What’s behind the office sector’s record vacancy rates: Economist

According to a Moody’s report, office vacancy rates set a new record of over 20% in the second quarter. Report author and Moody’s CRE economics chief Tom LaSalvia joins Market Domination to provide insight into the report and detail the thinking behind these record numbers.

LaSalvia expands on the shift in office use: “We think of it as obsolescence, that there’s a good 10 to 20 percent of office buildings that just won’t be able to compete in this new era, this era of remote work, this era of new offices, this era of new, let’s say, power centers in terms of office-centric locations, right? There’s a migration to the Sunbelt. You see that even in metropolitan areas like New York, some submarkets are doing much better than others. And so you’re left with 10 to 20 percent of obsolete offices that are going to have to find new life in this new era.”

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This post was written by Nicholas Jacobino

Video Transcription

In the second quarter, the office vacancy rate reached a record level of 20.1%.

For the first time in history this sector exceeded 20%.

This is according to a new report from Moody’s, co-authored by Tom Lasalvia, head of CRE Economics and Moody’s Tom.

Good to see you.

So look at this preliminary second quarter trends report, Tom, you say listen up because the vacancy rate in this sector is a record 20.1%.

How will this rate change further, Tom, let’s say in 6, 12 months.

And on what factors, on what variables does it depend?

Yes, unfortunately for office property owners, the vacancy rate continues to rise.

Our latest research suggests that as remote work becomes more common, we can expect a vacancy rate of 22–24% at the peak of the crisis, which will likely occur in 2025 or perhaps even early 2026.

So as the situation develops, we will have to wait a few more years of growing anxiety.

One of the key variables here will of course be office employment, and we know that the job market is starting to stabilize.

Another key variable here is remote work, which, as I mentioned earlier, is here to stay, at least at some level.

Normal.

I think we will still have to go through a period of trial and error that will last many years.

But we know that square footage per employee is going to continue to decline, and Tom, when you say peak office vacancy rates of 22% to 23%, I want to say that you said it was around 20% in the second quarter.

The story continues

So from this point on it will only get better.

So what will the long-term vacancy rate be?

Normal?

In other words, how long can it stay at 22 or 23%?

Is this the new norm?

It’s a great question, given the way we think about it as obsolescence, that there’s a good 10-20% of office buildings that just won’t be able to compete in this new era, this era of remote work, this era of new offices, this era of new, let’s say, power centers in terms of office-centric locations, right?

I mean, the migration to the Sun Belt, you see even in metropolitan areas like New York, certain submarkets are doing much better than others.

And that leaves 10-20% of outdated offices that will have to find new life in this new era, right?

They will have to follow in the footsteps of many B and C class shopping malls of the last 30 years.

And you see this?

I mean, that was one of the major trends that was often talked about, which was that office buildings would be converted into residential buildings, for example.

I mean, when you do the research, does that actually happen?

Because it seemed like it would take a huge bureaucracy to accomplish that, didn’t it?

Is that, is that a trend that we’re seeing that’s actually working, the combination of those two things, that’s a trend that we’re seeing, right?

And we saw it.

I think the Financial District in New York City post-9/11 is a great example of how you can take at least older office buildings with smaller ground floors and turn them into valuable residential properties.

So there is a precedent for this.

I think the problem comes when you’re dealing with office buildings from the 1970s and 1980s that don’t have a lot of natural light coming into the core of the buildings. That’s where the real financial issues come in that make it impossible to do this type of renovation.

And where does that leave us, since we have a lot of subsidies, a lot of public-private partnerships to transform some of these old office buildings from that era? Tom, finally, I wanted to ask you about a report that came out in the Wall Street Journal today that talked about potential fraud that was driving up valuations on some of these office properties. Now, as the market is pulling back, maybe those frauds have been exposed.

I’m curious how big of a problem you think this is in the market and how it will impact what we see in the future?

Well, what I can say about it is that there were a lot of extensions, a lot of modifications, a lot of work on loans, a lot of off-trade activities, whether they were on the loan perspective or the same perspective, and they did not allow any price to be set.

So whether it’s fraud or not, falsifying the books or whatever, a lot of this could come to light in the next year or two, because again, especially if a particular building is deemed obsolete in this new world, right?

What’s next?

Will there be some liquidation of these assets and the truth about what the actual occupancy and rent levels are going to be revealed?

What are the revenues, what are the management costs, right?

What happens to each of these properties?

So pricing is going to be a really important thing because of the unrest that we can expect next year.

I think over the next two years we’ll see a lot more price discovery and a lot more detail on some of these properties.

Tom La Salvia, here’s a pretty good snapshot of the office market.

Thank you very much.

I appreciate it.

Thank you.