- Demand Drivers. The Federal Reserve’s efforts to combat inflation have modestly slowed employment growth, but overall, labor markets remain in expansion and national GDP growth was healthy at 2.4% in the second quarter of 2023. National office-using employment is now 6.3% above December 2019 levels, led by technology, advertising, media and information companies. Accordingly, technology companies drove much of the leasing activity over the last two years; however, in the year-to-date, technology companies have accounted for just 8.7% of leasing activity, down from 37.0% in 2022.
- Leasing Fundamentals. Net absorption continued to contract in the second quarter of 2023, driven most strongly by the West and East. Both major gateway and secondary markets shed a comparable amount of occupancy in the quarter. The South and Sun Belt regions continue to perform well relative to the nation, though occupancy saw further declines in the second quarter of 2023. Leasing activity was again sluggish in most markets in the second quarter of 2023, decelerating nationally to 0.8% of inventory. Minimal leasing activity as a percent of inventory was relatively ubiquitous across most regions and market sizes, indicating a slowdown in the momentum that had been gained in the prior two years in some secondary and Sun Belt markets.
- Segmentation Analysis. Quality office assets continue to command a disproportionate share of the market’s limited activity. While Class A leasing activity as a percentage of inventory is pointing downward in the second quarter of 2023, it still exceeds the national average by 20 basis points; however, the Class A advantage appears to be eroding on the margin, having averaged 40 basis points in the preceding four-quarter period. Class A vacancy has increased 170 basis points year-over-year, in line with the overall market. Downtown markets continue to struggle: NCREIF suburban office vacancy was 14.7%, compared with 20.5% for Central Business District office vacancy. With national office vacancy at 19.0%, institutional core assets are outperforming.
- Debt Capital Markets. The office market faces unprecedented challenges over the next 18 to 24 months. Nearly $400 billion in office loans mature between 2023 and 2025. Of these, we estimate $351 billion would have an LTV of 80% or greater if marked to market. They will struggle to refinance existing loans, and legacy debt issues will impede new financing for the sector.
- Investment Activity. Office investment activity decelerated once again in the second quarter of 2023. While activity increased 4.8% quarter-over-quarter, it has declined 64.9% year-over-year in the first half of 2023. Office loan originations declined 59.9% year-over-year in the second quarter of 2023, while total originations so far in 2023 are down 55.4% compared with the first half of 2022. No market segment has been spared from the slowdown in transaction activity, though on the margin nonmajor markets, suburban assets, as well as Midwestern and Sun Belt markets, have been more resilient.
Pricing. Transaction cap rates increased by 80 basis points quarter-over-quarter in the second quarter of 2023 after months of puzzling stability in the face of rising rates and uncertainty. Further adjustments are likely, given the continued elevated cost of capital. While cap rates have risen for both CBD and suburban properties, CBD office markets have seen larger adjustments, causing cap rate levels to converge. Similarly, major metro yields now appear to be higher than in nonmajor metros. The increases in cap rates have been catalyzed by the rapid increases in the cost of debt, which have risen from 3.3% in the third quarter of 2021 to 6.7% today in the fixed-rate market. REIT-implied cap rates have been far more reactive and, in our view, far more honest compared to the illiquid transaction market. Office REITs are trading an implied 9.7% cap rate and are the only sector offering above-average spreads to the cost of debt.
Returns. Office REITs have rallied off of new lows set in May of 2023; nonetheless, they are still down 40.0% since December 2021, the worst performance of any sector. While the truth of valuation typically lies somewhere between the public and private markets, it seems this time the public markets were closer to the mark. Private markets have only recently begun to capitulate. According to NCREIF, office properties returned negative 21.2% annualized in the second quarter of 2023, making it the worst quarter since the second quarter of 2009.
United States Office Market Overview
The United States office market continued to soften through the second quarter of 2023. Leasing activity slowed, nearing 2020 levels, as occupiers wrestle with a still uncertain economic outlook even as they right-size their portfolios for hybrid work. Liquidity in the capital markets remains challenged in the face of a rising cost of capital and record debt maturities.