By Todd C. Monahan, Wolf Commercial Real Estate, LLC/CORFAC International
The recessions of the early 1990s, following September 11, and after the 2008 financial crisis affected the office market in different and negative ways, but none compare to the devastation caused by the COVID-19 pandemic. The ripple effects of hybrid work policies and corporate downsizing continue to negatively impact the office market, and no clear resolution is in sight.
Although vacancy levels are at historic highs, it is not clear if the market has reached bottom.
Many occupiers are marketing their space as available for sublease. But when the lease expires, will the original tenant renew the lease and return to that office or simply give the keys back to the landlord? Some opportunistic tenants are capitalizing on the sublease market, leasing these spaces at steep discounts. However, many are downsizing and vacating larger spaces in the process.
Tenants that are committed to their office space are downsizing and relocating to better buildings that offer more amenities. The flight to quality is real, leaving inferior and obsolete buildings behind to deal with increasing vacancies.
Examples in Center City Philadelphia include Fox Rothschild’s 40% space reduction from 133,500 s/f in 2000 Market to 80,000 s/f across the street in Two Commerce Square at 2001 Market St. KPMG vacated 134,000 s/f in 1601 Market, relocating to just 97,000 s/f in 1735 Market, a trophy building with first-class amenities, including a private parking garage. Baker Hostetler, another prominent law firm, relocated from the Cira Centre at 2929 Arch to 1735 Market, leasing just 45,000 s/f while vacating 80,000 s/f.
Tenants continue to study their workplace strategies: How they work, where they work, how the office design supports the company, and how to attract and retain talent. This analysis frequently results in less space, steadily increasing the vacancy rate in the market. Landlords cannot accurately predict for their investors and lenders when current vacancies will be leased.
Landlords and their lenders are operating in an extremely challenging environment as the dramatic rise in interest rates in 2023 left them with higher interest payments, or worse an inability to refinance altogether. Lenders want certainty, and landlords are challenged to predict when vacant space will lease, at what rental rate, and with what concessions.
Many lenders have redlined the office sector, leaving owners with few options as their loans mature. In some cases, should the landlord wish to retain ownership, they are required to put up more equity in order to refinance as the loan to value became untenable for the lender. If the Federal Reserve reduces interest rates later this year or in 2025, it will offer much needed relief.
However, the uncertainty will likely remain due to the election and geopolitical pressures around the world. Predicting interest rates at this stage is a fool’s errand.
Owners of obsolete office buildings or struggling assets are faced with turning the keys in to the lender as we’ve seen with Center Square at 1500 Market St., a 1.8 million s/f office complex in Center City. Other buildings, once vacant, have to determine their highest and best use, studying conversion opportunities and frequently selling at steep discounts.
Todd C. Monahan is executive VP & managing director at WCRE | CORFAC International.