Office vacancy expected to rise in coming months as more than 100M square feet remains under construction

Office vacancy expected to rise in coming months as more than 100M square feet remains under construction

The U.S. office market’s vacancy is expected to continue to climb — and surpass previous downturn cycles — in the coming months.

At the end of the second quarter, 107 million square feet of office construction was under construction nationally, according to Dallas-based CBRE Group Inc. Most of the office projects delivering this year were started pre-Covid-19, in a vastly different office landscape where remote work wasn’t uncommon, but not to the level of ubiquity it is today because of the pandemic.

The national vacancy rate — 16.5% at the end of the second quarter, according to CBRE — is expected to rise as supply continues to deliver in an environment where leasing activity hasn’t come back to pre-pandemic levels. Overall office absorption has remained negative this year.

To be sure, some of that new supply has tenant commitments in hand from preleasing efforts. Still, a lot of space will hit the market in 2021 and 2022.

“When you think about all of the uncertainly surrounding office and remote work, there’s a bit of concern there, especially when the national vacancy rate is trending toward 19% or 20%,” said Tom LaSalvia, senior economist at New York-based Moody’s Analytics.

Moody’s is forecasting the national office market vacancy to peak at 19.5%

But supply and demand dynamics can vary dramatically, depending on market. Atlanta metro at the end of Q2 had one of the highest vacancy rates among major markets, 21.3%, and is No. 7 in the amount of office construction underway, CBRE found. But it was the fourth-highest market in terms of employment growth in office-using industries through June 2021.

CBRE projects national vacancy will peak at about 18.5% in mid-2022. That’s considerably higher than peak vacancy during the Great Recession, at 16.8%, and the dot-com bubble, at 16.9%.

Richard Barkham, global chief economist and head of Americas research at CBRE, said roughly half of the cyclical peak of supply is being delivered in the next two years. A little more than 205 million square feet of office space will deliver between 2019 and 2022, the cyclical peak.

Unsurprisingly, new office construction in 2023, 2024 and 2025 will drop off significantly because of fewer new projects starting during the pandemic, and because of how much supply is coming online now and next year.

“There will be demand for offices, and modern offices have to have a range of facilities and work environments that are different from what was normal over the past 10 years,” Barkham said. But “the effects from the Covid crisis, I think, will pretty much suppress development for the next three years.”

Tenant activity and interest have risen this year, particularly this summer, but still aren’t back to pre-pandemic levels. It’s not clear how the Delta variant may factor in to the office market’s recovery, particularly around leasing, but it could push it back a couple of months, Barkham said.

LaSalvia said demand will eventually return because, even if companies reduce their physical footprint in a hybrid work model, many office-using industries are expected to see employment growth in the coming years.

That will, in turn, convert to tenant demand for offices in the coming years, LaSalvia said.

A CBRE occupier survey from April found 70% of companies polled expect a 10% to 30% reduction of their real estate portfolio in the next three years. Ten percent predicted a significantly smaller portfolio, or more than 30% reduction, and 5% expected their real estate size to stay the same. Another 12% expected a moderately larger portfolio, or an increase of 10% to 30%.

Conversions have been popular between multiple asset classes during the pandemic. LaSalvia said it’s possible new office construction could be converted to other in-demand uses, like multifamily. But for most that’ve already broken ground, it’s usually too late to change it to a new use.

Office rents didn’t move tremendously last year, when the impacts of the pandemic were first being felt. But U.S. average asking rent fell 3.1% year-over-year in Q1 2021, according to CBRE, and are expected to continue falling through mid-2022.

It could be that some of the new buildings delivering in 2021 and 2022 will benefit, as tenants in the market are looking for newer spaces that, likely, include technology and wellness features that have become en vogue during the pandemic. That may result in older buildings facing disproportionately high vacancy rates in the coming years.

“Tenants will gravitate to better quality,” Barkham said. “Now is the time for tenants to get good rental rates and deals on brand-new space.”