Potential losses in the US commercial real estate market is one of the top concerns of respondents to a recent Federal Reserve survey[1] on financial stability. This is due to estimated values remaining “elevated even as prices continued to decline”. The survey specifically highlighted that valuations are particularly elevated for the office sector, where fundamentals are especially weak in central business districts, with vacancy rates increasing further and rent growth declining.
Since the onset of the COVID pandemic people have changed a lot in the way they work, and buildings, especially offices, have a lot of catching up to do.
There is clearly a transformation happening in the landscape of commercial real estate, driven by the shift towards hybrid work models and also an evolution in lifestyle preferences. As organisations continue to embrace remote and flexible work arrangements, the demand for traditional office spaces has fallen, leading to a notable value decline in the commercial real estate sector. As a report[2] from McKinsey outlines, office attendance has stabilised at an average of 30% below pre-pandemic norms. However, the study’s “severe” scenario projects the demand falling by as much as 38% in the most affected cities by 2030 with office prices potentially falling by 42% in the nine cities included in the study.
However, the study also points out substantial differences between the cities, neighbourhoods and, most interestingly, between buildings. Office demand is projected to fall in New York and London but rise slightly in Houston and Beijing. Expensive, office-dense neighbourhoods have tended to suffer more out-migration through the pandemic and, looking into the future, it appears that neighbourhoods with more hybrid, flexible, mixed-use development will attract more people.
The resulting surplus of office space creates a situation where lower-quality, older buildings are out of favour with employers seeking higher-quality space as one of the ways to encourage office attendance. From 2020 to 2022, for example, in New York City “the average sale price per square foot rose 3% for Class A buildings but fell by 8% for Class B buildings.” The once sought-after towering structures may find themselves ill-suited for the changing dynamics, as modern offices with sophisticated equipment and more adaptable and collaborative spaces that align with the new work-life balance are now more desirable.
Real estate troubles are also compounded by climate change[3], which casts a shadow over the viability of aging office buildings, making them increasingly unsuitable for modern business needs. A Moody’s report[4] suggests a link between climate change and rapidly rising insurance costs for commercial real estate, tracking it closely with the frequency of natural disasters. As a result, some areas are emerging as having repeated hazards and there are “long-term implications for their viability.”
Investors are increasingly more aware about real estate’s exposure to flood risk and other environmental risks tied to particular locations. This sometimes affects areas which haven’t been damaged in the past but are considered at risk of damage in the future[5], showing changes in investors’ perception.
Consequently, climate-resilient architecture is becoming less of a luxury and much more of a way of securing the long-term viability of buildings.
In other areas office refurbishments are at an all-time high[6] as the sector is pushing to decarbonise in this evolving landscape of corporate responsibility and pressing climate goals. The built environment is the second-largest source of carbon emissions in the UK, so decarbonising buildings is vital in the journey to net-zero emissions.[7] Regulatory pressures along with a shift in tenant preferences are driving this transition which comes at a cost and timely response is important.
The research suggests that hybrid spaces which support diverse neighbourhoods are the kind of buildings that are attracting people today and are most likely to retain value in the future. One way forward for the real estate sector is to embrace flexibility and adapt to the new ways of operating and meeting different needs of people. While some buildings are doing well, there is also a lot of stranded assets out there[8] and the industry must be willing to reimagine and repurpose these structures. However, there is a crucial role for developers and industry stakeholders in lobbying regulators to relax stringent planning rules and laws that may impede the creative repurposing of these spaces. Collaborative effort between the private sector and regulators is essential for fostering a resilient and adaptive real estate market that can thrive in the face of change and uncertainty.
[1] Financial Stability Report, Federal Reserve, October 2023
[2] Empty spaces and hybrid places: The pandemic’s lasting impact on real estate, McKinsey global Institute, July 2023
[3] Commercial Real Estate is in Trouble. Climate Change is Part of the Problem, Time, August 2023
[4] Insurance costs trends becoming a headache for the CRE market, Moody’s Analytics, August 2023
[5] Commercial investors shift perspective of coastal properties in face of climate change, Phys.org, May 2023
[6] Office refurbishments: The race against obsolescence, IPE, August 2023
[7] How technology can save stranded assets, Property Week, August 2023
[8] Avoiding a commercial real estate crash requires some imagination, Financial Times, July 2023