If Remote Working is Here to Stay, What Happens to Office?

Key Takeaways:

• Amid the widespread acceptance of a hybrid workplace model, office demand is declining and beginning to expose a glut of marginal /obsolete office space within the U.S.
• Lenders will need to evaluate the assets, markets, and sponsors to find solutions that generate the most value for these at-risk buildings.
• Each case will differ depending on circumstances, but resolutions include recapitalization, “extend and pretend”, and conversion/redevelopment to other uses.

 
Few people could have predicted how the pandemic-induced shut down of the economy three years ago would have such a lasting impact on work patterns and office space utilization. While the immediate collapse of demand in the lodging was expected, as was the reduced foot traffic within the retail centers, these asset classes have largely rebounded. Offices demand remains depressed and directionally uncertain.

After office utilization rose to 50.4 percent in late January – the highest level since the start of the pandemic – however it retreated nearly five percentage points in early February amid winter storms in Texas, according to Kastle Systems, an access control company that is tracking office keycard swipes in 10 major markets, including New York, Chicago and Houston. While some have criticized Kastle’s return-to-office barometer for its limited scope, a JLL survey found that 53 percent of corporations planned to make remote working permanently available to all employees by 2025.

These trends underscore the widespread notion – one that I subscribe to – that the hybrid work model is here to stay. Some office investors and lenders are holding out hope that the movement is a fad and will end when a recession grants companies the leverage needed to force employees back into the office. While that is a possibility, companies may still operate on a hybrid working model to control costs and retain key staff during an economic slowdown.  This would not change the fact that U.S. has a secular glut of office space.

Flight to Quality

Following four consecutive quarters of positive demand/space absorption, the US office market recorded 5.9 million square feet of negative absorption in the fourth quarter of 2022, according to CBRE. Corporations returning space to the market combined with new supply totaling 7.3 million in the quarter drove the vacancy rate to a 30-year high of 17.3 percent.

Does that spell the end of the office? Hardly. The most significant revelation about the fourth quarter plunge in demand is that it occurred exclusively in offices built before 2010 – absorption in newer buildings remained positive, CBRE reports. So, while office users in the future may occupy less space, it appears that they will gravitate toward more modern and high-quality buildings (“flight to quality”).  

Consequently, office owners, investors and lenders are confronting the same decision that the lockdowns forced hotel and retail owners and lenders to contemplate a couple of years ago: How do we resolve assets that have near-term balloon payments – or are already delinquent – and that may be functional but can no longer command the rental rates needed to service their debt? And what do we do with obsolete assets?

Making that determination requires thoughtful analysis. In some cases, figuring out a way to reset the basis and rental rates to reflect today’s lower value may be a solution. In other cases, repurposing buildings for an alternative use may be the only viable strategy.

Start Evaluating

For lenders, the assessment focuses on the sponsor, the asset, and the location. Is the sponsor well-capitalized? How old is the asset? When are leases expiring and what are the tenant’s intentions? What condition is the building in and how competitive is it – does it have the amenities that today’s tenants demand? Are rental rates and concessions in the market rising or falling? Similarly, is job creation trending higher or lower? If it is the latter, is it temporary due to layoffs in an otherwise strong tech, or is it structural, such as the consolidation and relocation of certain sectors? These are important questions in these challenging times.

If lenders ultimately have a favorable impression of the sponsor, property and market, the next step is to determine how best to work with the borrower. Some sponsors may be willing to invest additional capital in an asset or bring in new investors / recapitalize to secure refinancing. Some lenders could also take an “extend and pretend” approach to allow for a potential increase in leasing over time. Sponsors that have recently completed certain green upgrades may qualify for property assessed clean energy (PACE) financing, which could provide funds to pay down traditional debt.

More negative assessments, or in cases where an owner has already returned the keys to the lender, likely will require examining alternative uses. Repurposing offices into multifamily has become popular, but such conversions won’t work for all office floor plates can be expensive.  Success is not guaranteed.

Zoning laws can make it difficult to change a building’s use as well, although some municipalities are encouraging conversions to create more housing. In fact, New York Mayor Eric Adams is urging more flexibility in office-to-apartment regulations that would affect 136 million square feet of outdated office space in the city. Still, in many situations, the solution will generate a loss, whether the lender works with the existing sponsor or auctions the loan to a new investor group.

Navigating Change

There is little doubt that widespread acceptance of a hybrid workplace model is providing an improved work-life balance for many people. It is a benefit that few are willing to give up. Unfortunately, it has also exposed the fact that the U.S. has too much office space – especially marginal or obsolete space. The change has put owners of those buildings, and their lenders, in a difficult spot. But by evaluating their situations today, owners and lenders have a better chance of identifying opportunities to maximize value and avoid more pain down the road, when options may be even more limited.