Big Picture: Preparing for and Profiting from the Office Real Estate Apocalypse, Part 1

Will commercial real estate ever get back to what it was before the pandemic?

In this three-part series, Management Professor Mark Markuly does a deep dive into commercial real estate’s struggles, the implications for local economies, and how the concept of the work place has changed, perhaps forever.

Despite the return-to-work mandate falling short of expectations and tech layoffs continuing, he says there is still opportunity amid the challenges. "When the demand for office space goes through the kind of cultural transformation brought on by a multi-year pandemic, the purpose, necessity, and volume of commercial real estate undergoes reassessment."

Note: This piece and its research were completed in mid-January, 2023.

Part 1: How Remote Work has Reshaped Commercial Real Estate

One of the most significant and obvious changes of the post-COVID work environment is the sea change that has occurred in American workers’ relationship with the “place” and “space” of their employment. A less explored area of the post-pandemic world’s worker “dis-placement” and “dis-spacement,” however, is starting to get more attention: the rippling effects remote work is having on the commercial real estate market.

As the square footage of empty space in office buildings across the nation increase dramatically, it is time to heed the echoing alarm bells coming from millions of square feet of empty floors and vacant offices, and the warning signals they are sending about the consequences for the American economy.

In 2019, only 24 percent of the American population worked from home, while 82 percent went into the office. [Source: “American Time Use Survey – 2021 Results,” Bureau of Labor Statistics: U.S. Dept. of Labor, June 23, 2022.]

As technology has made it possible for remote work to become more productive, periodic, partial, and full-time arrangements for work from home has been a growing phenomenon in the U.S. The U.S. Bureau of Labor Statistics found that in 2021 the percentage of the American workforce that did some or all of their work at home had risen to 38 percent, while the number doing most or all of their work in the office had dropped to 68 percent.

This has not gone unnoticed. A great deal of attention since the beginning of COVID has been given to the specific challenges of organizational management, like how to supervise remote employees, evaluate worker performance, build worker satisfaction, onboard new employees who never see their coworkers face-to-face, and a number of other issues.

What is less explored is the increasingly large number of vacant office buildings across the nation and how the cost of empty floors impacts the firms that rent the space, the mortgage lenders that hold the loans on the buildings, and the role these mortgages serve in securing pensions and investment portfolios.

In addition, the 14 percent increase of remote workers over a scant two year period represents a profound shift in worker practices. Statista, a market and consumer data company, reports that there have been 158.28 million Americans employed in 2022. This means that the number of Americans working from home in the workforce has increased by the staggering amount of 22,299,200.

This figure represents the diminishment of the number of workers showing up at the office in metropolitan areas, but it also is an indication that 22.3 million fewer people are purchasing gas, bus or train tickets Monday through Friday, and the same number are not buying breakfasts, lunches or dinner, or shopping in downtown stores. Collectively, these changes have a bruising impact on the economy, while also opening up new opportunities for the right kinds of entrepreneurial thinking people.

Although fluctuations in the demand for office space is common, the magnitude of the market shifts during and in the aftermath of the COVID pandemic are unprecedented. Since the beginning of the health crisis, millions of square footage in office space have emptied and remained vacant.

While much of American society has returned to pre-pandemic patterns, with restaurants operating at near full capacity, entertainment venues bouncing back to pre-pandemic numbers, and visits to retail stores actually jumping 14 percent from pre-pandemic levels, occupied office space is not bouncing back, and increasingly looking like it will not anytime soon, if ever.

The Downtown Seattle Association (DSA) has tracked the pandemic recovery with an assortment of metrics. During September, the region concluded a strong summer tourism season with seven million visitors, a rise of almost 25 percent over 2021, and sold 360,000 hotel rooms, which was 95 percent of 2019 levels.

DSA also found that more than 56,000 downtown residential units were occupied in September of 2022, representing a slight, but steady increase from the figure in 2020. However, during this same period of time, DSA found that worker foot traffic in downtown Seattle was estimated at only 40 percent of 2019 levels. This is a little lower than the activity reported in other cities throughout the nation.

Based on November figures, a 10-city occupancy average by Kastle Systems reached 47.5%. This figure is compiled by Kastle based on the data of office workers swiping into office buildings in 2,600 buildings and 41,000 businesses across 47 states.

Some cities are doing worse than others. Seattle’s 40 percent of pre-pandemic downtown foot traffic compares to about 30 percent in Los Angeles and a little more than 20 percent in San Francisco.[Source: Seattle's Downtown Recovery Dashboard.]

Manhattan is likely to have the worst situation in the nation. In July of 2021, the downtown area had only 21 percent of its office space occupied, creating perhaps that city’s largest office space crisis since the 1970s when more than 60 of the city’s 125 Fortune 500 companies moved out of town. The announcement of more layoffs in the technology industry will make the situation worse.

The news of significant downsizing in the tech industry is particularly bad for the growing commercial real estate problem. Not only will the layoffs across the sector add an estimated 30 million square feet of office space vacancy in the United States, but the technology sector accounts for an estimated 20.5% of office leasing activity in the nation and has been the most stable office space leasers during the pandemic.

While buildings emptied during COVID, often because of mandated lock downs, tech companies were still building new ones and leasing additional office space in preparation for the massive growth opportunities the work from home paradigm shift was providing for certain sectors of technology, particularly those related to e-commerce. Recent layoff decisions signal how poorly the tech decision-makers read the signs of the times.

Empty Commercial Real Estate Reaches Critical Mass

For companies caught with long term leasing contracts for office building space, they are now scrambling to sublease their unused space.

By conservative standards, there is now an unprecedented 232 million square feet of surplus office space for sublet, twice the volume from before the pandemic. By 2024, new building construction will add another 104 million square feet of available space.

These destabilizing forces in office space are distributed across the entire nation. Even Texas, which took COVID shelter in place restrictions less seriously than most cities with hard lock downs, is struggling with filling their buildings. Current occupancy rates compared to pre-pandemic numbers are 62 percent in Austin, 57 percent in Houston and only 53 percent in Dallas, according to Kastle.

There is significant collateral damage from all of these sparsely populated buildings in downtown areas across the nation. In Seattle, the DSA estimates that some 185 retail businesses have closed in the downtown area, easily noticeable with the boarded up storefronts.

Larger cities bring these patterns to scale. While the vacant office space in New York City grew from 90 million square feet to 125 million between April 2020 and March 2021, Manhattan also tallied the closure of more than 5,200 retail businesses.

All this empty square footage is beginning to impact the overall economy. Next to apartments, office buildings hold the most real estate debt, about $1.2 trillion of the total estimated $5.4 trillion that is owed. This means when office building landlords start defaulting on their mortgages, which is already happening, it will rapidly create larger economic challenges.

According to a study at NYU and Columbia, America might have a severe 39 percent downturn in the value of its office buildings, a loss of $454 billion in value that will ripple through the economy in ways not often discussed. Here is some of the potential impact:

The actual cost of office space for an employee is rarely demonstrated in company balance sheets, but Stijn Van Nieuwerburgh, the Earle W. Kazis and Benjamin Schore Professor of Real Estate at Columbia Business School, estimates that in New York City a company pays about $16,000 per year per employee.

Motivated by the current and potential consequences of this accumulating cost for workers who no longer use the space, Van Nieuwerburgh and his colleagues just published a research study, Work From Home and the Office Real Estate Apocalypse. Their study questions whether “commercial office buildings may become a stranded asset in the wake of the disruptions resulting from remote work.”

Of particular concern for him is the sobering reality that office space assets are frequently financed with debt, and a steep devaluation of properties would destroy the building owners’ equity. This would have the concomitant effect of a reduction in the tax base for local government, jeopardizing the funding of basic municipal services.

In addition, these revenue shortfalls would create the collateral damage of negatively impacting the investment portfolios of everyone carrying investments in commercial real estate, which includes pension funds, bonds, insurance companies and the portfolios of many investors.

The tax rate of commercial properties adds a significant amount to urban coffers used for city services. In the second quarter of 2021, for instance, each square foot of commercial office space in downtown Washington D.C. paid the government 2.5 times the property taxes levied for multifamily residential zoning. The 1,921 properties designated for commercial space in D.C. garnered $1.35 billion in property taxes (44 percent of all taxes collected) and $88 million in Business Improvement District taxes for the District.

When devalued commercial buildings begin paying less taxes, local governments begin having shortfalls in revenue and are forced to cut services. The amount of this shortfall can become substantial. As just one example, between spring of 2020 and 2021, the market value of Manhattan’s two central business districts dropped 25 percent, resulting in a decline of $1 billion in property tax revenue to the city.

Next week: Dis-spacement — The Commercial Real Estate Crisis Reboots Reflection on the Role of Place.