After several years of deep distress, the beleaguered U.S. office market has reached an inflection point. This year, office conversions and demolitions will exceed new construction for the first time in at least 25 years.
Simply put, more office space is being removed than added, shrinking the overall office footprint, according to exclusive new data from CBRE Group. The commercial real estate services firm has been tracking this since 2018, but estimates it may be the first time such a dynamic has played out this century, and likely longer.
CBRE found that across the largest 58 U.S. markets, 23.3 million square feet of space is slated for demolition or conversion to other uses by the end of this year. In comparison, developers are projected to complete construction of 12.7 million square feet of office space in those same markets.
“This net reduction – albeit slight – of office space across major markets likely will contribute to lowering the vacancy rate in the quarters ahead, which would benefit building owners,” said Mike Watts, CBRE Americas president of investor leasing.
All of this is being driven by the fundamental shift in office attendance, resulting from the growing remote-work culture since the start of the pandemic. Office vacancies soared to a record high and still hover right around there at 19%.
But the market is starting to recover. More employers are ordering staff back to the office full-time, and, as the job market tightens, more employees are willing to take what they can get, even if it means more in-person attendance.
Net absorption, which is the amount of space newly occupied in a quarter versus the amount vacated, has been positive for the past four quarters after six straight quarters of being negative. Office-leasing activity increased 18% in the first quarter of this year, compared with the same time frame the year before.
With less supply and steadily increasing demand, office rents should stabilize. For prime office locations and new, so-called Class A space, rent has recovered. Beneficiaries in that space are some of the major office REITs, like Vornado, BXP, Alexandria Real Estate Equities and SL Green.
“The office market will benefit as obsolete space is removed from the market in favor of the highest and best use. Additionally, conversions will boost the vibrancy of neighborhoods within various markets,” said Jessica Morin, CBRE Americas head of office research.
Developers also have another 85 million square feet of office space being readied for conversion in the next few years. Since 2016, office conversions to multifamily residences have generated roughly 33,000 apartments and condominiums, according to CBRE, given that each conversion, on average historically, yields about 170 units. There are about 43,500 units in the pipeline from conversions already underway.
The reduction in office space overall is a positive for commercial real estate, but it will be slow going.
“The conversion trend faces a few headwinds. The pool of ideal buildings for conversion will dwindle over time. And costs for construction labor, materials and financing remain high,” Watts said.