As companies grapple with finding the right hybrid strategy to serve their business and their employees best, the outlook for the long-term fate of the office market — both sales and leasing — remains uncertain. In this post, we’ll look at the national picture and then zoom in on Southern California markets, specifically Orange County and San Diego.
National Office Market Overview
Leasing: At the close of 2023, vacancy rates nationwide had climbed to historic highs, and millions of square feet of space continued to be dumped on the sublease market. Absorption recorded one of the worst years on record, comparable to the Great Financial Crisis and the dot.com crash, but the difference this time is that it’s the fourth straight year of negative absorption. Unfortunately, 2024 doesn’t look to be the year that the trend will reverse, as many in the industry have adopted the war cry of “Survive ’til ’25”.
One thing appears certain: the five-day office week is a thing of the past. But that doesn’t mean that office is dead. The data suggests that while most tenants are renewing as their leases roll over, they are also taking less space. Nationwide, tenants are taking approximately 15–20 percent less space on average, according to CoStar. The (somewhat) good news is that many predict that the trend will reach its bottom, possibly by the close of the year or early into 2025.
Despite the decrease in demand, rental rates have not declined appreciably. According to Yardi Matrix/Commercial Edge, the average U.S. office listing rate was $37.64 per square foot, down 1.4% year over year. In fact, many tenants — now reducing their rental expense by taking less space — are willing to pay up for amenity-filled Class-A office buildings, which many companies see as a key to getting employees back to the office. Some theorize that rents may eventually decrease if underperforming properties begin trading at discounts to their previous valuations. Landlords could conceivably offer lower rents, although it seems likely that those discounted rents would be in lower-quality, Class B buildings.
There are some positive signs as we enter 2024. Office utilization rates are expected to increase as return-to-office mandates are gaining traction with many companies, including large employers like Amazon, Meta, and Zoom — even if it is on a hybrid schedule. And how the office market is performing also seems to depend on the location. While the coasts are recording record-high vacancies, some markets (like the Sunbelt) and some submarkets in major metros are seeing strong demand.
Investment Sales: Given the rise in interest rates and the drop in demand for office leasing, it should come as no surprise that the U.S. office market sales closed out 2023 with approximately $34 billion in sales, 60% below the volume of $83.6 billion recorded in 2022 and far below the $116 billion in 2021. The price per square foot (psf) also plummeted from $247 psf in 2022 to $196 psf in 2023. (It should be noted that Yardi Matrix/Commercial Edge only covers office buildings 25,000 square feet and above.) Older trophy buildings were already being sold at discounts nationwide, often at 50 cents on the dollar, as Southern California has seen with the recent sale of the 62-story Aon Center, which traded in December at a 45% discount from its previous sale price.
Sales volume is predicted to increase dramatically by Q2 following the signal by the Fed that there would be three cuts to interest rates in 2024. Some economists are anticipating the Fed will begin lowering the benchmark rate as soon as March. In addition, owners of about 44% of office properties are underwater on their loans, according to the National Bureau of Economic Research. So there will be bargains to be had as lenders cease the “pretend and extend” on expiring loans. In response, several opportunistic private equity groups are looking to capitalize on what they hope will be once-in-a-generation buying opportunities. Last week, RXR, one of New York’s largest office landlords, partnered with Ares Management to form a $1 billion fund to invest in the city’s distressed offices.
Southern California Office Outlook
The overall picture for much of the SoCal market is a little more dire than the rest of the country, but some submarkets are performing relatively well. “The Orange County office market is facing challenges, and it’s been that way since the pandemic,” says Voit’s Doug Killian, SVP/Partner, Irvine. Vacancy is at 17.27%, up from 15.75% at the close of 2022, and availability is at 22.26%, “but it’s trending higher right now.” Despite the increase in vacancy, average asking lease rates have increased slightly (3.76%) year over year to $2.76.
Killian says tenants are typically seeking shorter-term leases on renewals because “they don’t know when all of their people are going to be coming back to the office or if they will, so companies are kicking the can down the road and are waiting to see what happens.” According to badge data, office utilization is at approximately 50% in the market, but some employees are only in the office for a few hours a day. Killian says some submarkets are performing very well, specifically the 9.1 million-square-foot Newport Center, the coastal area, and Fashion Island.
Both Killian and Chris Drzyzga, VP/Partner, Irvine, report that there has been a flight to quality for office users in the market. “Class A and trophy assets are performing incredibly well,” Drzyzga writes in his Voit Q4 Market Report editorial but adds that “approximately half of all tenants are reducing their footprint by 20–40%, using the savings to access nicer, newer buildings offering first-class amenities.” He adds that the flip side of the boost being given to premier properties by the flight-to-quality is that older, mid-tier properties, including the lower echelon of Class A, will continue to struggle.
In many instances, owners of these properties are eager to dispose of the assets, “so we often see these properties marketed at less-than-aggressive prices,” he writes. “Ultimately, this is a massive opportunity for well-capitalized and savvy investors.”
The San Diego office market is faring better from a numbers standpoint, with a vacancy rate of 11.75% (up slightly from Q4 2022) and an availability rate of just under 18%. But the vacancy rate number doesn’t tell the whole story, with a cavernous divide between some submarkets. Sorrento Mesa had the lowest availability rate at 11.9%, while the Downtown is at 38.6%, and the vacancy rate there is nearly 27%. The office market delivered 407,696 square feet of new construction completions in 2023, the lowest annual total in over a decade. But there are four million square feet currently under construction that will deliver in the coming years, which will push the vacancy rate even higher.
Jon Boland, SVP/Partner, San Diego, entitles his Voit Q4 Market Report editorial simply, “It’s Slow,” and writes that over the past 15 years, the only year with fewer office leases recorded than 2023 was 2020. However, this may be good news for tenants, as “landlords are noticeably hungrier to make deals.” Although the rent decreases have yet to materialize, they are offering more introductory teaser rates, open houses, and broker incentives and are becoming more generous with concessions. “If you are a tenant in the market for office space in Downtown San Diego, you will have a lot of options and a lot of leverage,” he writes.
On the investment sales side, the market is even slower than the leasing market — worse than in 2020, according to Boland. Owner-user sales are faring slightly better, and there are more owner-user sale options on the market now. With the Fed signaling multiple rate cuts in 2024, he expects lower interest rates to bolster the overall economy and add to acquisition demand from owner-users and investors.
While the future of the office market remains uncertain, leasing trends point towards continued downsizing but potential rent stabilization. And with the anticipated rate cuts by the Fed, investment sales are poised for a rebound in the second half of 2024.
For a more detailed, insightful, market-specific analysis of the office markets from our research team, visit the Voit Market Reports page.