By Tucker Hughes
The effects of the pandemic are becoming crystal clear as to how it’s affecting the commercial real estate industry
Now that we are two full quarters deep into the global recessions caused by the COVID-19 virus, the effects of the pandemic are becoming crystal clear in the commercial real estate industry. Everyone understands that the retail, hospitality, travel and leisure, and entertainment industry categories are completely distressed, so much so that we have seen tens of thousands of businesses already lost across the country.
There are, however, several bright spots in the economy despite the challenging circumstances. For example, we have not seen as significant of a loss of the businesses that occupy office facilities as many had anticipated, and the industrial and lab sectors of the space market economy have generally outperformed even compared to the pre-pandemic days.
By virtually every single metric that one can analyze, the office market for Los Angeles county is in the softest condition ever recorded. For example, the amount of available office space county-wide has skyrocketed by over 38% since the first of the year, now exceeding an availability rate of 16% across Los Angeles county. For perspective, peak availability through the financial crisis only reached 14.5%, and we are still in early innings of the worsening office market.
Available sublease space has also increased dramatically, rising by over 71% since the first of the year. Each passing quarter has brought upon a new all-time record in the amount of additional space being added to the market.
While the severity of what is being experienced in Los Angeles is extreme, there are many other cities around the country in a similar or worse position. The confluence of factors contributing to the negative state of the office market is consistent nationally and are as follows.
The first trend is that there has been a massive spike in sublease inventory, which is a trend we predicted in March. Sublease inventory at cheap rents and for typically shorter-term durations represent the landlord communities’ worst nightmare. Institutional owners of real estate are now in a position where their biggest competitors are no longer each other, but rather their own customers who occupy space in their portfolios, and are generally willing to take losses on what they are currently paying to generate some form of sublease revenue.
The second trend that is contributing to the distress of the office market is that a portion of the companies who have had leases expire during the pandemic have chosen to not extend or renew those space obligations. While it is true that a portion of these companies plan to go remote permanently, the vast majority of these companies simply do not want to pay for space that they are not using, especially with an unknown date of when they will return to the office. These companies are also banking on the ability to find suitable offices at the right time, hopefully next year, at overall more attractive lease economics, a bet that we think is likely to play out favorably for them. It is a lot less common for companies with 50 or greater employees to be working fully remote or to have returned all or even a moderate amount of their office space.
The third major trend is a dramatic decrease in leasing activity. Leasing activity in Los Angeles County for all of 2019 was 25.5 million square feet. To date it is only 10.9 million square feet, over 40% of which was signed before the pandemic. This represents a nearly 70% decline in leasing activity.
Major supply surges can occasionally be met with huge surges in demand, however, we have record supply growth at the same time that we have record reductions in demand, creating a perfect storm to create pain and softening on the commercial office markets, both locally and globally.
An enormous and increasing portion of the supply chain of industrial real estate that services the population of Los Angeles is coming from the Inland Empire. While the Los Angeles industrial real estate market has slowed its growth and both vacancy and availability have increased, the market is still incredibly strong, with very few options for industrial tenants and growing rents. The Inland Empire is even stronger than Los Angeles county. In the early days of the pandemic, many industrial developers slowed or temporarily paused their future development plans of additional warehousing space, which has created a major supply gap despite leasing activity that was consistent with pre-coronavirus years. Fortunately, many of these projects are back underway so supply will likely be more normalized moving through the balance of they year and into 2021.
Inland Empire vacancy is a mere 2.7% today, down from 3.3% at the end of 2019. Meanwhile Los Angeles county vacancy is at 3.1% but is up from 2.2% at the end of 2019.
Many institutional owners of real estate are optimistically trying to characterize the pandemic as only a temporary health problem, but the reality is that the economic damage caused by the pandemic on businesses is severe, and it will take many years, if not longer, to recover. The office market has a long road ahead, and it will get worse before it gets better. Even the strong industrial markets have exposure, as demand for industrial space is ultimately correlated with consumer spending, which is certain to be negatively affected by the overall state of the economy.
Our team has now had conversations with thousands of business leaders around the country since March and based on all of the information shared with us, we feel extremely confident that most tenants will return to the office. Many employees are suffering from fatigue, depression, work/life imbalance, or simply do not have adequate remote working infrastructure, and most employers want their teams back into the office where collaboration, teamwork and creativity can flourish. Tenants returning to the workplace may very well come back smaller as a result of reductions in force and/or offering part-time remote work to their team members who would like to take advantage of the increased flexibility.
One tenant at a time, companies will be downsizing over the next several years as their leases expire, putting millions of additional square feet of office space back onto the market. It is a phenomenon called “negative net absorption” whereby each quarter another couple of million square feet of office space will come back to the market through the collective rightsizing of corporate America. We have described this as death by 1,000 slices, and the effect on commercial real estate availability will be severe.
In the financial crisis, it took two full years for vacancy to hit its trough and three full years for rental rates to hit their low. Commercial leases are sticky, but the market eventually does correct.
As we continue to march into and through this brutal recession, business owners and executive teams will look to lean down their cost structure, and this coming soft market is good news for tenants that occupy office space, and have leases expiring in 2021-2023. As we head into the holiday season, it’s always a time for reflection and appreciation. We are all looking forward to getting 2020 behind us, and we are also looking forward to representing our tenant clients in the new year. Make no mistake, we are heading into the softest market in two decades, where choices have never been better, and with rents and free rent that have not been this tenant-favorable in a decade. This is not the end of office space. Great companies will always seek out great space for their teams, only now, it will be less expensive to do so.
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.