Dispatch from the front lines; the office market edition

The pandemic has upended the office sector more than any other commercial real estate sector, except arguably retail. By this stage, most of us are accustomed to working from home. Our schedules and routines have changed to adjust to this new normal, and we don’t anticipate working out of the office for at least the next few months. What does this mean for you?

In our November newsletter we discuss the latest trends in the office market, as well as some creative ideas that property owners and tenants can use to best capitalize on the evolving market conditions.

Vacancy is on the rise. Across the board in all submarkets of Portland, vacancy is on the rise. Some companies have gone under due to constraints on their business resulting from the pandemic, while others are finding that working from home is well suited for their employees. From an operating standpoint, not having the overhead of a physical office space frees up cash flow, and companies are seeing this benefit. As a result, sublease space is on the rise as companies are looking to shed excess space. According to Costar data, the latest figures show 560,000 SF of vacant sublease space in the CBD and 1.2 million SF market-wide.

Asking rates are holding flat, but we predict that the increase of sublease space will put pressure on direct rents. We are anticipating a decline in rents heading into 2021. We expect the most impacted submarket to be the downtown core.

Concessions

The implications of the current glut of office space (especially in the CBD) will be significant. Landlords are increasingly realizing they must offer additional financial incentives to entice both new prospects and existing tenants whose terms are expiring. The two tools landlords have to offer are 1) free rent, and 2) tenant improvements funds. In most cases, landlords will prefer to offer a generous concession package heavily weighted with free rent. In turn for the incentive package, landlords will cling tightly to a higher rental rate.

With the increase in vacancy and concessions coupled with a predicted drop in rents, we are seeing what was once a strong landlord market turn toward favoring occupiers. With so few tenants in the market right now, landlords are going to be eager to make deals when the opportunities arise. This is shifting the balance of power toward occupiers, and tenants signing leases right now are reaping substantial benefits as compared to a year ago.

So what can landlords do to position themselves to land a deal when the opportunity arises? First, you need to be ready to play ball and act quickly. Have a game plan and know what levers you can push to incentivize the tenant. Thinking about offering flexible terms up front. A chief concern we keep hearing from tenants right now is, What happens if there is another Covid-19 Stay at Home order? Counter that objection with month-to-month terms, but don’t tie yourself to the tenant long-term; make sure the landlord has a 30-day right to terminate as well. For landlords that aren’t in a position to offer such short-term deals, it’s even more important to be ready to jump on a potential tenant by being willing to play ball.

As for tenants, their negotiating power has increased dramatically. The amount of available space on the market is greater than what it was a year ago. There is also more sublease space to look at. Sublease space is likely to be deeply discounted in order to attract a tenant. It will typically offer shorter terms on the underlying lease, and if it is furnished it substantially cuts down on moving costs. This can be a great way to maintain an office, reduce occupancy, and ride out the uncertainty of the pandemic.

Given that there are more options available, landlords are starting to offer more concessions and lower lease rates. In order to maximize the tenant’s position in the market, we strongly recommend working with a real estate professional who can leverage the opportunity and drive the best deal.

Trends

We anticipate several trends starting to emerge in the current market; primarily, 1) flight to quality, and 2) new locations. Another emerging trend for tenants (especially office and professional services) is rethinking which employees need to be in the office. This brings location even more into play.

Flight to quality in an economic downturn is textbook in commercial office leasing. Historically, landlords of premier office properties have been able to pick and choose their tenants. Now the tide has turned, as the market favors tenants ready to take advantage of the conditions. (Despite those conditions, it is crucial for tenants to have their financial statements in good order. The market has shifted, but landlords will be adamant about credit quality.)

Location is obviously a significant consideration when selecting your office. Traditionally, law firms were situated close to courthouses. Parking was a big driver. Proximity to executive housing was at one time near the top of the list – no longer. Change has been coming for the past few decades, but Covid-19 has accelerated this. Everyone now has to embrace some version of the work-from-home model. We do not believe the office is a thing of the past. But it has most definitely changed and will be forever altered.

So what can we expect from the next generation of offices? The footprint will be smaller. Certain employees will be able to continue to work from home. However, some will need to return to the office more permanently. The specifics of this situation is a key factor for companies to consider. Beyond this, other considerations include reliance on mass transit, available parking, the need for private offices, common-area restrooms, HVAC systems, and janitorial procedures.

Overall, it is critical to develop a plan as we look forward through the darkness for that light at the end of the tunnel. We are ready to walk side by side down that path to help you navigate the new realities of commercial real estate.