Downtown Office Real Estate's Impending Collapse

 

Downtown office real estate is on the verge of collapse, according to industry experts. The high prices and strict regulations that have characterized the market in recent years are unsustainable, and a correction is inevitable. Many businesses are already moving out of downtown areas, and more will follow as rents continue to increase. This could be bad news for the economy as a whole, so it will be interesting to see how things play out.

 

It's no secret that the downtown office market has been booming in recent years. Rents have been going up and vacancy rates have been dropping. But many experts believe that this cycle is not sustainable, and that things are about to take a turn for the worse.

 

The high prices and strict regulation that have come to characterize the market are already starting to drive businesses out, and more will follow as rents continue to increase. This could be bad news for the economy as a whole, so it will be interesting to see how things play out.

 

It's worth noting that the downtown office market is not just booming in San Francisco. Cities all over the country are seeing similar trends, as businesses rush to take advantage of the current cycle.

 

But this cycle is not sustainable, and it's only a matter of time before things start to unravel. So stay tuned – it should be an interesting ride!

 

The imminent commercial disaster has San Francisco as its face, but everyone else is equally at risk.

 

The residential real estate market has now begun to collapse after seeing phenomenal gain over the past few years. Many doomsayers claim that this is the start of a complete collapse. While a pullback in the market is nearly probable, a collapse is almost certainly not in the cards. However, there is a portion of the real estate market that will experience a collapse-like situation.

 

In general, the future is not good for commercial real estate, especially office buildings. Additionally, particularly large office buildings are struggling and will face challenges in the upcoming years. Large coastal cities will be particularly affected, and San Francisco will serve as the model for this impending collapse with its serious downtown problems.

 

In fact, if there were such things as credit default swaps or a way to take a short position on real estate in downtown San Francisco, I would strongly advise considering such (I suppose non-existent) investments.

 

According to The San Francisco Standard, chief economist Ted Egan projected that once office leases expire in 2024, future vacancies might reach as high as 53% in the Jackson Square neighborhood and 43% in the mid-Market area.

 

The impoverished mid-Market neighborhood and the gleaming office skyscrapers of the East Cut are both affected by the current vacancy pandemic in San Francisco's central center.

 

The collapse has already occurred for some structures. For instance, 415 Natoma, a 653,900 square foot office tower owned by Brookfield Properties that was the only ground-up office project to deliver in San Francisco in 2021, has just one announced lease at the moment: 20,000 square feet taken by "remote-first" startup Thumbtack.

 

We can be assured that this issue will worsen because of the way commercial leases are composed. Commercial leases are typically 3-5 years long, and occasionally longer, in contrast to the normal lease on a home or apartment unit.

 

Before 2020, downtown commercial real estate was already in decline, but the pandemic accelerated that slide. Numerous businesses that signed leases in 2017–2018–2019 are still bound by those agreements for a few more years. But all indications are that a significant portion of them will quit after their lease expires.

 

So, if you believe there are a lot of vacancies right now, I advise you to sit down.

 

High Office Vacancy Across the Board

 

"Office vacancy is on the rise everywhere, but the rate of increase in downtown office vacancy is surpassing that of suburban office," The Business Journal observes.

 

They cite Ian Anderson, senior director of research and head of research for CBRE's Americas offices, who makes the following observation:

 

People have been far more comfortable driving to work in suburban regions with less crowding, so that has favored them more. "Downtowns around the U.S. have gotten clobbered considerably more through the crisis."

 

In fact, there are 25% fewer offices in downtown Los Angeles. It is above 17% in Manhattan, 26% in the center of Portland, Oregon, and 20% in Washington, D.C.

 

When their pre-Covid leases expire, they all face the same issue with pending moves out.

 

Vacancy rates in suburbs are typically much greater than those in cities. The two rates, however, have not only compressed but have also actually flipped, according to the most recent CBRE data.

 

Suburban and Commercial Vacancy Rates (2006-2022)

As Covid decreased and numerous limitations were lifted, the surge in vacancy rates this year (at least temporarily) leveled off. Even so, vacancy rates have stabilized at levels that are still more than 50% higher than they were prior to the epidemic.

 

Cause # 1: The pandemic and downtown deterioration

Obviously, Covid-19 and the ensuing lockdowns were the direct causes of this commercial real estate catastrophe.

 

The Visual Capitalist reported that small company revenues in 52 American metro areas were down between 13% and 49% in September 2020, the first month of the epidemic (but after the strictest lockdowns had been removed). (And naturally, San Francisco was the city where they had a 49% decrease.) Furthermore, 37% of small enterprises in the leisure and hospitality sector "reported no transaction data," making them particularly heavily hit.

 

The New York Times also noted that up to 400,000 small firms shut down, with many more failing and never coming back.

 

At the height of Covid, downtowns took a beating, with locations like Manhattan appearing deserted. Even though things have improved since then, the harm done cannot be undone fast or easily, especially because many downtowns have seen a sharp fall in quality.

 

The area's income and finances available for maintenance and upkeep are reduced as a result of improper maintenance and upkeep, which in turn discourages people from visiting or working there and maintains the vicious cycle.

 

Significant problems have also been brought on by other policies. Contrary to certain memes you may have seen, California did not legalize theft of $950 or less, but it did downgrade and deprioritize such crimes, which caused a noticeable increase in shoplifting and forced some stores to move. For instance, Walgreens closed ten locations in the city, including several in the downtown area, and cited "organized retail crime" as a major factor.

 

The nation as a whole is experiencing an increase in crime, which is often worse in densely populated places, making downtowns less desirable.

 

Unless the city has enough beds in homeless shelters to accommodate its homeless population, the Martin v. Boise ruling also made it challenging to remove homeless encampments from downtown districts. Unfortunately, relatively few towns have sufficient beds for this, and California's "housing first" rather than "shelter first" policy has led to a far higher number of homeless people spending the night on the streets. As a result, tent towns grow in high-density locations, where they frequently discourage foot traffic and reduce demand.

 

Sadly, as things worsen, they frequently spiral out of control because individuals no longer see the value in making an attempt to fix a situation because it would essentially make no difference.

 

Why pick up trash in a landfill? Why not litter yourself, in fact?

 

The situation has become so bad in San Francisco that someone even created an interactive "poop map" that shows the rise in "human feces events" on the streets, which was over 500% even before Covid struck.

 

Additionally, although I'm obviously focusing on San Francisco, this is a problem in many significant coastal cities and truly across the entire nation.

 

Cause # 2: Work from Home

 

Flex employment was all the rage a while back, and futurists imagined a period when everyone would work from home and lead contented lives. When Covid struck, those hopes were largely fulfilled.

 

And as it turns out, a lot of individuals get depressed when they can only work from home.

 

Despite this, many (perhaps the majority of people) adore the possibility of working from home and desire to do so 1-2 days per week. And some people prefer it and want to work from home continuously.

 

The number of people working from home tripled between 2019 and 2021, according to the Census. Companies like Twitter now permit employees to work from home as often as they'd want, but Tesla most definitely does not.

 

According to a McKinsey & Company poll, 87% of workers who are offered the option to work from home do so at least occasionally. Further research revealed that 23% of those with jobs can work from home part-time and 35% can do so full-time.

 

That seems a bit excessive, but these kinds of agreements are undoubtedly becoming more common. Additionally, some studies suggest that those who work part-time from home can be even more productive than those who primarily work in an office.

This reduces our requirement for office space, which has an impact on commercial real estate. Yes, businesses still require offices because working exclusively from home might make some employees feel extremely "cooped up" and because zoom meetings can't replace in-person meetings entirely. However, those areas don't have to be as large. Additionally, we require less of them.

 

Additionally, the areas that require the longest commutes to reach will be severely hurt. If my commute took two hours in traffic, I'm sure I'd be far more likely to work from home.

 

Vintage and the associated functional obsolescence are a significant problem. Old primary markets' vast tracts of commercial real estate are aging. People were forced into the units before the outbreak by inertia. No one wants to return there right now.

 

The expense of updating these old and perhaps outdated units will be significant.

Threats and Possibilities

 

It goes without saying that this is not the ideal time to purchase downtown office space. Generally speaking, offices are something that investors should be wary of. However, smaller homes and buildings are safer if you plan to purchase office space. Restaurants, industrial, and retail properties are better investments in terms of commercial real estate.

 

In light of this, every bear market has a low point. Both the need for office space and the need for space in downtown areas will persist in the future. After all, we have already witnessed how this particular story ends. The 1970s saw a sharp decline in downtowns across the nation, followed by a significant resurgence in the 1990s and 2000s.

 

In the United States, there is now a severe housing crisis. A report by Freddie Mac in 2020 claimed that there was a shortage of 3.8 million housing units. Additionally, new buildings were delayed down by the pandemic and lockdowns, widening the gap.

As of now, many of the regions with the worst housing shortages also have and will continue to have serious vacancy problems in commercial real estate.

 

Once the bottom falls out (probably around 2024), there should be major chances to convert existing office buildings into posh condos and flats. Despite crime and livability issues, many people adore living downtown and being "near to the action."

 

Yes, it will require a lot of finance, but for those searching for significant projects in the not too distant future, this is unquestionably something to watch.

JACOBS & CO. REAL ESTATE, LLC.

12923 Fitzwater Dr. Nokesville, VA 20155 

(703) 594-3800 | jacobsandco.com