Office
CUSHMAN & WAKEFIELD RESEARCH
The U.S. office sector remained the poster child of CRE woes in 2023, but the headlines reveal little about its growing complexity. While at one end of the spectrum there is resilience within the top tier of the market amidst a broad flight to quality, there is an extraordinary concentration of weakness at the other end. Dialing into the outlook for the sector requires peeling apart these layers and understanding that—even in the face of headwinds—there is underlying structural demand for office space along the quality and pricing spectrum.
The ongoing correction in the office sector reflects two distinct themes:
1) the transition to a hybrid work environment means that there is acute downward pressure on demand in the market now as companies adjust, and
2) moving forward, there will be structurally lower demand for office space (per additional office worker).
đź“Ł David Smith, Head of Americas Insights
As our prior research shows, office-using sectors, and knowledge work in general, are a growing share of the workforce, which have countervailing impacts on hybrid work’s structural demand erosion.4 In other words, we are in the midst of a transition period, but a new norm will emerge. As it does, continued job growth will ultimately drive demand for office space higher. This transition period will be painful as it will result in a portion of the office stock being rendered competitively obsolete. But this portion is limited in size; we estimate that about 330 million square feet (msf), less than 6% of the 5.6 billion square feet (sf) tracked by Cushman & Wakefield, is now obsolete.
The demand destruction caused by remote work will eventually filter all the way through and come to an end. The weighted average lease term in the office sector is about eight years. For Class A, it is closer to eight and a half years; while for Classes B and C, it is closer to seven years. Average lease lengths have not changed materially post-pandemic and currently sit near their 10-year averages. This means that mathematically we are past the “post-pandemic half-way point” for lease expirations in lower quality office space and we are closing in on it for Class A. What expirations do not capture is the significant amount of downsizing that has already occurred through the sublease market, which has accounted for 40% of all negative demand since the pandemic began. Moreover, given the shift to hybrid, many large occupiers of office space have also preemptively ended unnecessary leases or downsized them well before the original lease expiration. In this way, firms are “pulling forward” behaviors that would otherwise occur when a lease ends.
Thus, even as the economic outlook points to greater economic challenges next year, we expect the magnitude of negative demand to lessen from -86 msf this year to -55 msf in 2024.
By 2025, our modeling indicates that most firms will have completed their downsizing, allowing for the relationship between job growth and demand for office space to reestablish itself, and the office sector will begin to register positive absorption once again. From 2025 through 2033 (the end of our 10-year horizon), we expect 222 msf of net absorption to be realized.
Much like the trends observed over the last few years, the office recovery will remain highly uneven. Top tier office product—the top 10%-15% of any given market—has consistently outperformed lower quality product since 2020, registering 100 msf of positive net absorption. These assets are mostly new construction or recently renovated assets with a multitude of amenities, typically in prime locations. However, given the tight lending conditions and higher cost of borrowing due to the rapid rise in interest rates, the supply pipeline of new buildings is quickly shutting down. Thus, the highest quality product that was delivered to the market stands to benefit and is expected to experience very strong lease up. Demand will eventually trickle down and will be joined by value-minded occupiers, fueling stronger leasing activity for lower quality Class A and Class B/C buildings. It is important to recognize that not all occupiers require or even desire “trophy office” space. Since Q2 2020, there has been 261 msf of leasing activity in non-Class A buildings, which accounts for roughly one-third of total U.S. leasing. This one-third portion is on par with the pre-pandemic norm, so despite the flight to quality mantra, there continues to be a large market for less-than-trophy product. This is not to diminish the reality that the vast majority of poorly located lower quality buildings will remain under significant pressure. It is to simply acknowledge that there is a need for a range of office space quality for a diverse occupier base.
In our baseline, U.S. office vacancy peaks in early 2025 at 21.5%, up another 210 basis points (bps) from today’s 19.4%. Rents typically lag vacancy. First, demand stabilizes and turns up and then vacancy begins to erode. As vacancy tightens, we typically see rents inflect and turn higher—there’s typically a two to three quarter lag from the time vacancy begins to decline to when that triggers rent growth. We estimate effective rents will decline another 5.4% in 2024, bringing the total peak-to-trough decline to 23%. Effective rent growth will resume starting in the second half of 2025. As we noted earlier, there has been a notable drop-off in new construction of office buildings driven by higher costs of construction and capital, as well as tighter credit availability. After peaking in Q1 2020 at 135.2 msf, the office pipeline has receded by more than 50%, sitting now at 63.5 msf with little promise of a pickup anytime soon. From 2025-2027, we estimate new construction will average under 10 msf per year—well below the historic norm of 53.4 msf (the 1995-2019 average).
This historically low level of new development mid-decade will shift the focus to renovations of the existing stock. The amount of office buildings undergoing significant investment and renovation (not including conversions to another use) has more than doubled since the end of 2019. There is currently 11.4 msf of office stock under renovation, up from 5.6 msf in 2019. In the intervening timeframe, there have been 22.6 msf of renovation completions. Converting office stock to another use is difficult and costly, and while it may be appropriate for some buildings, the reality is that there is a growing appetite to upgrade the existing stock, which is manifesting as repositioning via renovation. This appetite will only grow as buildings’ cost basis get reset over the next 18 to 24 months.
As we look at the future of office, the nuance in the market needs to be fully appreciated. Headline statistics and forecasts mask an incredible degree of variation. As mentioned, we are further along in the hybrid work transition than is often acknowledged and still over half of all U.S. office buildings are fully leased; 90% currently have zero available sublease space. In 46% of office buildings across the country, overall vacancy has not changed since Q1 2020. In another fifth of buildings, overall vacancy has actually compressed. Headline statistics are no longer enough—understanding the complexity of the market will be critical for owners and occupiers to form successful strategies around the office sector as micro themes dictate performance over the coming years.
