New York’s predicament is going to challenge office optimists

A government report details a budding crisis in America’s largest workplace market. Its findings will make it hard for current landlords to further deny the asset class’s challenges.

The real estate sector is rife with bulls and optimists, individuals more inclined to extoll the virtues of a promising investment than admit the flaws of a bad one. This is particularly true for assets they already own.

Given this culture of positivity, it is of little surprise so many in the industry are reluctant to acknowledge the hardships ahead for offices. A sobering report from New York State’s top auditor lays bare just how dire the situation is.

The headline: New York City’s office market, the largest in the US at 460 million square feet, has lost 16.6 percent of its value during the pandemic, a decline of nearly $30 billion, according to data released by state comptroller Thomas DiNapoli.

This drop in asset value has been driven by record-low occupancy throughout the city. Manhattan’s vacancy rate was jaw-dropping 18.3 percent at the midpoint of the year, more than double the long-term average. A common refrain among New York office optimists, is that the city has proven resilient through crisis after crisis in the past. But this may be deepest hole in that rhetoric published so far.

Vacancy currently exceeds the doldrums following September 11, 2001, the bursting of the dotcom bubble, the global financial crisis or any other period during the past 30 years. That is as far back as the state’s data goes.

Another silver lining often cited by bulls is the appeal of highly amenitized new construction. This notion was supported in the third quarter of last year with Facebook’s 730,000-square-foot lease at the overhauled Farley Post Office building and the opening of One Vanderbilt, the city’s newest trophy tower, which set records for the price per square foot it has commanded. Yet, the vigor of those singular events fizzled quickly, DiNapoli’s report notes, as rents began falling again the next quarter.

Indeed, the most adversely impacted office submarket has been Manhattan South, which is awash with class B properties. Rents in the neighborhood were down 10 percent from the first quarter of 2020 to the second quarter of 2021. Such a decline does not happen in a vacuum, though. A deluge of sublease offerings by second- and third-tier office tenants has softened the overall market, causing class A rents to suffer, too. With a third of all leases at large Manhattan office buildings set to expire over the coming three years, supply is likely to further exceed demand.

Should this trend continue, the results would be calamitous for the 13.3 million square feet of under construction office space set to hit the market in the coming years. Initial lease up is crucial for offsetting development costs and few sponsors would have underwritten a market shift as drastic as the current one.

As PERE explores in this month’s cover story, the office sector is poised for a paradigm shift, one that will change how assets are developed, managed and valued. This will not play out uniformly across the globe. Growing markets in Asia-Pacific and the Southern US, for example, will likely still perform well in the years ahead in conjunction with a big picture that is less favorable elsewhere.

It is important to recognize the bright spots in the office sector to know what is working for a property type in flux. But doing so cannot come at the expense of understanding the state of play in critical markets such as New York and the potential ripple effects of its continued demise.