The U.S. office sector is still recovering. A recent Commercial Edge report found that the office construction pipeline has fallen by nearly 40% over the past two years, a trend that is likely to continue due to financing challenges, rising construction costs, and weak demand. Vacancy rates are still trending upwards in many markets, reaching 18.2% nationwide as of the end of March, according to the same source.
Still, hybrid schedules that offer employees more flexibility and access to popular amenities are bringing some office dwellers back, especially in Class A office buildings. The flight-to-quality trend is spreading across the country and shaping the future of the office sector. How are US investors and landlords responding? We spoke to Giovanni Cordobes, Western Region President at KBS, for his thoughts.
It's been more than four years since that incident that shook the U.S. office market to its core, but how do you assess the current U.S. office market?
Cordobes: The recovery of the U.S. office market has been very mixed. Performance has varied significantly by region, submarket, city and office building class. Rising interest rates have impacted nearly all commercial real estate, including office properties, and are now creating significant refinancing challenges. Class A buildings have, for the most part, seen favorable rents and higher office occupancy rates than less favorable buildings. This is likely due to a consistent trend of tenants seeking higher quality, better located, better amenity buildings.
Sideline capital continues to grow as many people wait for interest rates to fall and see if prices will stabilize before making their next move. Owners are weathering the crisis until they can refinance at more favorable rates. But some are choosing to exit the market, either by selling their properties at a loss or looking for buyers.
To what extent has the gateway market office sector rebalanced, and to what extent have office vacancy rates recovered in large U.S. markets since the peak of the health crisis?
Cordobes: Larger U.S. markets continue to lag behind gateway markets in office vacancy rates, likely due to regional responses to the health crisis, but most employers are still seeking office space to adapt to changing workplace environments, including hybrid and work-from-home setups.
Sunbelt markets are leading the way in workers returning to the office full-time, highlighting the clear market-driven bifurcation that exists between these markets and larger metropolitan areas like San Francisco and New York City. Even among these gateway markets, the return to anything resembling pre-pandemic normalcy varies widely. That said, office occupancy rates, especially during midweek (Tuesday, Wednesday, Thursday) hours, have risen steadily across the country, highlighting the need for office space; be it leasing new space, renewing current leases, or in many cases, renovating and expanding to accommodate the changing needs of employees.
Are there any particular trends in the office sector that you are seeing across the country?
Cordobes: In today's market, creating a very tenant-friendly environment is key to attracting and retaining tenants.
We pride ourselves on offering a unique amenity package for each of our properties. We have integrated numerous creative outdoor spaces that seamlessly integrate with our indoor amenities, and we have also added retail and dining options, gyms, meeting facilities, and tenant lounges to numerous assets across the U.S. From the visible amenities mentioned above to behind-the-scenes features like smart office technology, digital connectivity, and state-of-the-art HVAC systems, many of these enhancements are no longer just luxuries but have become tenant expectations.
Despite these efforts, office space availability in the United States is uneven and depends on a variety of factors, including regional characteristics and the primary industries in each metropolitan area. Which office markets are thriving right now, and why?
Cordobes: The success of any office property depends on market-specific factors. According to Brookfield, 90% of U.S. office vacancies are concentrated in the bottom 30% of buildings, many of which are older offices with limited amenities and declining functionality. In contrast, the top quartile of office buildings is seeing record rents and stable vacancy rates.
For example, in Chicago, where Colliers reports an office vacancy rate of 24%, leasing activity remains strong for trophy and Class A buildings. Accenture Tower, KBS's mixed-use facility, has achieved higher leasing momentum than pre-pandemic, with the 1.4 million square foot property now nearly 100% leased. The building's leasing velocity is due in part to multi-million dollar renovations completed during the pandemic, including improvements to tenant lounges, retail and restaurants, as well as the addition of health and wellness amenities. The property offers easy commuting with immediate rail and elevated rail access, and is home to hundreds of employees and thousands of daily commuters.
Overall, major Texas markets continue to perform well due to population growth and corporate relocation, but as is the case in most markets, certain locations and regions are performing much better than others. Certain submarkets, such as Austin's CBD, are experiencing significant new office development, weighing on supply and demand fundamentals and putting additional pressure on landlords.
We believe in consistently improving our properties each year to support leasing activity. This is part of our ownership strategy. One recent example is the Sterling Plaza property in Dallas' Preston Center micromarket. The property recently completed a multi-million dollar renovation that includes an all-new cafe, a state-of-the-art new conference center, a more convenient new administrative office, and an ultra-modern new fitness center. The property continues to see strong leasing activity. Occupancy at the asset has increased from a low of 80% in January 2022 to 97% at the end of 2023. Perhaps more importantly, net rent achieved during that period has increased by approximately 20%.
Meanwhile, what office markets are still performing weakly?
Cordobes: According to JLL's U.S. Office Outlook, cumulative net absorption in buildings since 2015 is positive at 133.2 million square feet since 2020, compared with negative 130.4 million square feet for properties built in the 1980s. In other words, older Class B or C buildings are underperforming, more or less regardless of the market in which they are located. Additionally, office starts have stalled in many markets, potentially increasing demand for existing, well-managed buildings that are better at attracting and retaining tenants, which is essential to sustaining performance.
Are there any US markets emerging as hotspots for office investment and which ones does KBS see potential?
Cordobes: Investment is driven by the details of the deal, not the market. In general, most markets in the Southeast continue to see strong investment activity. However, there are a number of investment hotspots in the region, including Preston Center and Uptown in Dallas, Cherry Creek in Denver and Century City in Los Angeles. From an investment perspective, the investment bright spots can be very difficult to get into, but investors, developers and others remain bullish on the future of properties in these hotspots. Regardless of the city or region, great assets in great locations that attract tenants will always be considered hotspots to us.
Given the current economic climate, have there been any changes to your office investment strategy? What types of assets are you targeting?
Cordobes: While market uncertainty is impacting liquidity, our overall investment strategy remains unchanged. Our acquisitions team continues to seek properties to add to our clients' portfolios, finding the right asset mix as well as exploring the right capital structure to fund acquisitions.
Buying or selling office assets in the current environment is certainly a difficult decision given the challenges in the lending market. That said, each asset must be analyzed carefully and many factors considered, including remaining lease or loan terms, capital life, and other factors that may lead some to choose to move assets now despite the headwinds. We consider these risks in our investment strategy and strive to build a portfolio that can withstand changes in the economy.
So what does the future of the office look like? Is hybrid here to stay, or should we expect a full return to an office-working model in the not-too-distant future?
Cordobes: While some workers have become accustomed to flexible working arrangements, employers are successfully implementing full-time and hybrid working arrangements. We are already seeing employers seeking office space in best-in-market buildings.
A complete “return to the office” is not necessarily key to the future success of the office sector. If the trend for higher quality space and better amenities continues, tenants may require less space but will be willing to pay more for it. At KBS, we have seen strong leasing across much of our portfolio over the past year, driven primarily by the strategic capital improvements we have made at our properties. We continue to undertake capital improvements to our properties each year, not only to maintain our properties but also to provide our tenants with the best amenities available in the market.
This article first appeared on Commercial Property Executive