Industry Pursues Solutions to Office Market Woes

From “Industry Pursues Solutions to Office Market Woes” – Heartland Real Estate Business

There’s no denying the office sector is undergoing a critical period marked by myriad challenges. The question is, how will it all turn out?

Currently, the inventory of U.S. office space is 5.56 billion square feet — and will likely reach over 5.68 billion square feet by the end of the decade. But today’s “flexible” workforce will only require 4.61 billion square feet to accommodate its needs, according to a Cushman & Wakefield report titled “Obsolescence Equals Opportunity.”

“The U.S. will end the decade with 1.1 billion square feet of vacant office space, 740 million square feet of which qualifies as normal or natural vacancy and 330 million square feet of which qualifies as excess vacancy attributable to remote and hybrid strategies,” the report states. “The overall level of vacancy will therefore be 55 percent higher than was observed prior to the pandemic.”

Those numbers are jarring, but opportunists say the office sector just needs to evolve and adapt, much like the retail market has done.

Adam Johnson, executive vice president of capital markets and office services for Oakbrook Terrace, Illinois-based NAI Hiffman, echoes this sentiment, emphasizing that there will always be a need for cost-effective space. “Service-related industries, startup companies and others need a place that fits their budget.”

“Just as retail didn’t die in the years following the e-commerce boom, the office sector is not in danger of demise,” states the Cushman & Wakefield report. “Recognizing the challenges and opportunities head-on with a proactive, creative and strategic approach will help both existing ownership and the prospective investment community ensure the viability of millions of square feet of commercial real estate space.”

The two main strategies for struggling office assets are to renovate them or repurpose them into new uses.

“Given there is a shortage of housing across the country, and since housing can take shape in many different forms and typologies, it’s a natural fit for repurposing office properties,” says Mike Krych, senior design leader and managing partner with Minneapolis-based architecture firm BKV Group. “The concept of converting office to residential is not a new one, but [the situation] has become much more acute now with a lot more space available.”

Naturally, some office buildings are more suitable for multifamily conversions than other property types. Krych says that pre-World War II properties constructed between 1900 and 1940 are particularly well suited for multifamily adaptive reuse because they are naturally ventilated with operable windows and feature shallower footprints. Modern office buildings are often more challenging to convert because of deep footprints that don’t rely on natural light or ventilation, and instead utilize mechanical systems, resulting in open floorplates without windows.

BKV Group is currently transforming a modern commercial building, Landmark Towers in St. Paul. When it was built in the early 1980s, the development featured five levels of condominiums at the top and 213,000 square feet of office space on the middle levels. The office floors are now abandoned, and the plan is to convert the space into 186 apartment units. Historic tax credits will help finance the $80 million project being undertaken by Sherman Associates.

David Lockwood, executive vice president and COO with Colliers South Carolina and SIOR global president-elect, says that all office owners are evaluating how much money to spend on upgrades to attract and retain tenants or whether a building is not worth the expense. “We see Class A tenants moving to Class A+, Class B tenants moving to Class A, but nobody’s really backfilling the B and C space,” he says.

The flight to quality occurring in the office market often translates to tenants downsizing their square footage in exchange for higher-quality space. On the other hand, some industry professionals say certain tenants are still showing an interest in Class B and C spaces.

“The assumption is that everyone wishes to have a Class A space with all the bells and whistles, but the older and underutilized office product is not going away because it remains attractive to smaller entrepreneurial companies that are starting out, or companies that prefer to operate from a smaller location and need a storefront persona,” says Marilyn Russel, interior design project manager with Baker Barrios Architects, which maintains offices in Orlando, Tampa, Nashville and Chicago. “These spaces are affordable and attractive to the right tenant.”

Adam Johnson, executive vice president of capital markets and office services for Oakbrook Terrace, Illinois-based NAI Hiffman, echoes this sentiment, emphasizing that there will always be a need for cost-effective space. “Service-related industries, startup companies and others need a place that fits their budget.”

Financial woes

Given the supply-demand imbalance and cashflow problems plaguing many office building owners today, the property sector has fallen out of favor with investors. Total returns year-to-date through May 23 for office REITs fell 21.2 percent, as tracked by the FTSE Nareit Equity Office Index. On a year-over-year basis through May 23, total returns for office REITs plummeted nearly 41 percent. There are 19 office REITs included in the index.

NAI Hiffman’s Johnson states that most distressed sales will be tied to buildings that have lost a large anchor tenant. He foresees more distressed sales to come, but not at the pace some might expect, particularly in the suburbs. “The underwriting by banks coming out of the Great Recession has been conservative for office, so many loan-to-value ratios and personal guarantees will keep many buildings from going back to the lender,” he says.

Atlanta-based Piedmont Office Realty Trust (NYSE: PDM) reported a net loss of $1.4 million in the first quarter compared with net income of $60 million in the first quarter of 2022. Philadelphia-based Brandywine Realty Trust (NYSE: BDN) reported that its net loss allocated to common shares totaled $5.3 million in the first quarter compared with net income of $5.9 million this time last year.

On April 26, New York City-based Vornado Realty Trust (NYSE: VNO) announced it would suspend its common stock dividends until the end of the year. The REIT also authorized the repurchase of up to $200 million of its outstanding common shares under a newly established share repurchase program. Cash retained from dividends or from asset sales will be used to reduce debt or fund share repurchases.

Many landlords are also at risk of defaulting on loans. According to Cushman & Wakefield, $40 billion in outstanding office loans currently face some form of trouble or distress, representing 1.7 percent of total outstanding loans. The office sector is also facing a wave of oncoming debt maturities representing more than $130 billion over the next two years.

Lockwood says much of that distress stems from Class B and C buildings where there may be nonrecourse loans attached to properties without high occupancy. “Owners will have to make the decision of whether they put more money into the building, or whether they default on the loan,” he says. “That’s where the biggest challenge is going to be.”

“This is a difficult situation and we’re going to see it play out over a period of time that extends beyond this year,” says Darin Mellott, a vice president of capital markets research for CBRE. “In terms of hard numbers, it’s difficult to say right now. But we’ll see more distress surface in the coming months.”

Distress is also mounting in the form of property sales. The Wall Street Journal recently reported that owners are starting to unload troubled office buildings at fire-sale prices. According to the newspaper, the uptick in these types of sales indicates that more owners believe that weak tenant demand is here to stay.

NAI Hiffman’s Johnson states that most distressed sales will be tied to buildings that have lost a large anchor tenant. He foresees more distressed sales to come, but not at the pace some might expect, particularly in the suburbs. “The underwriting by banks coming out of the Great Recession has been conservative for office, so many loan-to-value ratios and personal guarantees will keep many buildings from going back to the lender,” he says.

About NAI Hiffman:

NAI Hiffman is one of the largest independent commercial real estate services firms in the US, with a primary focus on metropolitan Chicago, and part of the NAI Global network. We provide institutional and private leasing, property management, tenant representation, capital markets, project services, research, and marketing services for owners and occupiers of commercial real estate. To meet our clients’ growing needs outside of our exclusive NAI Hiffman territory, we launched Hiffman National, our dedicated property solutions division, which provides property management, project services, and property accounting services across the country. NAI Hiffman | Hiffman National is an award winning company headquartered in suburban Chicago, with more than 250 employees strategically located throughout North America.

About Hiffman National: 

Hiffman National is one of the US’s largest independent commercial real estate property management firms, providing institutional and private clients exceptional customized solutions for property management, project management, property accounting, lease administration, marketing, and research. The firm’s comprehensive property management platform and attentive approach to service contribute to successful life-long relationships and client satisfaction. As a nationally bestowed Top Workplace, and recognized CRE award winner, Hiffman National is headquartered in suburban Chicago, with more than 250 employees nationally and an additional six hub locations and 25 satellite offices across North America.