Office Leasing in 2023 – Continued Hesitancy in the Return to Office
The tumultuous events over the last few years have had, and will continue to have, profound effects on all aspects of our daily lives and habits. As we move into 2023, we find that, while COVID-19 continues to affect all of us, many of the direct effects of COVID-19, such as isolationism, social distancing requirements, and the obligation to wear masks in public, either no longer affect us or have been blunted by time and familiarity.
The concerns and effects of COVID-19 on the U.S. real estate markets began to give way at the end of 2022 and have been largely replaced by concerns about the U.S. economy resulting from numerous factors, including the Federal Government increasing interest rates to the highest levels in decades, the corresponding higher cost and limited availability of capital, and the very real fear of an impending recession.
Most U.S. real estate markets, including the office leasing market, have not yet returned to their pre‑COVID–19 levels, and the current economic concerns have come at an especially difficult time. Fortunately for landlords, notwithstanding increased vacancies in office spaces, most existing office tenants have continued to make their rental payments, which is in part due to the long-term nature of most office leases, and the desire for tenants to have an office for their employees to return to, if and when the long hoped-for “return to office” occurs.
As we move into 2023, we expect that remote working will continue to steer office users’ leasing decisions. We also expect that those decisions will be affected by the availability of amenities for office workers as well as the types/locations of office buildings. These items, along with a large market of office space available for sublease, will tend to place downward pressure on rental rates and leasing activity in the office market in 2023, creating tenant-favorable market conditions. However, there are few bright spots in the office leasing markets such as best-in-class office properties, flex space, and medical office space, where leasing activity should continue to be robust.
The hybrid work model is likely to remain with us for the foreseeable future.
As cities went into lockdown early in the COVID-19 pandemic, there were few who could have predicted just how successful large scale remote working could be. Remote working has now become the new standard for many office employees. Remote working, especially working from home, can result in financial savings by eliminating commutes, and for many can also result in time savings that can be used for family time or to pursue other personal interests. Such additional time has, in turn, brought about a renewed emphasis on employee work-life balance and on individual autonomy. Now that office workers have lived with the benefits of remote working, few are willing to give up those benefits. What started as a necessity at the beginning of the COVID-19 pandemic has now become an expectation for many office workers.
Employers, on the other hand, have legitimate reasons to prefer that employees come back to the office. As noted in the recent PWC/ULI Emerging Trends in Real Estate 2023, some of the reasons include instilling culture, easing onboarding, and increasing productivity. Other analysts have pointed to employee focus, increased employee productivity, maintaining corporate culture/identity, and the benefits of in‑person face time (especially for more junior employees).
So far, there has been no consensus on a “return to the office” by employers across the country. Some smaller companies have embraced a fully remote work environment, while many larger companies have made large scale pushes for a full time return to the office. Last Labor Day, a number of large employers made headlines by imposing strict return to work requirements for their employees, most of which fell flat. In the current economic environment, workers see themselves as having an upper hand in work relations, and unless that changes, return to work mandates will likely continue to see little traction.
Consequently, as a compromise between employer and employee needs, companies have found it necessary, and will likely continue to find it necessary on a going forward basis, to offer hybrid work arrangements whereby office workers work from home several days during the week and work in the office the other days of the week. PWC/ULI indicates that the average office worker is currently in the office 3 to 3.5 days per week. These hybrid work arrangements are viewed as necessary in the ongoing effort to attract new talent and to retain existing employees who have grown accustomed to the freedoms and flexibility that remote working offers.
From a leasing perspective, hybrid work arrangements require employers to rethink how much office space is actually needed for their employees. In its recent U.S. Real Estate Market Outlook 2023, CBRE indicated that while employers are still trying to find a balance in their hybrid work agreements (and there’s no one-size-fits-all approach to hybrid work arrangements), the hybrid approach might “ultimately reduce demand for office space per employee by up to 15% from the pre-pandemic norm.”
Additionally, the hybridization of office work tends to result in an underutilization of office space. Since only a portion of office workers are coming into the office on any given day, employers are forced to consider what to do with their “excess” space. Many employers continue to hold on to their excess space, often due to a desire to retain the space for future planning needs, such as if the level of employees returns to its pre-pandemic levels, or for use as future open space/collaborative space. Other employers have elected to try to sublease their excess space. As a result, the subleasing market has exploded in the last few years, with one recent CoStar report indicating that there has been a 90% increase in the amount of sublease space available on the market as compared to the end of 2019, and we expect that trend to continue in 2023. The proliferation of available sublease space, which is often leased at rates that are lower than the typical market rates for similar space, will continue to place downward pressure on the rental rates in typical direct office leases.
Office amenities, once seen as merely desirable, are becoming necessities.
With the runaway success of remote working, workers who are able to work remotely have, in many cases, little incentive to return to the office. With return to office mandates falling flat, we expect that employers will need to incentivize workers to return to the office – if an office worker is going to give up the very real benefits of remote work, that worker will need an office environment that is conducive to a return – a place where that worker wants to be on a daily basis.
Amenities desired by workers include things such as collaborative and socialization space, open spaces, ready access to food and coffee offerings, onsite gyms, and patio spaces, as well as other less obvious but no less important items such as high ceilings, large exterior windows that allow natural lighting, highly efficient and filtered air ventilation, and touchless access technologies. As noted in CBRE’s recent U.S. Real Estate Market Outlook 2023, “[t]enants will demand more from their buildings in 2023 to better support activity-based work and increase productivity.”
Office buildings either currently have these type of amenities, or they can be added. While the idea of simply adding amenities might make sense in theory, it may be difficult to implement in practice. Many older building were originally constructed with standard ceiling heights and smaller floor plates that are not conducive to the creation of large open spaces or the addition of other amenities. For an existing owner to update those buildings to allow for such amenities would require a large influx of capital, but, as noted above, with rising interest rates and the higher cost and limited availability of capital, it may prove difficult for many landlords to make these types of updates to their buildings, which has the potential to limit the supply of amenity-rich buildings in the market. Additionally, whereas in prior years, purchasing an older building as a “value-add” project was often an attractive option, such value-add projects are currently out of favor, and we do not expect to see many such projects being completed in the near future, further limiting the supply of amenity-rich buildings in the market. This will likely negatively affect the desirability of such buildings as targets for employers’ long term office leasing needs, leading to a glut of “obsolete” vacant office space on the market, which in turn will tend to depress rental rates and leasing activity on these types of assets.
Best in class office assets, flex space and medical office space continue to be bright spots within the office leasing market.
We expect the greatest leasing activity in 2023 to be in newer Class A properties, flex space properties, and medical office properties.
Many analysts have pointed to a consistent “flight to quality” in office space needs, where those office buildings that have the most desirable amenities are the ones most likely to capture a large share of any new demand for office space. Given their more recent construction and modern design character qualities, newer Class A office buildings are simply more likely to be able to provide the amenities desired by today’s office workers. To help illustrate the divide between newer and older buildings, a recent report by JLL Research indicated that between the beginning of COVID‑19 and the second quarter of 2022, there was 86.8 million square feet of net space absorption in buildings constructed in 2015 or later, while there was 246.5 million square feet of negative net space absorption in older buildings, with the majority of such negative net space absorption occurring in buildings erected during the 1980s and earlier. As such, we expect to see the greatest amount of office leasing activity in newer Class A buildings.
Interestingly, it is not just the type and age of building at play here. Suburban offices tend to have higher leasing activity than offices in central business districts. This is consistent with the hybrid work model where office workers prefer the often-shorter commute to a suburban office location than to a downtown office location.
Flex space is office space that is operated by third party providers, such as WeWork and other traditional executive suite operators. Given the uncertainly of many companies’ space needs for the foreseeable future, flex space allows companies to supplement their existing leased spaces with flexible, often short-term leases that can be used to address short-term space needs, such as a rapid expansion or contraction of personnel. Flex space can also be used as part of a company’s hybrid work arrangement to provide satellite offices or to house specific individuals who may not be able to easily access a company’s main office. Given the desirability of flex space, we expect to see more owners partnering with experienced flex space providers, resulting in an increase in flex space leasing activity in 2023.
The demand for medical office space continues to rise. In addition to the COVID–19 pandemic, which made the need for readily available medical care all the more evident, a confluence of factors, such as the aging U.S. population and increasing lifespans, rising medical costs, new medical technologies/outpatient procedures, and insurance companies’ push for outpatient care in an effort to reduce costs, has caused an increase in demand for medical services at medical offices, rather than at more traditional hospital or surgery center settings.
The hybrid work model has less immediate impact on medical office space. While some medical officer work, such as accounting and other back-office functions, may be performed remotely, most workers, including technicians, nurses, and doctors, require “face time” with their patients and need to be in the office in order to have that level of personal interaction. Additionally, hybridization and remote working have not limited the patients’ need for waiting room space and exam rooms. As such, remote working will continue to have less of an impact on medical office space than in other office leasing sectors. Some analysts see video “telemedicine” as a factor that might diminish demand for medical office space, but telemedicine is more often seen as a means to help alleviate overcrowded waiting rooms, not as a substitute for a medical professional seeing a patient in person. In addition, following the increase in remote working, we expect that most patients will continue to prefer to have medical services available closer to home, instead of being located at or near large hospitals. As a result, we expect to see a continued steady growth in medical office demand in 2023.
Continued Uncertainty in Office Leasing.
With the current office working environment initially shaped by the COVID–19 pandemic, and continuing to be shaped by the drastic changes in interest rates and other aspects of our economy, office employees will continue to desire the ability to work primarily from home, and employers will seek ways to incentivize workers so that they will return to the office, in at least a hybrid work arrangement. While everyone is working to optimize the hybrid work environment, we expect that the general trend of slower leasing activity that we saw in 2022 will likely continue in 2023. However, with respect to certain asset classes, such as newer Class A properties, flex space properties, and medical office properties, we anticipate seeing increased leasing activity throughout 2023.