During the height of the COVID-19 pandemic, offices, stores, and factories across the country were closed and shuttered. Those who could work from home did, while those who couldn’t collected unemployment and wondered if life would ever return to normal.

Many questions were asked during the pandemic, such as: Will the workforce, by and large, return to the office, or is working from home here to stay? What will post-pandemic office space look like? How will the preceding questions influence developers and investors moving forward?

As part of the Winter 2023 Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey Kevin Shannon, Co-Head of U.S. Capital Markets at Newmark, and Julie Hoffman, partner at Allen Matkins, provide an overview of what the office real estate market in California looks like in the years ahead.

Getting Employees Back into the Office

For many people, the pandemic is already a thing of the past. Restaurants, shops, concerts, and sporting events are again full of people. Office occupancy, however, is still at less than 50% of pre-pandemic levels. Vacancy rates in both Los Angeles and San Francisco are at an all-time high. It seems that a solid 10% to 15% of the workforce is permanently working from home now. According to Shannon, “we’re overbuilt even though we didn’t really overbuild.” The commodity office is suffering the most, while the class A product is still attracting some large companies and investors.

However, a 10% to 15% decrease in office workers isn’t enough to account for the notable slowdown in the market. Some big tech companies, financial services firms, and certain other industries are strongly encouraging, if not mandating, a return to the office, at least for a few days each week. Still, in December 2022, office development was down significantly, and office investment activity was down 72%. What else is contributing to this?

Economy Plays the Leading Role

The economic landscape and financial uncertainties are major factors in the current cautious and conservative approach to office space. Interest rates are still very high, lending conditions are tight, and many anticipate a slowdown or even a recession in 2023. Most experts don’t expect a crisis on the scale of 2008. Nevertheless, “when it comes to making major financial decisions, current market conditions are still giving people pause on both the owner/developer side and the tenant side,” says Hoffman.

It’s hard for developers to feel confident enough to build new products in the current environment. Even the largest tech companies who traditionally grab up new Class-A spaces have pulled back. Construction costs have gone up, along with debt for new projects. As a result, construction lenders are much more hesitant to lend for new developments. With reduced demand and high vacancy, there isn’t a lot going on when it comes to building new spec office space. That trend is likely to continue through 2023.

Complicating the problem even more is that there will be a spike in debt maturity, specifically for the office sector, of about 39% in 2023 compared to 2022. Approximately half of those maturities involve floating rate debt, and rate increases could be significant. Many of these maturities are for assets that aren’t fully leased, and raising rents won’t get ahead of the rate increases. This will lead to a lot of distress for owners and investors, and rescue capital will most certainly be needed.

Interestingly, those who have built through such downturns in the past have done very well on the other side. But it seems, for now, the optimism needed to build spec just isn’t there with a lot of the equity and a lot of the lenders as well. This has had a definite impact on land values. Land values for entitled sites are way off from where they were at the beginning of 2022.

A Change in Sentiment

It’s interesting to note that a year ago, developers of office markets in Northern California were quite bullish as they saw workers returning to brick-and-mortar workspaces. However, that confidence has waned, and now most expect rental and occupancy rates to weaken in the coming year and not fully recover to current levels by 2025. Survey results indicate it’s high interest rates, stringent lending conditions, and fear of a recession that are making developers put on the brakes.

The good news is that if the recession happens, it will likely be relatively mild, and the uncertainty fueling a pullback in office development should abate by this time next year.

Best Leveraging Office Space

It’s important to consider not only how much office space will be needed a year from now, but how that space is utilized. If work-from-home employees need only come to the office for collaboration, rather than a full five-day work week, office space must change to accommodate this new dynamic. Additionally, the pandemic brought to the forefront the need for a safe working environment, and new office layouts and technology must facilitate this. As a result, lessees are looking for flexible spaces, shorter leases, and higher-quality buildings in transit-oriented locations.

Given the current amount of vacant office space, high interest rates, hesitation on the part of lenders, and fear of a recession, the office real estate market in California isn’t likely to see a lot of action in 2023. Owners are finding creative ways to fill the assets they have, investors are cautious, and developers are adopting a wait-and-see attitude when it comes to building new spec office space.