The Office Market Had It Hard in 2023. Next Year Looks Worse.

Office building owners, hammered by falling demand and high interest rates, struggled in 2023. But they mostly managed to stay afloat.

That is going to be a lot harder to do next year.

Many landlords have been able to extend their loans, often by putting in more capital. But a lot of those extensions are now expiring, and owners are losing hope that occupancy rates will rebound soon.

That means many more office landlords will be compelled to pay off their mortgages, sell their properties at a steep discount or hand their buildings over to their creditors.

“In 2024, it’s game time,” said Scott Rechler, chief executive of RXR Realty, a major owner of office buildings in the New York region. “Owners and lenders are going to have to come to terms as to where values are, where debt needs to be and right-sizing capital structures for these buildings to be successful.”

Office demand shows no sign of returning to pre pandemic levels. While the number of full-time remote employees has dwindled, hybrid workplace policies look here to stay. In the fourth quarter, 62% of U.S. businesses allowed employees to work from home some days of the week, up from 51% in the first quarter, according to Scoop Technologies.

Return-to-office rates also stalled for most of 2023. Kastle Systems, which tracks security-card swipes in 10 major U.S. cities, said that average office attendance is about half of its pre pandemic level. Placer.ai, which tracks mobile phone data, puts it in the 60% to 65% range. But it also said the return rate has topped out.

The office market has shown “some monthly fluctuations but little real change in the overall trajectory,” Placer.ai said in a November report.

The U.S. office vacancy rate stands at a record 13.6%, up from 9.4% at the end of 2019, according to data firm CoStar Group. The firm is forecasting it will rise to 15.7% by the end of 2024 and will peak above 17% by the end of 2026.

That vacancy rate is poised to push higher because nearly half of office leases signed before the pandemic haven’t expired, CoStar said. When they do, many of the businesses will likely take less space than they are currently occupying, whether they are renewing or relocating.

Take the case of Chicago law firm Neal Gerber Eisenberg, which signed one of the city’s largest 2023 office leases earlier this fall. The firm, which has grown steadily throughout the pandemic, adopted a policy that requires employees to work from the office at least eight days a month. Neal Gerber leased 90,000 square feet at its new location, down from the 113,000 square feet it will be giving up.

Beyond the longer-term decline in demand, office landlords are still contending with high interest rates. Landlords that have to refinance debt borrowed when rates were at historic lows will face much higher borrowing costs as high vacancy is putting rents and incomes under pressure.

In recent weeks, inflation has been declining and the Federal Reserve is likely to ease interest rates in 2024. That will soften the blow. But landlords still face a financial squeeze, analysts say.

“If you have a mortgage that’s expiring at 3% or 4%, there’s no way you’re refinancing at 3% or 4%,” said Steve Sakwa, an analyst with Evercore ISI. Even though rates have come down, he added, property owners are still looking at rates that could be double their expiring rates to refinance.

Not all the signals are bleak for the office market in 2024. Demand is still strong for the highest quality and best-located space in many markets from tenants willing to pay high rents to encourage employees to return to offices.

Developers have retreated from new construction in the sector, so there’s little competition from new supply. The 30 million square feet in office construction starts in 2023 was the lowest amount since 2010, according to CoStar.

Cities such as San Francisco, New York and Boston are lowering costs and streamlining the process for converting obsolete office buildings into apartments. While this isn’t expected to result in a big decline in vacancy, the actions might bring more activity to business districts, giving a psychological boost to downtown landlords and businesses.

But the steadily rising number of owners who are defaulting on their mortgages because of falling rent rolls looms over the market. The delinquency rate of bank loans and loans converted into commercial mortgage-backed securities currently is over 6% compared with below 1% before the pandemic hit, according to data firm Trepp.

High delinquencies combined with the dismal office outlook already have convinced some owners to hand properties back to lenders or sell for sharply discounted prices.

In Stamford, Conn., the owner of One Stamford Forum, a 500,000-square-foot building whose tenants include troubled Purdue Pharma, this fall gave the building back to its creditors, according to Trepp. In San Francisco, buyers have purchased office buildings like 60 Spear Street and 350 California Street for fractions of what they were worth before the pandemic.

Trepp is projecting that the office delinquency rate could be over 8% by the second half of next year. As more landlords default, the new owners that replace them—buying in at greatly reduced prices—will likely put more pressure on the market because they’ll be able to charge lower rents and still make a profit.

“What could be catastrophic is if you start seeing corporate profit pressures leading to continued or accelerated pace of office downsizing,” said Stephen Buschbom, Trepp’s research director.