U.S. Office Fundamentals Remain Week as 2023 Closes
The U.S. office market limped into 2023, and though the economy did not tip into the expected recession, the year concluded with numerous lingering questions regarding the overall health of the office market. During the year, the vacancy rate climbed 120 basis points to 16.9%, easily surpassing the prior peak of 16.3% at the height of the Global Financial Crisis (GFC).
Net absorption, which measures the change in occupied office inventory, declined by 16.9 million square feet during the fourth quarter, resulting in a yearly decrease of just over 68 million square feet. Despite a few quarters of positive absorption in late 2021 and early 2022, the impact of the pandemic has left more than 225 million square feet back on the market, surpassing the 93 million square feet during the GFC.
Among the 79 markets actively tracked by Colliers, nearly 32% recorded positive absorption in the fourth quarter, with Houston, Dallas, and Minneapolis-St. Paul leading. On the other hand, in six markets, negative absorption exceeded 1 million square feet. Seattle had the largest occupancy loss in Q4 2023, with a negative absorption of 2.8 million square feet, followed by San Francisco and Boston, each with a negative absorption of 1.9 million square feet.
While the U.S. office market now has 233.3 million square feet of available sublease space, notably higher than the previous cycle’s peak of 133.3 million square feet in Q2 2009, the supply of sublease space has declined for the second consecutive quarter, after it peaked at 245.5 million square feet in Q2 2023. As businesses continue to assess real estate needs in a post-COVID environment, sublease space will remain an attractive and cost-effective short-term option until there is greater clarity on long-term business strategies. As a result, the supply of sublease space is expected to continue moderating when combined with sublease space that reverts to the landlord after term expiration.
Not surprisingly, the development pipeline continues to drain due to elevated construction and financing costs. Over 39 million square feet of new projects were delivered in 2023, and 72.1 million square feet are underway, 56% below this cycle’s peak of 164 million square feet in Q3 2020. The New York metro area continues to attract the largest ongoing construction, at 8.2 million square feet; then the San Francisco Bay Area, with 7.8 million square feet, mostly focused on Silicon Valley; and Dallas-Ft. Worth, 6.5 million square feet.
Asking rates, by and large, continue to rise despite demand constraints. However, the gap between asking and effective rents remains significant because of generous concessions. For example, across 15 major office markets, the tenant improvement allowance for a new 10-year lease on Class A CBD space averages $124 per square foot, plus 11.3 months of rent abatement.
While there is a growing sense of optimism that the U.S. economy is on firmer footing than a year ago, the outlook for the U.S. office sector is not as clear. Despite CEOs’ desires, the slow and deliberate return to onsite office work appears to be moderating. According to Kastle Data Systems’ Back to Work Barometer, which tracks weekly occupancies based on key swipes in 10 cities, they peaked in early December at 51.6%, up from 48.4% at the same time in 2022.
While it appears most tenants are adopting hybrid working witha minimum of three days a week in the office, tight labor conditions continue to give employees the upper hand, making it difficult for CEOs to push for more office days in the hybrid tug-of-war. Looking into 2024, absorption is expected to remain firmly in the red as tenants reimagine property strategies. They will continue to prioritize building location, amenities, and communal and collaboration areas in their space. When leases expire, most tenants will consolidate space, with many large occupiers reducing space at least 20% to 30%.
Vacancy rates will keep rising, especially for older and outdated assets. Lease rates are poised to experience downward pressure, particularly in markets where distressed assets change ownership. New operators will find themselves with increased flexibility to actively pursue potential tenants.
Lenders will remain active with extend-and-pretend loan extensions, but with $2.8 trillion of loans across all asset classes coming due by 2028, according to Trepp, distress will rise. The significantly higher cost of capital today will mean that many borrowers may need to put more capital into their assets or hand the keys back. As more properties are offered for sale, pricing clarity will emerge and values will be marked down, allowing new owners to be more aggressive in lease terms and asking rates and saving costs for occupiers. As for CMBS delinquencies, that wave has yet to reach land; it took several years after the GFC for delinquencies to peak.
What areas hold promise for growth? We anticipate more pronounced performance gaps and variations in demand, particularly noticeable between trophy and non-trophy assets, but also within and between markets and various industry sectors. Quality will win out as companies strive to create the best working environment to retain and attract top talent and encourage reluctant employees to spend more time in the office. Further, with businesses and consumers prioritizing Environment, Social, and Governance (ESG) initiatives, owners who invest in this space will distinguish themselves from the competition.
Key Observations
Vacancy Approaches 17%
- The U.S. office vacancy rate stands at 16.9%, up 20 basis points from the third quarter.
- Central business district (CBD) vacancy rates rose by 40 basis points in Q4 2023, to 18.0%, while suburban levels increased by 10 basis points, to 16.4%.
- South Florida continues to feature the lowest metro vacancy rate outside of the tertiary markets at 9.92%, followed by Las Vegas (11.1%) and Jacksonville (11.7%).
- Austin has the highest metro vacancy rate at 22.7%, followed by Houston (22.5%) and Boston (21.7%).
Asking Rents Rise Slower
- Average Class A full-service office asking rates rose 2.1% in 2023, to $42.21 per square foot in the fourth quarter.
- Class A asking rates in CBD markets averaged $53.55
per square foot, down 1.0% during the fourth quarter but up 0.8% over the year. Average Class A suburban asking rates are $35.15 per square foot following a 2.1%annual increase. - There is still a notable disparity between asking rates and what tenants actually pay. In various top metro areas, tenants can secure improvement allowances of $100 per square foot or even higher, along with rent abatement periods lasting anywhere from 10 to 15 months for
Class A spaces. - Even with these substantial concessions, some tenants may need to share part of the improvement costs due to elevated construction costs. Although supply chains are easing, fit-out project timelines are still extended, due to skilled labor shortages.
Absorption Remains Negative
- For the second quarter in a row, in Q4 2023 U.S. office absorption totaled negative 16.9 million square feet, and for the year surpassed negative 68 million square feet.
- Less than one-third (32%) of markets tracked in our survey had positive absorption in the fourth quarter, up from 29% in Q3 2023.
- Houston saw the greatest amount of positive absorption at a metro level in Q4 2023 at 752,217 square feet, followed by Dallas-Ft. Worth (501,854 square feet) and Minneapolis-St. Paul (501,704 square feet).
- On the downside, 15 metro markets posted over half a million square feet of negative absorption in Q4 2023, and seven posted over one million square feet. The Bay Area led all markets (negative 3.4 million square feet), followed by Seattle (negative 2.8 million square feet) and Boston
(negative 1.9 million square feet). - On an annual basis, for the second year, the Bay Area was the hardest-hit market over the year (negative 11.2 million square feet). New York was next (negative 8.0 million square feet), followed by Boston (negative 6.4 million square feet), with Seattle (negative 5.0 million square feet) and Greater Los Angeles (negative 4.6 million square feet) rounding out the top five.
- Nashville (675,335 square feet) and Grand Rapids (581,788) were the only two metros with occupancy growth of greater than 500,000 square feet in 2023.
Construction Activity Continues to Slow
- The amount of U.S. office space under construction, at 72.1 million square feet, was 50% below this cycle’s peak of 162.6 million square feet in Q3 2020. In Q4 2023, 5.4 million square feet was completed.
- CBD markets account for 33.1 million square feet underway, while suburbs have 39 million square feet underway. The pace of construction in CBD markets is also greater, equating to 1.5% of inventory, compared with 0.8% in the suburbs. The national level is 1.1%.
- The New York metro area continues to have the most ongoing construction, at 8.2 million square feet, followed by the San Francisco Bay Area (7.8 million square feet) and Dallas-Ft. Worth (6.5 million square feet.)
Sublease Space Retreating From Record High
- The national average of sublease space available declined for the second consecutive quarter, to finish the year at 233.3 million square feet.
- San Francisco still has the highest sublease availability rate in the top 15 markets, at 9.6%. Philadelphia is next, at 9.2%, followed by Silicon Valley, 7.4%. The average across the top 15 markets is 4.7%.
- Class A sublease space is an average of 32.1% less than Class A direct space across the top 15 office markets, analysis reveals, and Silicon Valley leads all markets with a 61.8% discount, followed by Houston at 46.5%.
Investment Activity Slows
- Total office sales volume rose in Q4 2023 to $14.5 billion, up from $11.5 billion in Q3 2023.
- Total office investment in 2023 was $52 billion, down by 56% from 2022.
- Suburban properties continue to attract the most capital, with buyers placing $10.4 billion in assets in Q4 2023 compared with $4.1 billion in CBD locations.
- Average pricing in Q4 2023 was $219 per square foot, at $334 per square foot in CBD markets, and $190 per square foot in the suburbs. Average cap rates are 7.4%, up by 20 basis points from Q3 2023, and further increases are expected in the face of elevated interest rates and, in some cases, asset repricing.
- The most active sales markets by volume in 2023 were Manhattan, at $4.6 billion, followed by Los Angeles ($3.6 billion) and Boston ($2.7 billion).
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