When Silicon Valley search engine Pinterest opted to pay nearly $90 million to get out of its lease on 490,000 square feet of unbuilt office space in San Francisco in August, it sent shock waves through commercial real estate markets.
The message was that tech companies, which formerly thrived on productivity and creativity born around a water cooler culture, could do just as well when most employees worked from home and got together to hash out ideas over Zoom.
Suddenly, there would be no need for companies to lease as much space in expensive first-tier cities like San Francisco, New York and Chicago, or even in less expensive second- and third-tier cities. Workers could avoid long, frustrating commutes in bumper-to-bumper traffic and could protect themselves from exposure to COVID-19.
But what would happen to owners of all that office space and to the lenders who provided them with the capital to build and buy it?
Ever since the pandemic took hold, corporate executives have been pondering what to do about their office leases, how much space they would need going forward and whether their staffs can be productive working from home long term.
Because most have signed long-term leases and the questions they’re asking are difficult to answer, the impact on owners and lenders has not been as severe as on the hotel or retail sectors, whose loan delinquencies are at record highs.
Whereas 24% of all hotel loans and 18% of all retail loans sold in the commercial mortgage-based securities market fell into delinquency in June, only 2.7% of office building loans suffered the same fate, according to Cushman & Wakefield, the commercial real estate services firm.
“The office market, it’s like a slow motion car wreck,” said Christopher Marinac, director of research with Janney Montgomery Scott, a financial advisory firm based in Atlanta. “I see heavy uncertainty on the future demand for office space.”
It takes a lot longer for an office building owner to default on a loan, explained Jason Vanslette, a mortgage foreclosure litigation specialist with the Kelley Kronenberg law firm in Fort Lauderdale, Florida. Owners sign leases with multiple tenants and “a good amount” would have to stop paying rent at the same time for owners to get in trouble with lenders.
“Still, the slowing economy from COVID and the existential question of whether employees can continue working from home over the long term means the office sector will continue to struggle for the next two years,” Vanslette said.
As it stands now, about 14% of office space is vacant across the country, up from 12.8% last year, according to Cushman & Wakefield. And vacancy rates are expected to reach at least 17% – if not higher – by 2022, according to the firm’s estimates – rates not seen since the Great Recession.
Rents are also expected to fall by more than 5%.
According to a recent survey compiled by the DLA Piper law firm, large cities, including Chicago, Philadelphia and San Francisco – with their high-rise buildings and dependence on mass transportation – are expected to suffer more than smaller cities as residents and companies flee.
But John Sullivan, chairman of DLA Piper’s U.S. real estate practice, said it would be wrong to count out big cities just yet.
“It’s hard to determine what’s permanent and what’s not in the middle of a crisis,” Sullivan said. “After 9/11 and those horrifying pictures of planes hitting the World Trade Center, a lot of people predicted the death of high-rise office buildings. That was an understandable sentiment, but it obviously proved false in the long term.”
People have been choosing to live and work in densely-populated cities like London, Hong Kong and New York for hundreds of years for a reason, Sullivan continued. Those pronouncing the demise of those cities are being overly hasty.
The same goes for those who pronounce the death of office buildings.
Demand for space where people can work together will rebound, Sullivan predicted. Once vaccinations are widely available, people will be able to contemplate returning to their former routines.
“Then we’ll be able to distinguish the relatively short-term impacts of the global pandemic from fundamental long-term changes,” Sullivan said.