Office Space: In the Doldrums with a Hint of Cautious Optimism

New office development has come to a halt across the state and panelists expect they will be required to hold more equity in their projects over the next three years, but there is cautious optimism for vacancy rates in existing space. Among the Northern California panelists, only 5% of developers are planning to begin new office space development in the next 12 months but the three-year forecast for vacancy rates has improved. In Southern California, panelists believe that their markets are unlikely to get much worse over the next three years. Allen Matkins’ Erin Murphy, partner and chair, Los Angeles Real Estate Practice and Anthony Burney, partner and chair, San Francisco Real Estate Practice, dive into the outlook for the office sector as part of the Summer 2024 Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey.

Buyers Be Hopeful!

The next 12 months look hopeful for the office market in terms of price resetting and available opportunities. Distressed sales are closing, particularly in larger markets like San Francisco and Los Angeles, whether through a note sale, foreclosure, or just trading directly with the existing owner. “That in general is positive for the market,” says Burney. “It level sets expectations and hopefully brings more folks off the sidelines.”

The Ongoing Impact of Remote Work

Remote work is here to stay, and that is impacting the demand for leasing activity, both for new leases and those that are rolling and coming up for renewal. It is also impacting where tenants are going to want to enter into new leases. According to Burney, “We've seen a flight to trophy buildings in a lot of markets, particularly in San Francisco. Vacancy rates and other relevant factors continue to drag on the overall performance of those buildings, which far outweigh in number the trophy assets in a lot of the markets.”

Flight to Amenities

In markets with more amenities, like the Century City market of Los Angeles, there is a flight to quality. This has led to low vacancy rates there, while markets that are struggling with fewer amenities have higher vacancy rates. “We're also seeing tenants use their spaces in different ways as they follow return to work, often finding space that is smaller to best suit the needs of the employees and how they're working in the office,” says Murphy.

Leasing is Trending Toward Quick and Flexible

To improve occupancies, lease negotiations are evolving to improve occupancies. "Landlords are motivated to make deals quickly,” says Murphy, “There's a willingness to reach a fair compromise to get a deal done in a quick manner.” Other trends in the office leasing market are an increase in the level of concessions available to a wide variety of tenants, whether that's increased tenant improvement allowances, or longer free rent periods. Many landlord clients are having to face the reality of the market and offer those sorts of concessions to secure long-term tenancies, particularly with tenants who have good credit. One example from Burney: “We've seen generative AI tenants be a little bit more flexible in the types of terms that they want from their landlords resulting in a shorter length of the lease term itself. As a newer business, they're uncertain about the growth activity for the company as well as the larger office market in general.”