By Tucker Hughes
After nearly a ten-year run of consistent rental growth and strong market fundamentals, the commercial real estate industry, including nearly all real estate product types, has suddenly found itself faced with extreme challenges.
COVID-19 has been a brutal shock to the world economy and the economic spillover into the commercial real estate industry is just beginning, and will be severe.
Los Angeles’ second quarter of 2020 ended with more total office space on the market than we have ever seen in the county’s history. This consists of a total of 49.0 million square feet of available office space in a market that totals 425.3 million square feet in size. This puts the total amount of available space at 12.8%.
There are many other factors that are equally as alarming. For example, there is an unprecedented amount of sublease inventory that is hitting the market. From the first to second quarter of this year, the office market experienced a 20.4% increase in sublease availability, which is the highest ever recorded single quarter increase in the county’s history. Leasing activity also fell to its lowest level ever recorded, coming in at 2.17 million square feet for the quarter versus the prior year’s average of 6.46 million square feet per quarter, which has generally been stable for the last decade. This all is happening at the same time that we have the highest ever recorded amount of new construction being built.
After some of the most intense rental growth of any geographic area in the country over the last decade, the industrial segment of Los Angeles’ real estate market is also experiencing meaningful pain.
2019 industrial availability hovered at an average of 4% for the county but ended the year at 4.4%. We have since seen an acceleration in availability up to 5.9% as of the end of the second quarter of this year. In real numbers this amounts to 38.8 million square feet of available space increasing to 51.3 million square feet, representing an increase of approximately 32% in availability. While there is no question that the fundamentals are shifting to be less landlord favorable, the industrial market is in a much better position to weather this storm than the office space sector.
There are both macro and micro differences between the situations that office and industrial find themselves in today.
First, the amount of industrial space available going into this crisis was at such a low point that it created a severely landlord favored market, which is why we saw rental growth exceed 8.5% per year on average for the past decade as rents rose from their post Financial Crisis low of $0.51 per square foot triple net to $1.08 per square foot triple net ending for the second quarter of this year.
Second, the leasing activity for industrial space has only fallen by 15% versus over 70% for office space, and the amount of new construction is a healthy amount versus at its absolute peak as it is for office space.
Third, industrial is more insulated from the effects of the virus due to its greater dependence on tasks that must be completed in-person and allows for much easier distancing than office space, which usually will have densities that exceed warehousing space by a minimum factor of at least four, but often times much higher.
Lastly, while there is no question that there will be serious and long-term implications for consumer spending in the coming years, industrial is poised to benefit from our country’s all-important supply chain, supporting an overnight surge in online purchases.
Interestingly, the Inland Empire’s industrial market is performing much more favorably than Los Angeles. Vacancy is down from 4.3% at the end of the year to 3.6% ending as of the second quarter. This has come at a time when 21.5 million square feet of new construction has hit the market within the previous 12 months. This means that an amount of space equivalent to all of the new construction plus additional space was absorbed to drive the vacancy rate further down. Despite better performing fundamentals so far, leasing activity was down in excess of 50% in the second quarter and is on pace for a similar third quarter at this time. It does not take many quarters of massively reduced leasing activity for the data to wildly swing in an unfavorable direction.
The difference between Los Angeles and the Inland Empire’s industrial performance is largely explained by a higher percent of e-commerce and logistics buildings present in the Inland Empire, which are generally performing well, for now, around the country.
While it would be an understatement to stress the uncertainty that exists in the economy and all real estate product types, the asset class of greatest concern is office space. By the day, there are companies that are realizing that they have no intention of using the amount of office space that they have leased. This is nearly universal in the short term as many of these companies have not re-occupied their spaces, and there are many companies that are permanently re-evaluating their forward-looking space needs even in a post-vaccine environment. This is creating a supply surge, and it is just beginning to be realized.
While most of the commercial real estate industry is beginning to acknowledge the direction things are headed, there is little agreement among landlords and brokers as to just how bad the damage will be when the dust settles. Many landlords have already begun to lower rental rates in meaningful ways. Our Los Angeles team had several hundred active client negotiations underway at the beginning of the pandemic. We almost universally advised our clients to wait given the more favorable future conditions we were predicting. Many of these transactions have since been renegotiated, often at rental rates that are in the low double-digit range, and sometimes even exceeding 20% off of previous pricing.
Please remember that while we represent tenants, we wish no harm to landlords. The reality is that a strong commercial real estate market is the byproduct of a robust economy. A commercial real estate market in distress is likewise the sign of a recession, which we have been through three times in our careers. We take no pleasure in reporting on the office market’s decline, but our commitment to our clients and the market is to be transparent and truthful as to what we are seeing and where we think the market is going.
There are four major pressures on the office market that will add massive supply in the coming years, and ultimately put the office market in complete distress by the end of 2021.
1. Sublease inventory is rising.
Every day we talk to companies that have no intent to re-occupy their space and the only contractual way out of the obligation is to put it on the market for sublease. These almost always are priced at a discount to the market, typically by 10 to 20%, and sometimes more. In past recessions, when tenants become competitors to landlords, it ends badly for the landlords when tenants slash their prices in order to cut the bleeding, which they can do as they aren’t worried about maintaining market rents in order to preserve asset values like most landlords.
2. Some tenants have opted out of renewing their leases.
With no clear sign of a vaccine, therapeutic, or date on when the stay at home order could be lifted, we are seeing some office tenants with leases expiring this summer and into the fall opt out of having office space at all, and working remotely into 2021. This is causing more space to come onto the market unexpectedly.
3. Landlords are underreporting the number of Tenants behind in rent payments.
An increasing number of tenants, mostly small and medium size businesses, are in default on their leases. It’s been reported by large office building landlords that anywhere from 5% to 10% of their tenants are in default. Based on the thousands of conversations, phone calls, online polls, and zoom meetings over the past few months, we are not confident in the Landlord data being circulated and we believe the number of tenants in default is much higher. Some tenants have been using PPP money to pay the rent, which is depleted for the most part at this point, putting even more tenants at risk of default in the coming months. When the courts open up and landlords can file to evict those tenants, or tenants have to wind down and dissolve their businesses, a sizable amount of office space will be coming back to market by the end of the year in increments between 2,000 and 10,000 SF, increasing vacancy.
4. There is a “resizing” of Corporate America coming.
As leases expire in 2021-2023, companies are going to be downsizing their office lease obligations as the layoffs have settled through the economy and companies find that anywhere from 10% to 25% of their employees will have become comfortable and effective remote working on a permanent basis. Also, a significant percentage of employees will continue to work on a semi-remote basis for the foreseeable future. We have heard some landlord brokers advancing the theory that companies will need to expand their workspace to provide more social distancing between employees, and therefore increase their total space requirements. However, the marginal increase in square footage needed by some companies will easily be accommodated in their current footprint. Any need for increased social distancing will be more than offset in multiples by the shedding of space one tenant at a time as future office leases expire. Most tenants with leases expiring in the next three years will be getting smaller, the net effect of which is called “negative net absorption,” whereby millions of net square feet of office space will be coming onto the market in the coming years, 3,000, 10,000, and 15,000 SF at a time. It will be death by a thousand slices, and while landlords’ brokers that are being called upon to backstop building owners and provide price support are claiming that they have not seen a significant uptick in vacancy, it’s coming. It’s like a wave on the horizon that looks like it’s going to be something you could surf, only to realize that as it nears it’s actually a crushing tsunami wall of water.
What Lies Ahead
The coming surge of supply in the next 18 months will create the strongest tenant market that we have seen in two decades. For companies that make it to the other side of the crisis, there will be tremendous opportunities in the market, and pricing will likely be 20 to 30% below what tenants used to pay in pre-COVID days. The number of quality sublease opportunities and also lease renewal and restructuring opportunities will be abundant.
Some landlords, still in denial of the tsunami headed their way, are going to make tempting offers to tenants this year with only modest rent reductions in exchange for extending leases. Of course, there are always exceptions to the rule, and there will be sound reasoning for some companies to transact in the near term, such as landlords who are already providing aggressive double-digit percentage decreases in proposed rents and for companies that have a strategic reason for being in the market today. Each submarket, client situation and assignment is different, and it is important to set a specific strategy and objective for your particular circumstance.
Tucker Hughes is managing director at Hughes Marino, an award-winning commercial real estate firm with offices across the nation. As head of Hughes Marino’s Orange County and Los Angeles offices, Tucker specializes in tenant representation and building purchases throughout Southern California and beyond. Tucker makes frequent media appearances to speak on the future of commercial real estate, and is also a regular columnist for Entrepreneur.com. Contact Tucker at 1-844-662-6635 or firstname.lastname@example.org.