By Jeff Shepard
No matter how you look at it, the news is bad: U.S. economic output fell at a 32.9% annual rate in the second quarter, a level not seen since the Great Depression and by far the largest drop since government record keeping began in 1947, according to data released at the end of July. The sharp contraction, reflected in the government’s report of gross domestic product–the sum of all goods and services produced in the country–include data from mini-recovery that occurred before the latest surge in the COVID-19 pandemic.
The brutal shock to the world economy by COVID-19 will also drive the commercial real estate office market to very uncomfortable new depths not seen in 20 years…maybe longer. At the macro level, Orange County’s second quarter of 2020 ended with over 36,000,000 SF of office, industrial and flex space on the market. Of particular concern is the increasing amount of sublease space in Orange County, with the second quarter of 2020 ending with approximately 5,800,000 SF of total sublease space for office, industrial and flex space, and we believe this is just the tip of the iceberg. The office market alone in Orange County has seen the addition of over 300,000 SF of sublease space since March, with 46% being listed in June alone.
There is a significant disparity in the impact that the COVID-19 virus and related economic damage has had on the various commercial real estate market sectors.
One relatively bright spot is industrial real estate, in particular large-scale warehouse and logistics facilities, which serve our all-important supply chain supporting the surge in online purchases, with tremendous stability in all of the markets throughout Orange County.
Of great concern is the health of the office market in Orange County, and the trends that we are seeing regionally around office space availability. More companies by the day are realizing that they have no intention of using the amount of office space that they have leased, or no intention of using their office space at all in the near term. As a result, a supply surge is just beginning to be realized. While most people in the commercial real estate industry seem to acknowledge this, there’s little consensus among landlords and brokers as to where things are going, and how bad the damage is going to be. Most landlords have not changed their asking prices since pre-COVID pricing, and there have been very few market clearing transactions to justify the extent to which rents have declined, nor how much further rates will drop over time. However, we think the damage to the office market is severe, and will be getting worse by the month. 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 months and 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, or anywhere near 50% of it, so the only contractual way out of the obligation is to put it on the market for sublease, almost always at a 10%-20% discount of what the building owner is asking, sometimes more. As in past recessions, when tenants become competitors to landlords, it always ends badly for the landlords, as tenants will always slash their prices in order to cut the bleeding. Tenants aren’t worried about maintaining market rents in order to preserve asset value like landlords need to. In fact, many of the current transactions we are working on are exclusively happening in subleases, for less rent and less term, than the landlord of the same building would require.
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
While most brokers and landlords we talk to have tremendous uncertainty, and don’t see the tragedy in the data yet, there are other early indicators that present tremendous cause for concern for the office sector. The first is that the average time on the market for the average office space is increasing in almost every submarket throughout Orange County. Time on the market tells you how long the average office suite has been available for lease or sublease. In the last quarter alone, in the Airport area average time on the market has gone up from 8.1 months to 9.1 months, South County from 7.7 months to 8.3 months and in West County from 8.0 months to 9.1 months. This is really bad news for building owners and is a function of very few leases having been signed in the last four months.
Additionally, we are seeing office availability rates begin to rise (“availability” includes all office space on the market including subleases, and space for lease that is not yet vacant). The Airport area has seen availability rise from 15.3% at the beginning of the year to 17.3%. The Central County submarket has gone from 14.6% to 15.9%, and the submarkets of North County, West County and South County have all seen their own increases in availability. Adding COVID to the mix has amplified the problem whereby companies are not using their office space, and we are seeing companies re-evaluate leasing space every week.
Being blunt about the market, chances are that with the exception of Fashion Island and The Irvine Spectrum high rise market, by the end of the year availability rates could very likely be above 20% in almost every core office market in Orange County. There is the very real potential that many key office markets in Orange County will be at 30% availability by the end of 2021. While I admit that preceding sentence is terrifying, and controversial, and will be greatly disputed by my colleagues in the commercial real estate industry, based on the hundreds of companies that I’ve spoken to in the region, and the thousands of companies that my team has spoken to throughout the country, I don’t see how it ends any other way.
All of the surge in supply that’s going to occur over the next 18 months will create the strongest tenant market that we’ve seen in two decades. For the companies that make it to the other side of this crisis, as they work hard to rebuild their businesses and stabilize their losses, there will be tremendous opportunities in the market to downsize, and likely pricing will be 20% to 30% below what tenants used to pay in the pre-COVID days. There will be tremendous opportunities for subleases, and also lease renewals and restructurings and favorable prices for those companies that can still utilize the space that they have. For those companies that need flexibility, they’re going to find a market that will provide 2 to 3-year solutions versus the 5 to 10-year solutions that tenants had to sign in pre-COVID days. Many of those solutions will be “plug-and-play” and fully furnished, allowing companies to avoid the expense of purchasing furniture and setting up new space with technology systems.
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.
Jeffrey Shepard is a senior vice president of Hughes Marino, a global corporate real estate advisory firm that exclusively represents tenants and buyers. Contact Jeffrey at 1-844-662-6635 or firstname.lastname@example.org to learn more.