving needs. In retail’s case, he said, the evolution led to retail that blends so-called “experiences” with shopping and urban retail centers. For the office sector, it could mean investing in updated wellness and lifestyle amenities or repurposing a building for a new use, converting it to lab space or residential units.

For instance, Dallas-based property owner Woods Capital is transforming three office skyscrapers in downtown Dallas into hundreds of apartment units and a hotel.

“Finding the right building is harder than finding the right owner or developer that has the vision to do this,” Smith said. “Even if we start to see 3%, 4% or even 5% of office buildings go through this process, we’ll see a significant impact on vacancy rates.”

The biggest challenge to large redevelopment projects will be the continued headwinds in the capital markets and interest rates in the short term, Smith said, adding he expects decreases in interest rates next year. Another potential challenge for landlords will be continued construction labor constraints, he added.

By the end of the decade, Cushman & Wakefield estimates U.S. office demand will measure 4.6 billion square feet of space, which is slightly above current levels. That estimate assumes a projected 6% growth of office employment by 2030. In looking at that demand, the firm’s executives say the U.S. market is on track to have 1.1 billion square feet of vacant office space by decade’s end, which is 55% more than prior to the pandemic.

Location, Location

The success of future office could rest on where in the country it is located and the ease of getting office workers to the property.

“We’ve seen in some Sun Belt markets that office demand has broadly recovered with job growth being stronger in those markets,” Smith said. “The number one reason why people don’t want to go to the office is the commute. Right now, there’s a distinction between markets that have easier commutes being less public transportation dependent and more car dependent. If you have to take two trains and a bus to get to the office with an hour or one-and-a-half commute to the office, it’s a harder sell.”

For suburban versus urban office buildings, Smith said there are both challenges and opportunities for each type of property. The ability to redevelop a property can rest largely on municipalities and if a landlord can solve a housing shortage or come up with a mixed-use destination that can reposition a neighborhood.

If a property owner is able willing to invest, there could be “a ton of upside if someone were to come in that knew what they were doing and had the money to invest and turn it into a world-class office or something else that it’s not today,” Smith said.

For example, Irvine, California-based Greenlaw Partners bought a vacant 1980s office building in Ventura County, California, in 2020, converted the property into a last-mile distribution center and signed Amazon to a 15-year lease. The developer then sold the Amazon-leased building about 40 miles northwest of Los Angeles for a hefty profit in 2021. The deal showcases how the property owner repurposed an obsolete office building to capitalize on tight industrial supply, rising rents and soaring demand by logistics tenants.