11.15.2023 Co-working giant WeWork’s bankruptcy filing earlier this month exemplifies the fundamental challenges facing the post-COVID office market. It is the largest real estate bankruptcy this year, with over $18 billion in liabilities. The co-working company, once valued at $47 billion, joined 19 other real estate industry bankruptcies this year, collectively totaling about 10 per cent of all bankruptcies recorded so far in 2023. WeWork had grown to become the largest office tenant in Boston, New York, Chicago, Washington DC and London, according to the company’s website. While the future of the firm is uncertain, it has already announced plans to close 1.9 million square feet of office space, or about 35 per cent of its footprint. WeWork’s failure will reverberate in downtown business districts across the country.
Underscoring office challenges, The Wall Street Journal recently reported that lenders are foreclosing on a record number of mezzanine property loans, like second mortgages, many of which were lent against office properties. The report found that lenders foreclosed on 62 mezzanine loans through October, more than double last year’s number, as property owners, particularly of office space, struggle with high interest rates, rising vacancies and falling rents. Moreover, the pandemic lockdowns accelerated work-from-home (WFH) trends that were already gaining traction before 2020. Building access pass data suggests that only about half of office employees are at their desks on average, leading to stagnating occupancy rates. While many employers are urging their employees to come back to the office, some, including Allstate, a large Chicago-based employer, will be offering work from home for their employees and announced it will be cutting its office footprint in half. However, other employers, like Zoom Technologies, one of the biggest beneficiaries of the WFH trend, are moving back to the office.
Today’s office market fundamentals are clouding the investment landscape, but the disconnect between job growth and absorption makes forecasting future demand for space particularly perilous. Notwithstanding record employment, net office space absorption is negative, suggesting that occupancy has shrunk relative to existing office space and new construction coming online. From its peak in early 2022, office transaction volume plunged 84 per cent through September, underscoring the uncertainty.
“Highest and best use” strategies suggest that empty office buildings would be better served as multifamily dwellings. The prospect of converting an empty office building into residential is, however, challenging. Many offices are not near where housing is needed and many downtown business districts would need to be overhauled to welcome families. Functionally, office floor plans are much deeper than multi-family apartment footprints, so a sizable amount of interior space is not near a window. Moreover, offices don’t support many kitchens and bathrooms, so water lines and drain stacks would be another renovation impediment.
The proliferation of artificial intelligence (AI) is another unknown when gauging white-collar hiring trends. Similar to what the Internet did to retail real estate, AI could potentially do to office space. That’s because AI is the first major innovation targeting knowledge workers, many of those junior and senior managers who occupy today’s office space. It’s impossible to know the extent to which AI will crimp demand for knowledge work, but it represents another risk office investors must consider when making such a long-term investment.
At the same time, $93 billion of commercial real estate loans are coming due over the next five years. Banks, not wanting to be property owners, will likely play the “extend and pretend,” a strategy they employed amid the housing bubble. Banks own about half of commercial and multifamily real estate debt, with regional banks owning double the amount of the big banks. Collectively, the industry has charged off over $1 billion in commercial real estate loans through June, a nearly 40-fold increase over the previous 12 months. And that trend is escalating. We don’t expect the capital markets to normalize for the office sector until lenders and investors understand the implications for demand of WFH and AI. Meanwhile, transaction volume, at just under $10 billion in September, is down more than 80 per cent from its January 2022 peak. We expect deal volume to remain subdued against a gaping spread between what sellers want and buyers are willing to pay for office buildings.
Before we throw a wet blanket over the entire sector, it should be noted that office real estate, like other property types, is extremely local. There will always be desirable office properties somewhere. In fact, office space along the Chicago River is nearly full even though occupancy within Chicago’s “Loop” is mired at 60 per cent. Century City in Los Angeles is fully occupied despite record rents, while downtown LA offices sit half empty. In today’s office market, quality matters. Desirable Class A office buildings will likely remain fully leased while older, lower-quality office buildings will be plagued with high vacancies.
Bottom Line: Office property owners could find themselves in a bind as the nearly $100 billion in loan maturities over the next few years will be met with higher refunding rates and tighter lending standards. Even though banks will be loath to take over troubled properties, they will likely do so while requiring additional equity infusions from borrowers. We believe there will be opportunities to offer a combination of debt and equity to stretched borrowers who own high-quality assets in need of additional capital. While lower-quality office space will need to be renovated, converted or torn down, high-quality office space will remain places where most professionals would want to work.