The U.S. office market, which is over $2 trillion in size, has not been immune to the pandemic-imposed disruption. Over the past year and a half, office vacancies have ticked up while rents have gone down. While the delta variant may have delayed a return to the office this fall for many firms, we are now seeing a steady increase of employees returning to work. According to Kastle Systems, office occupancy among the top 10 metro areas has been improving on a weekly basis, most recently reporting 37.8% average occupancy for all industries. However, the current national vacancy rate of 18.2% is higher than what we experienced in 2010 after the financial crisis.
While many questions remain regarding the future of office space, the death of the office is largely exaggerated. The office market is in a period of transition as businesses are evaluating space dedicated to individual use versus collaborative work. The pandemic dramatically fast-tracked the growing trend of remote work. Companies have successfully worked from home during the pandemic and many have now pivoted to a hybrid work model.
The longer-term demand for office space may decline as hybrid work remains in favor. However, more space per employee may now be needed as companies rethink their workspace and allow more collaboration and meeting space within their offices. Office de-densification (allowing more square feet per employee) began before COVID-19 and has been accelerated by the pandemic. Technology investment will be essential to make both in-person and virtual collaboration seamless.
On average, office properties compose about 30% of the underlying collateral within commercial mortgage-backed securities (CMBS). Given the significant exposure, investors should keep a close eye on upcoming lease rolls, particularly those that coincide with the loan’s maturity date. As leases begin to expire, businesses need to make decisions regarding their future office space needs.
Overall, the performance of office loans within CMBS has remained stable, with low levels of delinquencies to date. However, the office sector may be challenged over the next several years, and I expect performance to vary by region and property class. Investors should be more cautious on exposure to Class B or Class C office properties. In addition, older properties may struggle to compete with newer Class A trophy properties.
What is next for the office sector? As COVID-19 cases fall and vaccination rates rise, I would expect to continue to see a slow but increasing trend of people returning to the office. The long-term nature of leases means that it may take some time for vacancy rates to reflect the real trend.
It may take years before we have a clear vision of how the pandemic will impact future office footprints. The purpose of office space may shift, with it becoming more of a destination for social interaction and networking. The key to the future of office space will be flexibility and prioritizing employee well-being, while providing workers with the opportunity to collaborate safely.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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