Sublease Space to Spare?

Commercial Vacancy High in Major Metros

By Erica Rascón on Aug 21, 2020 in News

Commercial real estate has encountered a space problem: there is too much of it. Unused, unwanted square footage is having a ripple effect throughout the industry, stalling new deals and prompting tenants to get creative with their leases.

Which markets have the most excess space?

Tech markets such as San Francisco and Boston are among the cities with the most space to spare. The report suggests that tech companies often lease more space than they need. If they are hit with a sudden need to expand, the resources are readily available. Conversely, they are apt to offload unneeded space during economic downturns such as this one.

Markets with a broader range of employment sectors recorded more modest increases in available space. Dallas-Fort Worth, Manhattan, and Washington, D.C. are among the top markets with a moderate increase in excess space scattered across its large providers of health care, tech and energy services.

“We believe that the second quarter was the low point for the market with office leasing activity down by more than 40 percent from a year earlier – and that we’ll begin to see a gradual recovery,” says Ian Anderson, CBRE’s Americas Head of Office Research in an interview with World Property Journal.

Huston was the only market with negative space to lease between March and June 2020. The city recorded a -2% change for a total of 5.2 million sq. ft.

How is the excess space impacting the commercial market?

Though the national vacancy rate increased 10 basis points to 13.2%, listing rates remain comparable to figures recorded at this point last year. Average full-service equivalent listing rates only fell by 0.7% to $38.15 per square foot in May.

Analysts suggest that the demand for new office space has declined to such a point that traditional price reductions would not produce the desired effect. Additionally, multi-year office leases make substantial price decreases unfeasible. It also seems that many office owners are still optimistic for a V-shaped recovery, counting on pre-COVID-19 levels by Q4.

While listing rates seem stable, the excess office space has had a notable effect on future demand. Per the Yardi Matrix Office National Report, the second quarter recorded only $4.4 billion in transactions compared to $12.7 billion at this point last year. Buildings near completion are still slated for delivery. New supply, however, is being added at a pace slower than seen at this point in 2019. The total amount of planned office space decreased by 8.5%. Due to the current downturn, analysts expect deliveries to continue at a slower pace than last year.

Get the complete Yardi Matrix Office National Report

Subletting office space provides some relief to lessors

The recession, high vacancies rates and low demand have left tens of millions of square feet on the negotiation tables. To add to the excess, the average company requires about 20% less space now than it did pre-COVID 19. The market has plenty of space to spare, and tenants are seeking creative ways to make the most of unused square footage.

Per a recent report by global property consultant CBRE, the 10 largest U.S. office markets experienced a 12% increase in space offered for sublease. Since March, the major markets offered 6.1 million additional square feet of space to bring the current total to 59 million.

Lessors seek to sublet to recuperate costs on unused space. Per Tenant CS, which offers conflict-free tenant representation services, tenants can expect to recover less than 50% of their rent obligation. During the current economic downturn, that cushion may be the difference between making rent or not. Nearly half of commercial retails rents were not paid in April and May, for example.

Figures are better for office tenants. Currently, REIT-owned office buildings report that they are collecting about 90% of rents from tenants. The concern, however, is that employers will embrace remote work for good. Some will make that decision mid-lease. This could lead to fewer lease renewals and more cumbersome subletting agreements.

Will the space surplus last?

Whether excess space will be a lingering problem in the future of commercial real estate depends largely on how employers address remote work.

“The million-dollar question is what is going to happen to office, and in my opinion, there is going to be some carnage,” said Eric Northbrook, managing director of Voit Real Estate Services in an interview. “We are going to lose some tenants, and there is going to be some additional space on the market.”

He adds, “On the other hand, you have companies that want their people in the office. With social distancing and the new way that they have to occupy office space, they may have to take a little more space to accommodate all of their people.”

Real estate finance analysts at the University of San Diego School of Business estimate that 18% to 20% of employees will work from home in the near future. That’s not a carnage-caliber increase from the current 12% that work from home. There is hope that space surplus will be absorbed.

“But it’s too early to tell,” concludes Northbrook.