New Office Development Still Awaiting Recovery

Amid ongoing discussions about the redevelopment of underperforming office buildings, the office sector is not expected to fully recover until the end of 2026 as rental and occupancy rates weaken. As such, new development of office space continues to rapidly decline. As corporate tenants evaluate their real estate needs, the office leasing process is becoming more complex, with an increase in subleases and slow-walking of the office leasing process. Landlords that are more flexible and more willing to take on complex projects are best positioned to boost occupancies. Crystal Lofing, Partner at Allen Matkins, and Matt Field, Co-Chief Executive Officer at TMG Partners, dig deeper into the current state of the office sector as part of the Winter 2024 Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey.

Two Sides to the Office Sales Coin

Distress asset sales will likely take the center stage in 2024, with the wave of distress that started in 2023 continuing as maturity dates hit and owners are unable to refinance due to a variety of factors, including weak occupancies and finding debt or a lender that will loan against office product.

According to Matt Field, “I think office sales are really going to fall into a couple of categories and they're probably trophy and train wreck.” The train wreck sales are going to be highly structured due to the lack of available debt financing and the capital intensity of projects which need significant leasing improvement. Lenders are falling into two categories – those who sell the note and those who try to recover a more significant amount of the original loan principle.

A New Reality in Lease Negotiations

In terms of lease negotiations, most tenants are adapting to the new reality of a more flexible work week, leading to consolidation from 20% to sometimes as much as 40%. The practical reality of doing a renewal really depends on whether a tenant can be accommodated with the same amount of space or whether it's more efficient to put them into new space.

Crystal Lofing says that the concession that tenants are focused on in both renewals and new leases is construction, including delays, permit timing, material shortages, and cost. Tenants want to offload all of those risks to the landlord, which means that landlords are increasingly doing turnkey buildouts, or building the space to approved plans, whatever the cost, with no rent being paid until substantial completion.

With respect to renewals, lease terms are going back to the more typical five-, seven-, and 10-year deals from the short term two or three-year extensions of the pandemic era. Tenants’ projection for their space needs going forward have stabilized and they're willing to commit to longer lease terms, says Lofing.

Filling Urban Office Space: LA and San Francisco

Field sees certain urban areas as more challenged than others. Downtown San Francisco continues to suffer because its workforce is concentrated in the technology space, which is still largely hybrid. While artificial intelligence companies have started to backfill space, a lot of the space is obsolete, so it will take some time for San Francisco to recover.

In LA, Class A office space that caters to financial and law firms and entertainment and is well-located will continue to do well, according to Lofing. The location and the quality of the building seems to be more important to tenants than building-specific amenities. People want to be in a nice building, easily accessible and close to retail and dining options. This is why Century City has done so well as opposed to downtown LA.

Pushing for Office-to-Residential Conversions

The state of California has been aggressive in trying to help facilitate new regulations for repurposing or redeveloping office properties. A number of new regulations have come into effect in the past few years including the state density bonus laws that allow the conversion of commercial to residential by right. The city of San Francisco has also taken action on this front and is relaxing a number of regulations which would typically make it difficult to repurpose a building.

Field points out that while there is still a large gulf in terms of the cost of converting a high rise building to a residential building, it typically is working better for historic properties, where the skin of the building can be reused. It gets much more difficult to find bigger, taller buildings that are suited to be converted to residential. There are a lot of challenges with the inefficiency of an office building relative to what an efficient residential building would be.