The sector seems to have entered a perfect storm that threatens to bring it down. Christopher Walker reports

Meltdown in the US office market

A chill wind blew through California in early June, as realtors did their math. Wells Fargo finally found a buyer for 550 California Street, which it had purchased in 2005 for US$108m (€79.3m). The 13-storey tower had originally come to market in 2022 at a price of US$160m, or around US$450/sqft. The final price paid, according to local sources, was just $42.6m, or US$120/sqft. 

There is something rotten in the state of California, and it is perhaps an indicator of just how serious things are getting in the US office market.

Michael Steingold, director of private markets at Russell Investments, notes: “The work-from-home phenomenon continues to cut a swathe through the US office market. In some sectors, such as the technology market, operators seem to be questioning how much they need a physical office presence at all.”

Chief executives have been making vain appeals for workers to return to offices. When Jamie Dimon made such requests at JP Morgan, it was reported that he attracted overwhelmingly negative responses citing mental health, family life and workplace diversity, and pouring scorn on talk of better collaboration.

Michael Soto, head of office research at Savills in Los Angeles, says: “Corporates [are] becoming increasingly desperate in their efforts to tempt staff back to the offices,” he says. “Just recently we’ve had one leading tech company, Salesforce, trying to lure employees back with the offer to make donations to charity. We have gone way beyond offering workers free breakfasts or gym memberships. Faced with this dilemma, many tech companies are abandoning office working on a large scale.”

The Kastle Systems key-card data on office occupancy is at least stabilising now, albeit at extraordinarily low levels. Having initially fallen 90% compared with pre-pandemic levels, it recovered to 50% last year. It now stands at 49% across the US. In some cities like San Francisco it is only 43.5%. In San Jose it is 37.6%.


“The link has been broken between job growth and office demand”

Savills’ most recent quarterly ‘State of the US Office Market’ report talks about “a new normal emerging”.

Ryan Hegy, associate director of real assets manager research at WTW, affirms this: “It is my belief we will never go back to 2019 levels and that will obviously have a significant impact on future office use/demand.”

The impact is clearly a “structural change in demand”, says Joe Rubin, consultant at Eisner Advisory Group. “Tenants are always trying to reduce space, because it is a major cost for any business. There are some signs of hope that remote working is ebbing, but hybrid working is becoming ever more popular and this trend is here to stay.

“This means the link has been broken between job growth and office demand. Tenants can now do what they always wanted to do – namely, reduce space and reduce costs. So we’re seeing this happen every time a lease comes up for renewal, and increasingly tenants are not even waiting for that. We’re also seeing a record amount of subletting going on.”

On this last point it is worth noting how much sublease space is now available – 171m sqft according to Savills. That is up 100% on Q1 2020. Rubin continues: “Companies always used to rent office space for seven days a week and only use it for five. Now they are essentially renting it for seven, and only using it for three. So the pressure on space is significant.”

Todd Henderson, head of real estate for the Americas at DWS, notes: “If you look at the new offices which are being planned, you see a decline in the office space per person which is being allocated.” It used to be in the range of 250sqft to 300sqft, but now is between 150sqft and 175sqft. “This is a consequence of more hot desking, but principally because of a realisation that it is no longer an automatic requirement that each executive above vice-president has their own office. This is an increasingly rare privilege.”

Savills reports on the growing glut of empty buildings across the US (figure 1). Soto says: “Availability is at a record high and continues to go higher with direct and sublet vacancies rising fast.”




“Every major US office market now has double-digit vacancy, and vacancy is rising”

Steingold agrees: “In the first quarter, we were seeing vacancies in most US markets rising to 20% or so. Since then the situation has deteriorated. This is particularly the case in the technology-exposed markets of San Francisco and Seattle. The more diversified markets on the east coast seem better positioned, but even in these markets vacancies are elevated and still rising.

“Every major US office market now has double-digit vacancy, and vacancy is rising or at peak even in the high-population-growth markets – such as Dallas, Phoenix, San Antonio, Charlotte and Seattle – and in the markets with more affordable rents.”

Henderson even admits: “These are the most challenging office conditions that I’ve seen in my career, on a par with what happened when I began working 30 years ago during the [savings and loans] crisis. We now have office vacancies in the US at record levels, and in my opinion, the vacancies are likely to continue to rise.” 

How high could vacancies go? “In the worst affected cities such as San Francisco I would not be surprised for vacancies to head into the 40s,” Soto says. “The tech cities are being hit particularly hard – not just San Francisco, but also Seattle, all of Silicon Valley and Austin, Texas. Everyone wanted to be in these spaces just a year ago and now they are running for cover.”

How far will values fall?

Then there are falling transcation volumes and valuation uncertainty. “Top of our minds is how the fall in transaction volumes will influence valuations,” says Steingold. “Transaction volumes are down by around two thirds on last year and this means that there is a lack of transparency, which is preventing the necessary correction in pricing that we have seen in European markets.

“The US is moving much more slowly, mainly because those transactions which are happening tend to be very specific. Only sellers with pressing short-term cashflow needs are coming to market and we see a lot of disagreement over correct valuations, which we see both in public markets with large discounts to NAV, and in private markets with large discounts on the secondary market.

With few transactions happening in the market, it is difficult to know what the correct valuation parameters are.”

Soto agrees: “The office market has been frozen over the course of this year as market operators are completely unclear of what the correct level of valuation is. We’re basically still in a period of price discovery.”

So where are office valuations going? When the National Council of Real Estate Investment Fiduciaries (NCREIF) asked its members to forecast the drop in office valuations this year, the average was -12.1%. But this seems conservative.

Soto continues: “We expect valuations to fall considerably. I think the estimates of a fall of around 10-12% in 2023 are overoptimistic. The underwriters, lenders and acquisition analysts are predicting a more dramatic repricing.”


“These are the most challenging office conditions that I’ve seen in my career”

In this sense the office sector is an outlier in the real estate market. Henderson says: “Whereas most other sectors of real estate reflect the current cost of capital and have seen falls of 10-20% in valuations, office has not reached the bottom and will likely go down by 20-40% from peaks before stabilising.”

Hegy is worried, saying: “Further material writedowns are expected, especially for the lower-quality class-B and C urban properties. There is much more pain to be had. Recent office transactions… have shown anywhere from 20% to 60% discounts to peak pricing.”

As highlighted by CBRE and MSCI Real Assets (figure 2), every city in the US is predicted to show major valuation declines, with the one exception of West Palm Beach.

Bank lending and the jingling of keys

The situation is not helped by the US banking crisis. Soto fears that “with interest rates rising, a lot of property owners are being forced out of their properties, with debt often higher than the property is worth. We started to see this in February when Brookfield put two offices into default in Los Angeles and since then more and more office owners are defaulting.” 

Rubin agrees: “This is the imminent problem. An office owner can struggle along but when a loan comes due, that’s the day of reckoning. Lenders are getting much stricter, so LTVs are going down and every loan refinancing will require a cash injection. From the office owner’s point of view, when a loan comes due they have to ask themselves a very difficult question. Do they want to double down on their investment, or do they want to just give the keys back? There’s been a lot of walking going on lately.”

The Mortgage Bankers Association estimates something like $180bn of office debt is due this year. Soto says: “What is concerning is that this is based on the debt that is most transparent, and there are considerable loans on banks and insurance companies balance sheets which are not transparent, where it will only be clear that owners are under stress when they hand back the keys.”

The biggest risk Henderson sees comes from what he terms “zombie buildings”. With building valuations below the debt attached, “equity owners are not spending the capital necessary to maintain the building, and too often the lenders are taking control of the building themselves”, he says. “This often leads to declining occupancy and increased deferred maintenance, which unnecessarily further deteriorates the value of the building. Tenants have become very smart and will not lease a building where the capital structure is at risk.”


The looming spectre of obsolescence

According to Steingold: “The narrow path through this for investors is the increasing emphasis on higher-quality office assets, a factor that is now accepted by all commercial real estate operators.”

Sotos agrees: “What we’re seeing is a lot like what has happened in retail where we saw the higher-quality part of the sector survive and thrive. The greener offices with better amenities will survive. Our analysis of data shows a continuing flight to quality amongst those professions which may be likely to continue to need office space – the lawyers and many working in the financial sector.”

This is the way out for the sector. As Hegy says, “a bifurcation… with the newer, high-quality office buildings winning out, just as we saw within the mall sector last cycle”.

But this cannot provide complete salvation. “There is a general phrase going around the industry – ‘survive until 25’,” says Soto. “This might be true, but I’m concerned that there are long-term secular trends underlying the current decline. Now that the work-from-home genie is out of the bottle, companies will struggle to put it back in.”

Rubin adds: “Everyone is trying to make the office an attractive place because of… the benefits that come from collecting all your talent in one space and, in particular, the opportunities to mentor new and young employees. [But] this can still be accomplished with hybrid working.”

As Henderson puts it, “the main challenge for office is the obsolescence of many class-B and class-C office spaces”. He explains: “If you have poor air quality, a difficult window line, limited common spaces and food options, and no gathering/collaboration areas, tenants realise it is not worth taking a property because workers will simply not accept a difficult commute to occupy poor space.”

Conversion to residential is increasingly being considered. But, as Henderson says, “that poses its own challenges”. 

The conclusion may be stark. Soto says: “Most office stock needs to be upgraded at considerable expense, or torn down.” Hegy says that “office is not overbuilt, but under-demolished”, while Rubin predicts “record teardowns”.