The COVID-19 pandemic has profoundly altered the landscape of the office real estate market. As companies adapted to remote work and hybrid models, the demand for traditional office spaces shifted dramatically. This article explores the key factors that have influenced the office real estate market post-pandemic, including the impact of cost of living, lease expirations, investment trends, and lease negotiations.

The Impact of Cost of Living on Office Demand

Housing Prices and Office Occupancy

The cost of living, particularly housing prices, has emerged as a significant factor in office space demand. Metropolitan areas with high median home prices have seen a notable decline in office occupancy rates. According to data from the National Association of Realtors, markets with a median home price above $600,000 experienced an aggregate decline in office occupancy of more than one percent of inventory over the past 12 months.

San Francisco, with a median home price nearing $1.3 million, exemplifies this trend. The city has seen a decline in office occupancy of over 4% in the past year, making it an outlier among major U.S. markets. However, this correlation extends beyond San Francisco; every major U.S. office market with a median home price over $600,000 has recorded negative net absorption, indicating a broader pattern where high housing costs are driving down office space demand.

Apartment Rent as a Cost Indicator

Apartment rent, another critical measure of the cost of living, also influences office demand. Markets with average asking rents below $1,500 per month have experienced negligible negative absorption, whereas those with average rents above $2,000 per month have faced office occupancy losses approaching one percent of inventory.

High-rent coastal gateway markets such as Boston, Los Angeles, New York, San Jose, Seattle, and Washington, D.C. have all seen shrinking office demand. However, there are exceptions. For instance, Miami and Fort Lauderdale, despite their high rents, have recorded positive office absorption. Conversely, cities like Atlanta, Chicago, and Denver, with moderate apartment rents, have experienced negative office absorption, indicating that factors beyond rent also play a role in office space demand.

Household Income and Office Performance

Household income further underscores the relationship between the cost of living and office performance. Major markets with lower median annual household incomes tend to have better-performing office markets. Cities like St. Louis, Houston, Fort Lauderdale, Las Vegas, San Antonio, and Miami, all with median household incomes below $80,000, have shown robust office performance.

In contrast, of the 12 major markets with median incomes above $100,000, only Long Island has seen positive office absorption in the past year. This suggests that higher-income areas, often with higher living costs, may be more prone to declines in office space demand.

Lease Expiration and Its Implications

The Slow Adjustment of Office Leasing

The long-term nature of office leasing has slowed the market's adjustment to the changes in office utilization triggered by the pandemic. This has helped building owners preserve some income from in-place tenants. However, with demand for office space slow to recover, the lease expiration calendar suggests that more challenges lie ahead for landlords facing lease rollover risk.

Most leases that were active during the first quarter of 2020 have expired, meaning tenants have already decided whether to renew or move out. Nationwide, only 20% of office leases that were outstanding at the beginning of April 2020 are still active. However, the remaining leases represent 44% of the space held by office leaseholders in early 2020, indicating that renewal decisions still loom for nearly half of the space initially leased before the pandemic-induced disruption in demand.

The Risk of Lease Rollover

The reality is even more stark for owners of large, multi-tenanted office buildings dependent on leasing big blocks of space. Historically, lease deals of at least 10,000 square feet have accounted for approximately half of all office space leased, though they represent less than 10 percent of transactions. Within this subset, nearly 46% of leases executed before the pandemic have yet to expire, putting about 55% of big-block space at risk of churn.

Major cities are particularly exposed to the rollover risk from large leases. Boston, New York, and Philadelphia still face the expiration of over half of all space leased before April 2020, including more than 60% of office space from leases over 10,000 square feet. Similarly, Chicago, San Francisco, Seattle, and Washington, D.C. have significant portions of large-block space yet to expire. In total, 20 of the country’s largest cities are at risk of large lease expirations comprising at least 40% of the office space with active commitments as of early 2020.

The implications for the office sector are significant. Since 2022, office leasing volume has stabilized at levels well below those seen before 2020. This stabilization has not been enough to counterbalance move-outs and consolidations, which have also accelerated since 2022. If these trends continue, the expiration of more pre-pandemic leases will likely lead to further increases in vacancy rates, already at record highs.

Investment Trends and Market Liquidity

Decline in Investment Activity

Investment activity in the office real estate market has experienced a significant downturn, particularly in historically robust markets like Orange County. Elevated capital costs and operational risks have curtailed investment, leading to the market’s lowest quarterly sales volume in over a decade. In the first quarter of 2024, fewer than 50 deals closed in Orange County, driving just $170 million in sales volume—less than half of the historical average and a 70% decline from previous averages.

While buying activity from institutional investors and real estate investment trusts has slowed dramatically, owner-user acquisitions have seen a relative uptick. These acquisitions, which involve businesses purchasing buildings for their own use, have accounted for 17% of buyer volume over the trailing year, nearly doubling their historical share. Examples include MicroVention's purchase of 45 Enterprise in Aliso Viejo for $44.25 million and New American Funding's acquisition of 1 MacArthur Place in Santa Ana for $31 million.

Despite these instances, overall market sentiment remains bearish, with many owners hesitant to sell at today’s depressed prices unless compelled by impending loan maturities. This reluctance is likely to limit purchase opportunities and maintain sluggish sales activity in the upcoming quarters.

Owner-User Acquisitions

The rise in owner-user acquisitions reflects a strategic shift as businesses look to secure office space at favorable prices while customizing properties to their specific needs. MicroVention's acquisition of 45 Enterprise, a Class A, 243,000-square-foot building adjacent to its headquarters, highlights this trend. The building was purchased for $182 per square foot, a considerable discount from peak pricing in 2020.

Similarly, New American Funding's acquisition of 1 MacArthur Place in Santa Ana underscores the trend. The 208,000-square-foot building was acquired for $149 per square foot, and the company’s co-founder plans to occupy significant portions of the property, enhancing its utility for the business.

Overall, office pricing in Orange County has averaged $190 per square foot for assets traded this year, significantly lower than the $350 per square foot peak in 2020. This trend indicates that prospective investors and users willing to accept lease-up risks can find attractive pricing compared to previous years.

Pricing Trends and Market Outlook

The current pricing trends in the office market suggest that users and investors are cautiously navigating the uncertainties of the post-pandemic landscape. The sharp decline in average prices per square foot reflects the broader market’s adjustment to new realities, including higher vacancy rates and reduced demand.

Most market participants anticipate continued sluggish sales activity, with few owners motivated to sell under current conditions unless facing financial pressures like loan maturities. This environment is expected to persist, further challenging market liquidity and investment dynamics in the near term.

Lease Negotiations and Term Lengths

Shortened Lease Terms Post-Pandemic

The COVID-19 pandemic introduced unprecedented uncertainty into the office leasing market, prompting tenants to avoid long-term commitments. By the end of 2020, the typical lease term for large office spaces had shortened by nearly nine months compared to mid-2019. This trend was particularly pronounced for leases of at least 10,000 square feet, although smaller leases also saw a reduction in term lengths.

The Return to Pre-Pandemic Lease Lengths

Despite the initial shift towards shorter lease terms, the market has shown signs of stabilization. By the end of 2022, the typical term for large office leases had returned to nearly seven years, closely aligning with pre-pandemic averages. Smaller leases still tend to have shorter terms, while medium-sized leases have slightly longer terms compared to their pre-pandemic counterparts.

A significant factor driving the return to longer lease terms is the demand for new buildings. Tenants have been attracted by generous lease concessions from landlords, particularly tenant improvement allowances that enable tenants to customize spaces. In exchange for these concessions, tenants have been willing to commit to longer lease terms, allowing landlords to amortize the cost of concessions over several years.

Market-Specific Lease Trends

While the overall trend points to a return to pre-pandemic lease lengths, notable variations exist across different markets. For instance, in San Francisco and Seattle, the average term for large leases has decreased by more than a year compared to 2019. In San Jose, the average term for large leases has shrunk by more than 2.5 years, indicating a significant reduction in commitment from tech companies that previously dominated these markets.

In contrast, other markets have seen lease terms rebound to pre-pandemic levels despite lower overall leasing volumes. This discrepancy highlights the uneven recovery and varying market dynamics across the U.S. office real estate landscape.

The Tenant's Advantage in Lease Negotiations

Record-High Space Availability

With record-high space availability, office tenants are in a strong negotiating position. The surplus of available office space has allowed tenants to secure favorable lease terms and concessions from landlords eager to fill vacancies. This trend has become particularly evident in markets where high vacancy rates have persisted since the onset of the pandemic.

Leveraging Long-Term Commitments

Despite the tenants' advantage, owners of market-leading office buildings still possess leverage, particularly through their ability to extract long-term commitments. At the height of the pandemic, office tenants were reluctant to make long-term commitments due to the unprecedented uncertainty. As a result, average lease terms, especially for larger leases, shortened significantly.

However, by the end of 2022, the typical term for large office leases had nearly returned to pre-pandemic levels. This rebound is largely due to tenants seeking new buildings and benefiting from generous lease concessions, such as tenant improvement allowances. These concessions have incentivized tenants to commit to longer lease terms, allowing landlords to spread the cost of concessions over several years.

Smaller Leases and Shorter Terms

The notion that lease terms are generally getting shorter is not entirely without merit. The majority of leases today are smaller than they were a few years ago, with shorter terms typically associated with smaller leases. Before 2020, over half of office leasing volume came from leases of at least 10,000 square feet, whereas now, the share of large leases is closer to 45%, while smaller leases make up nearly 25%.

Market-Specific Trends in Lease Negotiations

Nuances in lease term trends vary across different markets. For example, in San Francisco and Seattle, the average term of large leases has decreased by more than a year from 2019 levels. In San Jose, the reduction is even more pronounced, with average lease terms for large deals shrinking by over 2.5 years. This decline suggests that tech companies, which previously anchored these markets, are now more cautious about long-term commitments.

Conversely, other markets have seen a return to normal lease lengths, even as overall leasing volumes remain subdued. This disparity underscores the uneven recovery and varying dynamics within the office real estate sector across the U.S.

Future Outlook and Strategies for Stakeholders

Summary of Key Findings

The post-pandemic office real estate market is characterized by significant shifts influenced by the cost of living, lease expirations, investment trends, and lease negotiations. High living costs in major metropolitan areas have contributed to declining office demand, while the long-term nature of office leases has slowed market adjustments. Investment activity has declined, with a notable increase in owner-user acquisitions, and lease negotiations have evolved to favor tenants, albeit with some leverage retained by landlords.

Strategies for Landlords

Landlords must navigate the complexities of the post-pandemic landscape by adopting flexible strategies. Offering generous lease concessions and tenant improvement allowances can attract tenants and secure long-term commitments. Additionally, focusing on enhancing building amenities and adapting to hybrid work models can make office spaces more appealing to potential tenants.

Strategies for Tenants

Tenants are in a prime position to negotiate favorable lease terms due to the high availability of office space. They should leverage this advantage to secure concessions such as rent reductions, flexible lease terms, and tenant improvements. Moreover, tenants should evaluate the benefits of committing to newer buildings with modern amenities and infrastructure that support hybrid work models.

Market-Specific Considerations

Stakeholders should remain attuned to market-specific trends and conditions. In markets like San Francisco, Seattle, and San Jose, where lease terms have shortened significantly, tenants may find more negotiating power. Conversely, in markets where lease terms have normalized, landlords may retain more leverage, necessitating different strategies.

Long-Term Outlook

The office real estate market is likely to continue evolving as stakeholders adapt to the new normal. The trends observed post-pandemic suggest a gradual recovery, with variations across different markets. Stakeholders must remain agile, responsive to market conditions, and proactive in their strategies to navigate the ongoing changes and seize opportunities in the evolving office real estate landscape.