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What's behind record office sector vacancy rates: Economist

According to a Moody's report, office sector vacancy rates have set a new record at over 20% in the second quarter. The author behind the report and Moody's head of CRE economics, Tom LaSalvia, joins Market Domination to give insight into the report and detail what's behind these record numbers.

LaSalvia elaborates on the shift of office space use: "The way we're thinking about this as obsolescence, that there is a good 10 to 20% of office buildings out there that really just will not be able to compete in this new era, this era of remote work, this era of new offices, this era of new, let's say, centers of power in terms of where office-centric locations are, right? You're getting migration into the Sunbelt. You're seeing even within metropolitan areas like New York, certain submarkets doing much better than others. And so what you're left with is 10 to 20% of obsolete offices that are going to have to find some new life in this new era."

For more expert insight and the latest market action, click here to watch this full episode of Market Domination.

This post was written by Nicholas Jacobino

Video Transcript

Office vacancies hitting an all time high record in the second quarter at 20.1%.

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It is the first time the sector has ever eclipsed 20%.

It's according to a new Moody's report and with us now is the co author of that report, Tom Lasalvia, head of CRE Economics and Moody's Tom.

It is good to see you.

So look at this Q two preliminary trend report, Tom, you do say listen off the sector record vacancy rate 20.1%.

Where does that rate go from here, Tom in the next, let's say 6, 12 months.

And, and what factors, what variables does that depend on?

Yeah, unfortunately, for office property owners, that vacancy rate continues to go up.

Some of our most recent research shows that with remote work really here to stay, we could see a 22 to 24% vacancy rate as at the peak of distress that's likely to hit sometime in 2025 maybe even early 2026.

So there's still a couple of years of accelerated distress as this plays out.

Uh One of the key variables here, it's gonna be well, office employment of course, and we know that the labor market is beginning to soften.

And another key variable here is remote work and remote work, as I said before, it is here to stay at least at some level.

Right.

I think there's still a trial and error period that's gonna last multiple years.

But we know that square footage per employee is gonna continue to drop and, and Tom when you talk about a peak vacancy rate in office of 22 to 23% I mean, just for so people know you said in the second quarter, it was about 20%.

So still an increase from there.

What then is the long term vacancy rate?

Right?

Like in other words, how long can it stay at 22 or 23%?

Is that the new normal?

It's a great question the way we're thinking about this as obsolescence that there is a good 10 to 20% of office buildings out there that really just will not be able to compete in this new era, this era of remote work, this era of new offices, this era of new, let's say centers of power in terms of where office centric locations are, right?

I mean, you're getting migration into the Sun Belt, you're seeing even within metropolitan areas like New York, certain submarkets doing much better than others.

And so what you're left with is 10 to 20% of obsolete offices, they're going to have to find some new life in this new era, right?

They're gonna have to go the way of a lot of these class B and class C malls over the past 30 years.

And do you see that?

I mean, that was one big trend time that was often talked about that you would see office buildings, you know, repurposed as for example, residential buildings.

I mean, I is that when you do your research to, is that actually happening?

Because there seemed like it seemed like it would be such tremendous uh red tape and bureaucracy to make that happen or no?

Is that a, is that a trend we're seeing that's actually playing out well, a combination of both of those things, it is a trend that we're seeing, right?

And we've seen it.

I, I think um the financial district in New York since 911 is a perfect example of how you can take at least older office buildings with smaller uh floor plates and you can renovate those into valuable residential real estate.

So there is a precedent for that.

I think the problem comes in is when you have some of these 19 seventies, 19 eighties office buildings where there's not a lot of natural light hitting the center of those buildings, that's where you're gonna run into real cost pressures that make it prohibitive to actually go ahead with one of these renovations.

And so where does that leave us that leaves us with a lot of subsidization, a lot of public private partnerships in order to convert some of these obsolete office buildings from that era, Tom, finally, I wanted to ask you about a report in the Wall Street Journal today that talked about potential fraud that has elevated the the valuations of some of these office properties that now that the market is pulling back, maybe those are being uncovered.

Now, I'm just curious how much of an issue you think that is in the market and then how that affects what we're gonna see next?

Well, what I can say about this is there's been a lot of extensions, there's been a lot of modification, a lot of work with loans, a lot of non transaction activity going out there, whether it's from the loan perspective or from the same perspective and that has not allowed really any price discovery.

So whether there's fraud or not or cooking of books or whatever, it might be a lot of that's gonna have to come out over the next year or two because again, especially if that building is considered obsolete in this new world, right?

Where do we go from there?

There's gonna have to be some liquidation of that asset and the truth has to come out about really what are the occupancy levels, the rent levels?

What's the income, what are the management expenses, right?

What's going on with each and every of these properties?

So price discovery is gonna be a really big deal because of the distress we see coming over the next year.

Two years, I think we do see a lot more of that price discovery and we see a lot more of the specifics of some of these properties.

Tom La Salvia, quite a picture here of the office market.

Thanks so much.

Appreciate it.

Thank you.