Office Building Owners Drown in Tide of Sublease Space

Office space is hitting the market as landlords grapple with low demand, lease expirations

Record High Office Lease Expirations Pose New Threat to Landlords and Banks

Rise in office space hitting the market this year is a direct result of the Covid-19 pandemic

A record amount of U.S. office space is hitting the market this year due to a jump in lease expirations, putting property owners in a bind and threatening to leave banks and other lenders stuck with more troubled loans.

Most office building owners have been able to ride out the pandemic because corporate tenants have been locked into long-term leases. They continued paying rent even when their employees stayed home. Now as more leases expire, a growing number of tenants are shrinking their offices because they need less space under hybrid strategies that blend office with remote work, brokers say.

Leases for 243 million square feet of U.S. office space are set to expire in 2022, the most office space to hit the market in a single year since real-estate services firm JLL began tracking this data in 2015. The expiring leases represent about 11% of the nation’s overall leased office space.

The rise in office space hitting the market this year is a direct result of the pandemic. Many office tenants whose leases expired last year or in 2020 negotiated extensions of only a year or two, rather than renewing at the typical length of 10 years or longer, as these firms tried to determine how much less space they might need under a hybrid approach.

“I don’t think the landlords have felt the pain yet,” said Jeffrey Peck, vice chairman at commercial real-estate brokerage Savills. “Now they’re going to start feeling the pain.”

The looming lease expirations represent a 40% increase since 2018 and pose a new threat for office landlords already frustrated by stubbornly slow return-to-office rates and a national vacancy level of 12.2%. That rate is a high for the pandemic period and up from 9.6% at the end of 2019, according to real-estate data firm CoStar Group Inc.

It could move higher. Real-estate analytics firm Green Street estimates that hybrid work will cause a 15% drop in demand for office space. Because most building expenses are fixed, even a small drop in leasing revenue often leads to a big drop in profits and an even bigger drop in a building’s value. An economic slowdown could add further strain because office leasing is highly dependent on the economy.

Troubled loans to office building owners are also on the rise. In February, 21.2% of office loans made after the global financial crisis packaged into commercial mortgage securities were either being handled by special servicers or on watch lists, two closely watched categories that could lead to defaults, according to a Barclays report. That’s the highest level since 2010.

Esther George, president of the Federal Reserve Bank of Kansas City, last month said that she is concerned about risks from remote work and rising interest rates, which could hurt office landlords and their lenders.

“Community banks in particular can have concentrations in this area,” she said during an event hosted by the Economic Club of New York. “We do see the structural changes that are taking place right now.”

Analysts will be keeping an eye on office loans when banks start reporting first quarter earnings in the coming weeks. Financial institutions with the largest exposures to the office market include Heritage Financial Corp. and Eagle Bancorp Inc., which both have more than 13% of their loan portfolios backed by office buildings, according to a report published Monday by financial services firm Stephens Inc.

So far most lenders haven’t taken any big hits from their office loans but that could change if a decline in leasing causes property values to fall. “We’re watching closely,” said Chris McGratty, head of bank research for KBW.

About $1.1 trillion worth of loans backed by office buildings are outstanding and about $320 billion of those loans are maturing this year and next, according to data firm Trepp Inc.

Not all the news is bad. Big technology companies have expanded by 12.1 million square feet since the onset of the pandemic, according to JLL. Lenders also showed more caution in the years before the pandemic than they exercised in the periods before the two previous recessions. While loan volume hit records, banks and other lenders mostly stayed clear of superhigh leverage levels that provide little cushion when values fall.

But the combination of rising interest rates, lower occupancy and mountains of debt coming due “could be a triple whammy” for building owners, said Matthew Anderson, a Trepp managing director.

Problem loans have already started to surface. Blackstone Inc. is expected to hand back to creditors a troubled Midtown Manhattan office building with a $308 million debt load, according to people familiar with the firm’s thinking. The building’s loan was turned over to a special servicer after its main tenant, L Brands, decided not to renew its lease when it expired last month. The retailer is taking much less space in a new location, in part because it is turning to a hybrid-work strategy.

A Blackstone spokeswoman said that the building posed “a unique set of challenges that are not representative of our portfolio.”

Most tenants aren’t expected to boost their leasing activity anytime soon. Real-estate data firm VTS said one indicator of tenant demand—how much space companies are touring—in February was about half its prepandemic level. Companies increasingly prefer shorter-term deals, bringing more uncertainty for landlords. Material ConneXion, a materials consulting firm, for example last year moved into a co-working space managed by Serendipity Labs in Manhattan after ditching its much larger Park Avenue office.

New York-based law firm Herrick Feinstein LLP wants to reduce its office space by 30% to 40% when its lease expires in a few years, said Jonathan Adelsberg, co-chair of the firm’s real estate department.

He said he isn’t thrilled about giving up his private conference table, but spending less on office space means the firm’s lawyers can take home more pay. “You can have a bigger office or a bigger home,” he said. “I mean, what would you prefer?”

This article from the Wall Street Journal sheds some light on the purchase demand for office buildings, but also highlights how central business districts in major cities (San Francisco, Los Angeles, New York, etc.) are continuing to suffer much reduced demand for space…which translates into much better lease deals for tenants looking to either relocate there or who are looking to renew there.

This CoStar article highlights what one of the West Coast’s biggest tech landlords is hearing from their tenants such as Google and Apple: companies and their employees are ready to get back in the office to collaborate! They are already signing leases for unfinished developments. This is great news for our economy, the Associated Press reported just this morning that U.S. productivity fell by the largest amount in 39 years. 

“I have spoken frequently over the months on how the pandemic is changing how we all do business. One day the office is dead, the next day everyone wants to go back to collaborate. I firmly believe that like retail, the office isn’t dying…it’s just evolving, and I am very proud to be part of these sizable companies maintaining their leaseholds in Orange County.” says Jeff Tabor, principal of Jeff Tabor Group.

Whatever the “look” of offices will be when we all “go back”, it is my belief it will be more of a hybrid return. That is, many more firms will be allowing a good portion of their workforce to work both remotely and at the primary office location...perhaps 30-40% of the workweek will be remote, with the balance at the office. This will directly result in reduced demand for space and, consequently, softer long term rental rates and increased landlord concessions. This article from the weekend edition of The Wall Street Journal outlines many possibilities.

The fall of office rental rates is taking longer than most tenants have expected considering the current crisis. Many economic indicators are grimmer than the 2008-2010 crisis. Hundreds of thousands of square feet of office space in Los Angeles are empty, another 8 million square feet is currently under construction…and subleases are at an all-time high. This brief article hits the highlights of the current market. It might be time to start looking…

Santa Monica, California, a coastal Los Angeles County city nicknamed Silicon Beach for its high concentration of tech firms and investors, had more than 1 million square feet of office space available for subleasing as of Aug. 19, nearly 40% more than the prior record set in 2009, according to data from CoStar Group and area brokerage firms.

In a measure of how much COVID-19 has affected commercial real estate, mortgage loan origination fell 48% in the second quarter from a year earlier, according to a new report from the Mortgage Bankers Association.

The primary damage came in the initial few weeks after the outbreak in the United States, when lending came to a near halt. Since then, the pace of lending has been picking up, but the pace and amount lent indicate it may be a while before it returns to pre-coronavirus activity.

The Empire State Building, New York’s most famous office skyscraper, has come to reflect much of what ails the city and its commercial real estate during the Covid-19 pandemic.

The tower looks vulnerable to losing office tenants as more companies embrace remote work or cheaper satellite offices outside city centers. Some in the industry say it is worse off than many peers because the building relies on smaller office tenants...

The e-commerce giant says it is adding 3,500 employees in six major cities...

Amazon.com Inc. is expanding its physical offices in six U.S. cities and adding thousands of corporate jobs in those areas, an indication the tech giant is making long-term plans around office work even as other companies embrace lasting remote employment.

Commercial property owners across the nation are hiring for positions such as “experience ambassadors,” hygienists and even an on-staff medical doctor to help make returning to the coronavirus-era workplace feel as safe and seamless as possible for companies. The pandemic has created a whole new category of jobs for the commercial real estate industry in an effort to reduce the risk... 

HomeStreet Bank CEO Mark Mason said he knows the Seattle-based company has a lot of space, too much space, in fact. So when the coronavirus pandemic temporarily shut down the country's economy within a two-week span back in March, the community bank began to plot how it could emerge from the crisis with a more efficient footprint.

I have seen a University of Chicago study referenced in a number of articles I have read recently...this study estimates between 32-42% of jobs lost during this pandemic will be permanently lost…ouch!  Not a good omen for office space demand.

This article in this past Saturday’s edition of the Wall Street Journal really hits home (no pun intended) as to the now realized cons of so many folks trying to work from home.  It was relatively effective at first but now we are starting to realize some of the potential negative side effects.

I believe office space will still be in demand, but I would expect a downturn in that demand over the next 2-3 years, of upwards of 25%...which means landlords will be getting much more aggressive in their lease negotiations.  From my present experience, they already are…significantly.

Elevator safety is a top priority in office buildings right now and the economy is not even fully reopened...far from it. Capacity is being restricted to as few as two people in most high-rise buildings. Riders must queue while maintaining social distance, then stand in designated areas, wear masks and many are being asked not to speak while inside. 

COVID-19 has been a shock pubic health and the economy. As the toll of new cases starts to subside in some states, it is becoming clear that “normal life” in the future will be different from our pre-COVID days. Changes to our work routines have been so significant that some will be permanently adopted. What does this mean for the office market in the near term, and in the long term?

The public health upheavals of COVID-19 have affected every facet of our lives. People are even moving from condos and apartments into single-family homes at an unexpected rate. This trend may spill over into office spaces and have some longer-term impacts on high-rise office buildings and even constrain availability for space on lower floors as well as low-rise buildings. 

There is no going back. Only moving forward to a healthy, well and resilient new generation of space. No one could have predicted the tectonic disruption to America’s business community that we’re experiencing right now. At the flip of a switch, everything we have ever known to be true about corporate protocols and operations came to an abrupt halt.

Before the coronavirus outbreak, the Los Angeles office market was in a favorable position with vacancies near a decade low. Gross leasing levels during 2019 were in line with the past several years.

Have a look at what companies are saying about us and the work we do for them!!

Before the pandemic, about 10% of workers able to work remotely did so full time, and an additional 20% did so some of the time, according to Gartner. Now, chief financial officers the company surveyed indicate 19% of workers will go remote full time and 29% will go remote some of the time. 

A proposed bill aimed at providing eviction protections to some of California's commercial tenants is setting up a battle among lawmakers and landlords. 

Even after the crisis eases, companies may let workers stay home. That would affect an entire ecosystem, from transit to restaurants to shops. Not to mention the tax base (NYT Article) 

Kilroy Realty Corp., one of the most active developers in the top office districts along the West Coast, said it won't start any new speculative projects and may not begin any new construction for at least a year.

The company is the latest of office and industrial developers from Los Angeles to Washington, D.C., that have announced plans to halt most new construction, especially projects built without signed tenants, as landlords wait to see if they will receive their next rent checks from companies paralyzed by the coronavirus pandemic shutdown.

Prior to the coronavirus pandemic, the Los Angeles office market was in a favorable position with vacancies near a decade low. Gross leasing levels during 2019 were in line with the past several years. 

However, since the impacts of the coronavirus have continued setting in, there has been a clear deceleration in gross leasing activity. The market has experienced minimal leasing levels since the middle of Marc....

The good news is that number of new, confirmed cases of Coronavirus in the United States has, at least for now, peaked and appears to be falling. Stay-at-home mandates across the nation have been having their intended effect of limiting the spread of the virus beyond the initial surge. We are far less cognizant, however, of what the full scope of the shock will be, as economic statistics significantly lag public health stats. 

The Judicial Counsel of California adopted 11 temporary emergency rules in response to COVID-19 pandemic affecting eviction proceedings, judicial foreclosures, and statutes of limitations for civil causes of actions, among other things. The rules adopted April 6, 2020, are effective immediately and apply to all California state courts. 

Here at the Jeff Tabor Group we have been spending our days working out how best to serve our clients during the current health crisis, including keeping an ear to the ground for any information about how it’s effecting commercial tenants. Just this morning, our efforts paid off when we came across the Playbook one of the best commercial real estate law firms is now using in advising their landlord clients during this pandemic…very, very insightful.

With rent and other bills coming due April 1, some small-business tenants affected by the coronavirus are facing tough decisions regarding whether to work out extension terms with their landlords, or simply fold their tents and move out because the business is beyond rescuing. 

As tenants and landlords brace for mass building closings, lease disputes and funding issues in the midst of the coronvirus pandemic, they are flocking to their attorneys to discuss protections like force majeure that may soften the blow. 

It’s essential to read and understand the fine print of a commercial real estate lease before you sign it. Once the ink has dried, it’s often too late to make any changes. Your business may be negatively impacted by the terms and conditions you agreed to.

There are several documents relating to office building CAM costs and other operating expenses that can show you whether additional rent will end up wreaking havoc on your cash flow

Most commercial leases that require payment by the tenant of its share of the building’s operating expenses include a lengthy definition of the term “operating expenses.”

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