Amazon’s announcement last year that employees would return to the office five days a week starting Jan. 2 may have created consternation among some employees, but for investors it was a tangible signal of a strengthening sector.
Owen Thomas, chairman and CEO of BXP (NYSE: BXP), speaking during the REIT’s third quarter earnings call, noted that “given Amazon’s scale and industry presence, this decision could be a harbinger for the future policies of other technology companies.”
Even before return to office mandates, some parts of the office property sector had already started to show resilience after the dark, early days of the pandemic.
“There’s a real bifurcation in the office market between the top tier, what we call prime office space, which represents about 8% of the sector, and the lower tier,” says Julie Whelan, head of occupier research for the Americas at CBRE.
“Overall, market vacancy seems to have stabilized in 2024 at 19%, but for the previous four years vacancy rates were increasing. However, in prime spaces, the market average is 15.5% vacancy, and net absorption has been positive every quarter since the pandemic, despite new delivery of prime space to the market,” she notes.
The top end of the office market, in particular, is showing early signs of recovery based on overall supply and demand, according to Colin Connolly, President and CEO of Cousins Properties (NYSE: CUZ).
“There was quite a bit of doom and gloom, which is beginning to subside as we start to see return to office activity in greater numbers,” Connolly says. “We’re seeing a meaningful pickup in demand and the sense that office markets are beginning to stabilize. Lifestyle office supply is declining, especially as older and obsolete buildings are repurposed or torn down, and because there’s little to no new construction,” he adds.
John Kim, a senior REIT analyst with BMO Capital Markets, says that the office sector underperformed for the first half of 2024, “but then starting in the late summer and into September, leasing activity picked up and there were more return to office mandates.”
‘Haves and Have-Nots’
While there are regional differences in office performance, the wider gap is between high quality buildings and older buildings that have not been properly maintained or modernized.
Christina Chiu, president of Empire State Realty Trust, Inc. (NYSE: ESRT), notes that New York City has “massively outperformed” in terms of recovery since Covid. “But in the office sector, it’s really a story of haves and have-nots,” she says.
“The ‘haves’ are buildings that are well located near mass transit with attractive physical attributes. They are new construction or modernized older assets that have great floor plans, are energy efficient, and have amenities. They have service-oriented operators and owners that have financial stability,” Chiu says.
Top-quality assets in good locations are mostly full or filling up fast, according to Ben Breslau, chief research officer for JLL.
Demand is concentrated in those high-quality buildings that have the features occupiers are looking for, and vacancy is concentrated in the lower end of the market, Breslau says. “The bottom part of the market is struggling due to issues in the capital stack, deficiencies in location or physical attributes, while the middle tier is trying to position itself to be competitive as demand flows down from that top tier,” he adds.
Since the pandemic, approximately 140 million square feet of office space has been absorbed in buildings that are 10 years old or newer, Breslau points out. But among offices built before 2015, there have been about 420 million square feet of occupancy declines in that same period.
“That’s an opportunity for investors into renovated buildings, or those that can be renovated, because newer buildings are getting full,” Breslau says.
Renovations that attract tenants include amenities, particularly outdoor space such as terraces and roof decks, and technology, Breslau says. Tenants also value sustainability investments such as energy efficient mechanical systems for cost savings as well as to meet regulatory pressure to reduce emissions.
“Companies have an even greater focus on a location near mass transit and with good amenities to get employees back in the office,” Kim says. Demand and supply dynamics are exacerbated because the amount of capital needed to upgrade a space is so expensive that a lot of lower quality buildings can’t get financing, he says.
Quality Matters
During the BXP earnings call, Thomas noted that asking rents for premier workplaces are 50% higher than the broader market— “a consistent gap from prior quarters.” This outperformance, he noted, “is evident in BXP's portfolio, where approximately 90% of our NOI comes from assets located in CBDs that are predominantly premier workplaces.”
Office market performance has rebounded more quickly in New York City and the Sun Belt than in other locations.
“New York City’s recovery is inspiring investors to think that other markets can recover, too,” Kim says. He points to data from Placer.ai that shows that in October 2024 visits to New York City offices were 86.2% of visits in October 2019. Miami was second in terms of recovery. Office demand data from West Coast markets was weaker though, with both Los Angeles and San Francisco in the bottom three markets on Placer’s survey, Kim says.
While San Francisco still has high vacancy rates, leasing is making a rebound relative to its low point, Whelan says.
Connolly at Cousins notes that the Sun Belt as a whole still benefits from inward migration. “The bigger differentiator in our markets is the quality of the buildings, especially what we call lifestyle buildings with indoor and outdoor space for collaborating in neighborhoods that have restaurants, bars, and cultural amenities.”
Enticing Tenants and Employees
Top tier buildings aren’t limited to trophy buildings or new construction, Chiu says. “It’s more of a value proposition based on the tenant’s price point.”
The Empire State Building isn’t the most expensive office, Chiu notes, but it’s fully amenitized in a great location. “LinkedIn has over 500,000 square feet there because they want high quality space with service. High level operational service and customer orientation is more important, especially in buildings that didn’t have that in the past,” she adds.
Tenants also expect a future-ready, sustainable building with all relevant data provided, which helps the tenants on their own path to carbon neutrality and sustainability reporting, Chiu says.
What CBRE terms “prime” properties are typically less than 10 years old or heavily renovated, Whelan says. They include a location near transit and retail options, along with wellness and sustainability features.
“Buildings in the right location with amenities, services, technology and aesthetics relevant to today’s tenants such as outdoor spaces trade at higher prices than those without,” Whelan notes. “Instead of dark conference centers, people want light and bright meeting spaces and sustainability features such as biophilia that connect tenants with nature.” Whelan says that one building she recently visited in Chicago included huge trees in interior spaces that “gave a connection to nature and sense of serenity.”
A corporate event space and shared meeting rooms that can be reserved on an as-needed basis is a must-have for many tenants, Whelan adds. “Those meeting spaces can be a good trade-off for tenants taking smaller footprints overall because they can use their leased space for more consistent every day uses. It also generates a diversified revenue stream for landlords, especially if they can rent it out when tenants are not using it during traditional business hours.”
Recalibrating Office Space
While return to office mandates may generate marginal improvements in occupancy rates, Whelan anticipates that discussions about office use will continue.
“Over the long term, I expect office attendance will remain below pre-pandemic rates,” Whelan says. However, this reality is not uniform across all tenants. Smaller tenants are active in the office market relative to historic levels. “They’re transacting more because they typically have stronger in-office attendance and need space for existing and future employees to be happy and effective.”
Larger occupiers, such as multinational firms, typically have more existing space to work with, Whelan says, but she anticipates leasing activity among larger tenants to increase, particularly among those who overcorrected earlier and are now mandating stronger attendance or those looking to amend their existing space to meet new work styles.
Economic growth has also led to companies needing more space, Breslau says. “In our Future of Work survey, more than half of the respondents said they expect to grow their head count and their real estate footprint over the next five years.”
That growth may be offset by companies that are still rightsizing, Breslau says. A big issue is that some tenants are finding fewer options than anticipated because of the limited availability of high-quality space, he says.
“Many tenants are thinking about optionality when they lease space,” Chiu points out. “They want expansion options for the future and many tenants are already taking these options as they start to use up space.”
Improvement Ahead
The focus in 2024 was on leasing activity, BMO’s Kim says. He anticipates more focus in 2025 on earnings.
“Office REITs are starting to shift into growth mode and invest and buy assets,” he says. “They’re finding attractive pricing and that some generational owners are now willing to sell because upgrades are so capital intensive. REIT share prices have recovered and interest rates are better, so they’re willing to buy assets.”
Over the next several quarters and beyond, Connolly anticipates a gradual improvement in market fundamentals, as supply continues to decrease and demand improves. In December 2024, Cousins acquired a lifestyle office property in Charlotte, North Carolina for $328.5 million, which Connolly says is less than the replacement cost for the two-year old building that is 97% leased.
“We think it's an interesting time to invest, particularly when the private market is very constrained for capital,” Connolly says. “Debt and equity in the private capital markets is limited in availability and quite expensive, and that creates a unique environment for a well-capitalized public company like Cousins, especially in a market that we expect to slowly improve.”