In its original forecast on the impact of the pandemic on the office sector, Capital Economics said that office occupancy would fall by 7% to 8% by 2025, with that, vacancy would rise markedly and remain elevated through 2030. And those lower occupancy levels and declining rents would result in a 20% decline in portfolio incomes by 2025, all the while net operating incomes would remain below pre-pandemic levels through the decade.
Now, the research firm suggests that the 35% plunge in office values were forecasting by end-2025 is unlikely to be recovered even by 2040, in a new report published on Thursday. That means that offices are unlikely to regain their peak values in the foreseeable future, or in the next 17 years, per Capital Economics. Thats because of dramatically lower demand following the shift to remote work that emerged from the pandemic.
In the report, written by Capital Economics deputy chief property economist, Kiran Raichura, he likens the reduction in office demand to the experience of malls over the last six years as consumers leaned into online shopping. Theres been no real recovery in the mall sector thats been plagued by structural headwinds, Raichura said, and Capital Economics expects the office sector wont prove to be much different.
We expect office landlords to face a similar fate over the next few years, with the prospect of a rapid bounce-back in the sectors relative performance looking slim despite its sharp falls to-date, Raichura wrote.
As Fortunes previously reported, all commercial real estate is vulnerable to the Federal Reserves aggressive rate hikes because its largely built on debt. So with higher interest rates, the cost of borrowing goes up, and that can sometimes result in delinquencies and defaults. But, on top of that, the office sector is suffering from a lack of demand because people are working from homethats why the sector is considered to be the most at risk.
Raichura said they have the data to support this view, comparing offices to malls. Raichura first pointed to a global survey by Knight Frank and Cresa that recently found 56% of firms have adopted a hybrid work model, which he said is consistent with low rates of physical office utilization, like office keycard swipes that are close to 50% of early 2020 levels (that were only around 70% to 75%). Because of that, companies are moving to save on physical space. Office vacancy rose from 16.8% in the last quarter of 2019 to 19% in the first quarter of this year, Raichura said, citing the Real Estate Information Standards data. However, that might not be totally representative of the situation at hand.
The true increase is roughly double that when sublease vacancy is taken into account, Raichura wrote in the report. And theres likely further to go. As a result, office vacancy has already seen a bigger increase than the 3.5%-pts increase seen by malls between H2 2016 and Q1 2023.
Although, office net operating incomes were actually higher in the first quarter of this year than in the first quarter of 2020, according to the report. Still, office investors are moving forward with caution. Raichura wrote that major lenders have returned stranded office assets to investors and thatll likely continue over the next couple of years considering the uptick in commercial mortgage backed securities delinquencies seen in May.
REIT investors are also shying away from offices, Raichura wrote. A little more than three years into the downturn, the office REIT total returns index is down by more than 50% relative to the all-equity REIT index. That is roughly on a par with the drop in the regional mall REIT total returns index in the first few years of the retail sectors correction.
The office sector hasnt hit its bottom yet, which is why Capital Economics suggests office values are unlikely to return to their pre-pandemic peaks even 17 years from now. However, if they did, there would be some caveats.
Demolitions and conversions of the worst assets may partially counteract the impact on valuation-based indices, but ultimately landlords will have to bear those costs, so the road ahead for office owners is set to be an arduous one, Raichura wrote.
