The effects of the pandemic are becoming crystal clear as to how it’s affecting the commercial real estate industry

By Cameron Love & Kevin Brennan

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 causation, companies that operate in non-retail and non-hospitality facilities tend to be surviving, and in some cases thriving.

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. Removing co-working availability from the sublease count, San Francisco is now up to over 8.1M SF of office space, up from 2.1M SF a year ago—a 385% increase. 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 overall office space availability, where the availability of office space in San Francisco has gone up 65% since the pandemic began, from 11% percent to 17.5% percent.

The effects of the virus are most visible Downtown in the Financial District given the drastic contrast of empty sidewalks and boarded up retail, where availability rates are on par with the citywide increases up 65% in the North Financial District and 66% in the South Financial District since the pandemic began. Yet the submarket most dramatically impacted has been South of Market where over 20% of all office and flex inventory is available, up 65% since mid-March. The least affected submarket has been Mission Bay/China Basin where availability is now 7.9% in the submarket, up 80% driven almost entirely by the Dropbox offering at The Exchange. Of the ten largest submarkets in San Francisco, four (Yerba Buena, South of Market, Jackson Square and Union Square) are above 20% availability. North Financial District and Mid Market will likely be over that mark by years end with the balance of the city’s submarkets following by mid 2021. This is the thing that landlords and their listing brokerage firms don’t see coming. The number of companies that choose to sublease or abandon their space, versus reoccupy it, will continue to increase over time. As such, supply and demand fundamentals in 2021 through 2023 are likely going to negatively impact the commercial real estate office market like never seen before.

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. It’s 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’ve described this as death by 1,000 slices, and the effect on commercial real estate availability will be severe. 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 city will find availability rates at 25% by the end of 2021, and potentially 30% by the end of 2022.

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 25-50% off sale.