The effects of the pandemic are becoming crystal clear as to how it’s affecting the commercial real estate industry
By Alex Musetti
Now that we are a full two quarters deep into the global recession caused by the COVID-19 virus, the effects of the pandemic are becoming crystal clear as to how it’s affecting the commercial real estate industry. Certainly, everyone understands that the retail, hospitality, travel and leisure and entertainment industry categories are completely distressed, to the extent that tens of thousands of businesses have already been lost and the retail real estate category is in complete chaos. However, one of the bright spots of this recession is that we have not seen a significant loss of the businesses in the region that occupy industrial, research lab and office facilities. While difficult to pin the cause, companies that operate in non-retail and non-hospitality facilities tend to be surviving, and in some cases thriving.
Despite this year’s economic challenges, some companies have seen a spike in demand. Fueled by the transition of consumer spending from retail to e-commerce, distribution and fulfillment companies have gobbled up warehouse space in the region, resulting in over one million square feet of new warehouse leases in the region since March. In prior recessions, all asset categories of commercial real estate were affected in the same way and at the same time. However, this time it’s different, as we are seeing some industries grow during this pandemic, and certain submarkets like Platinum Triangle and Orange have actually seen availability rates decline to near-historic lows. In many cases, we are representing tenants that literally only have one option in the market that works well for them.
The story is very different for office space in the region, and throughout the country. There are two national trends that are causing an increase in supply in the office space category. The first is that sublease inventory is spiking as we continue to go through the recession, a trend that we identified back in March. Sublease inventory at cheaper rents and shorter terms is not only the leading edge indicator of a recession, but also a landlord‘s worst nightmare. The Orange County region is now up to just under 8.2M SF of sublease office space, up from approximately 6.1M SF a year ago—a 34% increase. We see similar trends in other California markets, including what’s happened in major urban markets like San Francisco and Los Angeles, where office sublease inventory has almost doubled and now reaches 9M and 9.5M SF respectively. With some exceptions, most of the office space tenants that we are representing in the market right now are looking exclusively at sublease spaces, and getting beautifully built out furnished space at big discounts to market, with more flexible length of terms. This is what landlords have to contend with when trying to lease out their competing vacant space.
The second factor contributing to the distress of the office market is that many office tenants that have had leases expire since the pandemic started have not renewed their leases and have elected to operate until post-COVID without any office space, essentially foregoing having any significant office space until they can reassess their needs in the post pandemic reality. Further, many office tenants with lease expirations in the next six months are also choosing not to renew their lease for the same reason. This is more common for smaller companies with 50 or fewer employees that are working fully remote and have determined that eliminating the expense of office space is to their benefit. This has caused an uptick in Orange County office space availability, where the availability of office space in the county has gone up from approximately 17.6M square feet last year to about 24M square feet today—a 36% increase.
The effects of the virus have been felt most strongly in the Irvine Airport submarket, where vacancy rates have increased by 17.5% since the pandemic began. The least affected market has been the Irvine Spectrum submarket, where the ubiquitous landlord The Irvine Company owns nearly 50% of all office buildings. In the Spectrum, vacancy rates have dropped from approximately 11.5% in March to 11.2% today. That, however, is not representative of the market as a whole, which has seen negative net absorption—an overall net increase in the supply of space—across the board. This is the thing that landlords and their defensive listing brokerage firms don’t see coming. Although there are still healthy, even thriving companies, the number of companies that choose to sublease or abandon their space, versus reoccupy it, will continue to increase over time, following the trend of negative net absorption. The result of this—and what’s coming in 2021 through 2023—is likely going to negatively impact the commercial real estate office market like never seen before.
That said, we strongly believe that most tenants will come back to the office. This is backed up by our thousands of conversations with business leaders around the country since March. Many employees are suffering from fatigue, depression and work/life imbalance, or do not have appropriate remote working infrastructure, and most employers want their teams back into the office where collaboration, teamwork and creativity can flourish. The issue is that most tenants are going to come back smaller, as a result of reductions in force and the fact that anywhere between 10% to 25% of their employees will now see full-time or part-time remote working as a significant lifestyle benefit. Employers are now talking about remote working as an employee recruitment and retention necessity for some functions and employees. Office clients that we are working with for 2021 occupancies are generally targeting 60% to 80% of the space they leased pre-COVID. One tenant at a time, companies will be downsizing over the next several years as their leases expire, putting millions of square feet of office space back onto the market. We’ve described this as death by 1,000 slices, and the effect on commercial real estate availability will be severe. The Irvine Airport area, Costa Mesa, South Santa Ana, Laguna Hills and Aliso Viejo are all already above 15% vacancy, and it’s likely that the remaining submarkets will see increased availability through at least the end of first quarter 2021, and likely beyond. If the last six months are any indicator of what the next year has in store, and unfortunately this appears to be the case, many submarkets in the region will find availability rates at 20% by the end of 2021.
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. Better to think of it like a 30% off sale.
Alex Musetti is a vice president of Hughes Marino, an award-winning commercial real estate company specializing in tenant representation and building purchases with offices across the nation. Contact Alex at 1-844-662-6635 or firstname.lastname@example.org to learn more.