What's driving office property valuations across the US?

Hangover from the 2010s office space boom

As recently as the mid-2010s, the recovery from the Great Recession meant rapid office development and growing tenants -- especially tech tenants in growth markets like Seattle, Austin and Silicon Valley.

All together, the United States added 682 million square feet of office space in the 10 years between 2010 and 2019, inclusive. The supply growth was fueled by low interest rates and strong demand.

Office development surged in many parts of the country. For example, major markets in the Pacific Northwest increased their office inventory by 32% during the decade, while the cities of the Midwest saw an increase of 18.5%. The Northeast grew its office stock by 16.5%, and Texas markets likewise mushroomed (such as downtown Austin, up more than 25%).

The demand for office space was there, especially in markets favored by the tech industry, which was seeing its own post-Great Recession boom. Amazon, Facebook, Google and Apple and countless smaller companies absorbed space like there was no tomorrow.

All these factors conspired to drive valuations upward. Low mortgage rates meant that office building investors could afford to pay more. Threadbare yields on securities also made rent-based income from office assets seem like a better bet in comparison, driving up investor demand.

New headwinds on office space

Fast forward to 2022 and the demand for office space isn't there. At least, not the way it was.

The shift has been fast, and in some ways, radical. This time around, office market headwinds aren't the usual business cycle downturn, though that could well be another factor if and when a recession kicks in next year.

Instead, a number of less-usual headwinds are ganging up on the market: the permanent change in workplace utilization, with five days a week in office going the way of the passenger pigeon; inflation putting pressure on business bottom lines, inspiring plans to cut total floorplates; and a major contraction in the tech industry.

Office space utilization varies widely across the country, but nowhere is it as robust as before the pandemic hit in early 2020. As of November, Kastle Systems puts office space utilization at a high of 56% on the highest occupied days of the week (Tuesday, Wednesday or Thursday), and as low as 32.2% on the least occupied day of the week, Friday. (The company surveys usage in 10 major metros.)

The total amount of office space leased has also been taking a dive. In Q3 2022, office vacancy inched up, while sublease space hit new record highs. For now, asking rents are mostly holding steady, with landlords offering generous concessions packages.

To add to the pressure on office assets, tech companies are now cutting thousands of jobs, and are expected to cut more, especially if the US falls into any kind of recession in 2023. Meta (formerly Facebook) has so far cut the most jobs, with 11,000 in early November. Also slashing staff: Twitter, Lyft, Shopify, Netflix, Microsoft, Tesla and many more.

But better-quality assets will hold their ground

The impact of a tumultuous economy is already having an impact on office asset valuations. In markets such as New York and Chicago, prices for some older office towers have already dropped by roughly a quarter. Even buyers who still want to buy are finding it tough, as elevated interest rates make it harder than ever to make deals pencil.

During the first ten months of 2022, the S&P 1500 Office REITs Sub-Industry Index dropped more than 37%, while the S&P 500 caused great gnashing of teeth by only falling 18.2%. Since the beginning of the pandemic (February 2020), S&P 500 is up more than 20%, but office REITs are down 43%.

Those fundamentals point to office valuation reset in the not-too-distant future. But despite the downward pressure on valuations, there are modest tailwinds for office assets that may help keep the fall from being too hard or too fast. For one thing, though tech jobs are being shed, the overall labor market is still relatively healthy, with the headline unemployment rate at 3.7% in October.

Also, the market is having a hard time reaching the necessary consensus among sellers and buyers about pricing. How long that can remain the case is anyone's guess, but as long as either side is willing (and able) to hold out, the impact on valuation will be restrained as less data about market trends is generated.

Moreover, there will still be a flight to quality among tenants, office experts say. Trophy Class A-plus office buildings have much less to fear from the current crisis, and are still seeing strong leasing activity. Companies that can afford it still want high-quality office space in growth markets.

Geography will be destiny for some office markets as well. There could be further outflows of human capital from expensive coastal cities (San Francisco being a prime example) to less expensive inland metros (Phoenix being an example of that).

Thus, the US office market is poised to further divide into winners and losers. The winners will continue to attract companies and their workers, while the losers will slowly fade away -- or quickly disappear -- as viable office space.