Office vacancies are at an all time high

Office vacancies are at an all time high.

"The office sector has broken its previous vacancy record set just a quarter ago," and is nearing the 20% mark, according to Moody’s. In the first quarter of this year, the office vacancy rate reached 19.8%, up from 19.6% in the prior quarter. This new record-high vacancy rate is 50 basis points "above the recessionary peaks recorded in 1986 and 1991," an analysis published earlier this week revealed.

All commercial real estate is susceptible to higher interest rates, especially after a period of low-cost borrowing. This is the primary cause of distress within the industry. Capital Economics, a research firm, estimated a $590 billion loss in commercial real estate property values last year, followed by another $480 billion decline this year. Analysts at Morgan Stanley once predicted something "worse than in the Great Financial Crisis" for commercial real estate. Furthermore, offices are facing challenges stemming from the pandemic-induced trend of remote work.

The previous peaks in 1986 and 1991 "occurred under notably different market conditions than today, highlighting today’s vacancy rate peak as a result of shifting working styles," said Nick Luettke, coauthor of the analysis and associate economist. "The two historic peaks came as a result of underlying macroeconomic conditions. The 1986 vacancy rise came as the result of surging supply with high construction levels, while 1991 came as a result of the previous decade of construction fusing with greater economic uncertainty at the time."

Currently, the situation can be simplified as follows: if people are working from home, they are not working in an office. Despite the emergence of hybrid work models, the need for physical office space has decreased, leading to record-high office vacancies. "Another quarter of vacancy increase emphasizes the long-term ramifications of hybrid work models, despite positive employment and GDP trends in the current economic cycle," the report stated. Effective rents also decreased by 0.04% in the first quarter.

Kevin Fagan, head of commercial real estate analysis at Moody’s, previously stated, "The story of the office isn’t a story of mass obsolescence, it’s more of an 'it’s going to take time for it to normalize and discover what it is in the future.'"

The analysis from this week noted that some companies are doubling down on office space, which explains the "slow bleed" in the sector. San Francisco's office sector, in particular, is showing signs of recovery due to the growing interest in artificial intelligence. "San Francisco went through a very low low, and we heard words of doom loop, and now we’re going through what I think a lot of people see as just the nascent beginning of a recovery," said Alexander Quinn, senior director of Northern California research for JLL, a real estate services company. By the end of last year, AI companies had leased 3.9 million square feet of office space, a 50% increase from the previous year, making up roughly 28% of leasing activity within the office space.

So, while offices have not become obsolete, they still face challenges. Capital Economics expects office values to fall by more than 40% peak to trough by the end of 2025, with no recovery expected even by 2040, as of the end of last year. Fagan previously mentioned that vacancies would start to decline next year, but this year would still be challenging for the sector given the impact of vacancies on rent growth. Thus, it remains unclear if office vacancies have reached their peak in this current cycle.

"The doomsday scenario has yet to play out as financial, company culture, and collaboration explanations made by many companies underscore the salience of local, in-person footprints for many firms," the authors of the Moody’s analysis concluded. "With significant lease rollovers and shifting interest rate expectations, uncertainty remains over exactly when office vacancy rates will truly peak."