“Sublease Pandemic?” Office leasing activity plunged or collapsed, depending on city, even as companies dumped huge amounts of suddenly unneeded office space on the sublease market.
By Wolf Richter for WOLF STREET.
In the third quarter 2020, the commercial real estate segment of office space in Houston, Manhattan, Chicago, San Francisco, and Los Angeles – each representing a different area of the US with different economic dynamics – has gotten hit hard by the stunning shift to work-from-home (WFH) and the sudden corporate realization that, after years of hogging all available office space for future use, they need to get rid of this space.
There are big differences between the cities. But all of them are getting hammered by a tsunami of sublease space, where companies that leased the space long-term need to shed this space, and the only way of shedding it, other than defaulting on the lease, is to put it on the market and sublease it. These companies will take lower than market rents, thereby driving down overall rents. A surge of sublease space is toxic for commercial real estate.
“Total availability” – sublease availability plus availability of space directly leased by landlords – has soared in all five markets, as has the “total availability rate” (availability divided by total office space), while leasing volume has either plunged or outright collapsed. With transactions nearly frozen during a supply glut, pricing is hard to nail down and will take longer to shake out.
Manhattan wheezes under the weight of sublease space.
Sublease space soared by 2.5 million square feet (sf), including 191,000 sf from Starr Companies at 399 Park Avenue and 147,000 sf from Omnicom Group at 1 Hudson Square.
This drove overall market availability in Q3 to 13.3%, even as leasing activity plunged by 45% year-over-year to 4.7 million sf.
Class A asking rents fell 5% year-over-year to $93.43 per sf per year; but the “taking rental rate” – the rate at which leases are actually signed – fell to $84.39 per sf. Overall asking rents dropped 3.1% to $80.29 per sf, “due largely to the pricing impact of sublease additions rather than a shift in direct availability repricing,” Savills Research reported. By submarket, rental rates ranged from $122.38 per sf at Plaza North to $56.31 per sf in the Financial District.
In addition, average concessions jumped by about 25% to 14.3 months of free rent. Plus, tenant improvement allowances rose by 5% to $115.87 per sf.
“Even if owners remain hesitant to significantly lower direct asking rents, the reality is that the gap between asking rents and taking rents is widening, and generous concessions will result in declining effective rents,” Savills said.
That the lease activity didn’t plunge even more was due to Facebook signing the largest lease of Q3 for 730,000 sf at the redeveloped James A. Farley Building in Midtown.
“Evidence is mounting that occupiers may seek a more permanent WFH shift, which could lead to a 10-20% structural reduction of aggregate demand for office space across the market,” Savills said.
“When discussing WFH in quarterly earnings calls, more than 80% of S&P 500 companies expressed positive sentiment. Even a more permanent shift of WFH for just one-to-two days per week across these companies could drive a potential reduction in space demand of 9-18%,” Savills said.
“Trophy assets will benefit from a flight-to-quality trend as organizations transition the use of office space from ‘performing work’ to centralized collaborative meeting places for culture and innovation,” Savills said.
San Francisco got rug pulled out from under it, leasing volume collapsed.
Leasing activity collapsed by 88% year-over-year, and by over 50% from Q2, to a minuscule 300,000 sf. There was only one lease over 50,000 sf.
Sublease, already high in February, has more than doubled since then, to over 7.5 million sf, the highest in San Francisco’s history, according to Savills Research.
Overall availability, driven by sublease space, soared to 17.7%, more than double the 8% availability in 2015. Availability ranged from 13.4% in the Financial District South to 34.8% in the Jackson Square submarket.
“This glut of lower-priced sublease space has spurred some repricing,” Savills said. Overall asking rents fell 6.5% year-over-year to $75.98 per sf per year. Class A asking rents fell 10.8% year-over-year to $79.55 per sf.
However, with leasing activity having collapsed to near nothing, there hasn’t been “opportunity for true price discovery, and quoted rents remain artificially high in relation to the tsunami of sublease inventory and rapidly rising availability,” Savills said.
Some of the companies that have put office space on the sublease market, after re-evaluating their space needs, include Twitter (100,000 sf at its HQ) and AirBnB (61,000 sf).
And Pinterest, which had signed the largest lease in San Francisco in 2019 (490,000 sf), recently agreed to pay nearly $90 million to terminate that lease.
“Some companies are exploring permanent work-from-home policies as well, allowing employees to move out of the Bay Area and continue employment,” Savills said. “This will continue to impact the market now – and in the future – as companies restructure their business strategies and downsize office footprints.”
Houston, worst hit: double whammy of Oil Bust & WFH.
At the end of Q3, overall office availability in Houston rose to a new record of 27.9%, up from around 17.5% in 2014, when it was already high following a Texas-magnificent construction boom. Class A availability jumped to 29.1%.
In terms of submarkets, availability ranged from 8.4% at Medical Center/South – health care and life sciences being a big industry in Houston – via 29.5% in the Central Business District, to a catastrophic 50.7% in North Belt/Greenspoint, according to data from Savills Research.
But leasing volume in Q3 plunged by 47% to just 2.0 million sf.
Overall asking rental rates have been wavering in the same narrow range since 2014, with the overall asking rent currently at $29.15 per sf per year. The Class-A asking rent at $33.67 per sf per year is down about 6% from 2014. Over the years since the oil bust began, companies, when their leases came up for renewal, upgraded to the latest and greatest office space, leaving their old digs behind and vacant. But that too appears to have ended now, as “cost-consciousness has come to the forefront with tenants actively seeking out lower-cost options.”
“While optimistic landlords are slow to implement downward asking rent revisions, the reality is that the variance between asking rates and taking rates is widening and concession offerings are becoming increasingly competitive,” Savills said.
The largest lease signed in Q3 was by JP Morgan Chase for 252,000 sf at 600 Travis Street in the Central Business District.
Chicago Downtown sublease space surged, as leasing volume plunged.
Leasing volume plunged by 73.3% in Q3 compared to a year ago, to below 1 million sf, and overall availability soared to 18.6%, the highest since 2000, driven by sublease space that soared to over 5 million sf, Savills Research reported.
Given the “glut of newly available space, both direct and sublease,” overall asking rents have begun to skid in Q3, to $40.63 per sf per year.
Los Angeles sublease space doubled in six months.
Office lease activity in Q3 plunged by 61% year-over-year, to just 1.6 million sf, as most companies “are continuing to put long-term real estate decision-making on hold with short-term extensions accounting for many of the leases that did close in the quarter,” Savills Research reported.
Available sublease space nearly doubled since February to over 7.0 million sf in Q3. This pushed overall availability to 20.1%, the highest since 2012. Class A availability rose to 19.6%.
“Quoted asking rents are holding firm, even in the face of a softening market, although these are expected to decrease in the months ahead,” Savills said. Overall asking rents were flat with Q2 at $3.66 per sf per month ($43.92 per sf per year).
Class A asking rent ticked up by 1.8% to $3.89 per sf per month ($46.68 per year). “However, this increase in average rents was solely due to high-priced availabilities in under-construction projects, as most landlords of existing buildings have been hesitant to reduce quoted rents despite increasing downward pressure due to tepid demand and a sharp rise in availability,” Savills said.
On Tuesday during morning rush hour, I walked through the Financial District of San Francisco and took photos to document the spookiness of it all. Pedestrians used to rush to work on crowded sidewalks, balling up at red lights, then stream across the intersection, and cars used to be stuck in traffic, and throngs of people would pour out of the Montgomery BART and Muni Metro station. Used to. Read... Haunting Photos of San Francisco’s Desolate Financial District During Morning “Rush Hour”: Visual Effects of Work-from-Home
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