U.S. office market is signaling coronavirus distress, but here's why some see opportunity for growth

This article was originally published in The Business Journals.

The coronavirus is putting the commercial real estate market's conventional wisdom to the test.

The sector is by many accounts a lagging industry, with unexpected economic shocks often taking months if not years to surface in the form of unpaid rents, mass vacancies and downward pressure on pricing. The pain will come in time, or so the thinking goes.

However the speed and ferocity of the coronavirus fallout — and subsequent trillions in government subsidies — have opened divisions among real estate experts. Some interpret the pandemic's immediate stress as a sign of greater carnage to come. Others see another path, one where Covid-19 could turbocharge office markets already frothy with sky-high rents before the pandemic struck.

What follows are some of the bigger trends and market indicators shaping the fast-changing opinions and fluid forecasts within office-market circles. No matter how you slice it, there's little debate something game-changing is in store.

Observation No. 1: The office market has dodged the bullet ... so far

Unlike the retail sector, where estimates of missed rents have ranged from 70% to upwards of 90%, the office market's initial Covid-19 distress appears far more subdued. Anecdotally, real estate experts interviewed said missed rent payments were in the single digits as of April 1, with many of the nation's largest office landlords reporting pushback from tenants but nothing close to what other parts of the CRE market are experiencing.

"Monetary default is not the way to start your negotiations," said Adam Subber, a managing principal at tenant brokerage Cresa in Boston, on the delicate dance many office tenants are having with landlords at the moment.

Nor is monetary default a necessity for many of the office market's white-collar tenants — yet. Despite a surge in national unemployment claims since mid-March, much of the early job losses have been confined to the retail and food-services sectors, according to updates from the Bureau of Labor Statistics.

Bloomberg Intelligence recently predicted office rents will stay flat as tenants in financial, technology and business-services sectors work remotely and stay current on leases. The same report pointed to another encouraging sign: Many property owners, particularly real estate investment trusts, were well capitalized heading into the downturn and have wiggle room to make tenant concessions.

"We believe most office tenants with revenue coming in will keep up with their long-term lease obligations," wrote Bloomberg's Jeffrey Langbaum in an April 27 research note.

Observation No. 2: Red flags are multiplying

To be sure, warning signs abound, particularly in the trillion-dollar commercial mortgage-backed securities market. As of April 23, there were 806 U.S. office properties flagged with the "Watchlist" monicker, a 58% increase from a week earlier. The Watchlist label is used by administrators who manage CMBS portfolios to highlight a range of situations that might threaten the health of a property's underlying loan.

For the first time since the coronavirus outbreak, signs of the virus' toll were apparent in monthly updates on CMBS properties.

"Covid-19 relief requested," wrote the loan servicer in an April 17 report on the 160,000-square-foot office property at 501 Fifth Avenue in New York. The same comments were found in dozens of servicer notes this month, affecting everything from run-of-the-mill single-tenant properties to the 1 million-square-foot Galleria Office Towers in Houston.

"Borrower is working with lender towards possible solution," read the boilerplate language.

On a city-by-city basis, the numbers in some cases are alarming. In the New York City area, the number of Watchlist properties spiked 64% to 72 locations this month. In Philadelphia, the jump was 142% to 46 properties, while Los Angeles saw a 63% increase to 52 properties. Jacksonville, Florida's number increased 600%, from three properties at the beginning of the month to 21. Baltimore saw an increase of 550%, going from four properties up to 26.

Observation No. 3: Much hinges on the prospects of co-working space

The Galleria Office Towers in Houston was one of a half-dozen Watchlist properties to list troubled co-working space provider WeWork Inc. among its tenants, a point of concern among loan servicers monitoring the locations. Those properties dotted markets throughout the country and represented a mix of assets including the 325,000-square-foot office building at 332 S. Michigan Ave. in Chicago as well as the 80,000-square-foot property at 7083 Hollywood Blvd. in Los Angeles.

"Loan is being monitored due to high exposure to tenant WeWork," read the April 17 notes from the loan servicer assigned to 600 California St. in San Francisco. The report cited WeWork's recent layoffs and limited communication with the property's owners, Embarcadero Capital Partners, among its top concerns.

The risks posed by WeWork, not to mention other co-working tenants, span beyond the CMBS market. According JLL, co-working tenants accounted for 39% of the occupancy gains in the U.S. office market in 2018 and 2019. With millions of job losses, a new emphasis on social distancing and virtual workspaces, and an economy seemingly destined for recession, the expectation is co-working spaces in particular will be under severe financial pressure to pay their bills.

Observation 4: It's unclear if the pandemic will throw gasoline or cold water on the hottest office markets

Signs of a coronavirus slowdown were apparent as the commercial real estate industry wrapped up its first quarter. U.S. leasing activity bottomed out to its worst three-month performance since the 2008-09 recession. All told, about 6 million square feet of space were consumed between Jan. 1 and March 31, marking a 20% decline from the year-earlier period and only accounting for about 0.2% of the nation's total inventory.

That compares to a normal quarter when between 1% and 2% in net office space is absorbed with new leases, said Scott Homa, JLL senior director of office research. Homa said Q2 is likely to finish even lower, with the energy sector's troubles and other "specific occupiers" affected by the economic downturn expected to pull back on space.

Nonetheless, Homa pointed to a handful of indicators that could move the market in a counterintuitive direction, that is, they could heighten office demand in some markets like never before. He cited JLL's recent negotiations with "a well-capitalized technology company" in which the tenant was hoping to expand its space per employee by roughly 70%, to about 300 square feet from 175 today. He said the pandemic's renewed emphasis on employee safety could have similar effects in markets such as Boston, Washington, D.C., and Silicon Valley — places with "irreplaceable" infrastructure supporting higher ed, health care and R&D.

"It's conceivable the office market could come out ahead in the long term," Homa said.

Cresa's Subber had a similar take, albeit with the caveat that smaller and midsize tenants "that don't leave much money in the business" will be affected far worse than larger well-capitalized corporate tenants. He said the outlook is especially cloudy amid the federal stimulus efforts and whether they can jerk the economy back to a "new normal."

If not, Subber said the nation's once-hottest markets could see a "massive repricing" triggered by vacancies, a flood of sublease space and a cram-down in rents.

"Either way it's going to be tenuous for a lot of businesses," he said.