Office Valuations are Plummeting: Are Our Cities in a Doom Loop?

Office attendance is lingering around 30 percent lower than it was pre-pandemic. Rampant low utilization reflects the elephant that’s (not) in the room: What is the country going to do with its empty office space problem?

Because the scope of the issue has expanded beyond being solely a concern for commercial landlords.

A dip in office valuations translates to lower tax revenue, straining the ability of municipalities to maintain and enhance public services...but we’re not really talking about a “dip” here, are we? Most recent estimates predict a full-on 44% decline in office valuation in major metros, underscoring the profound level of distress we may be in for.

And with billions of dollars in CMBS loans coming due in upcoming years, trouble in the office sector is spilling over into the country’s economic landscape as a whole. Let’s discuss how falling office valuations signal more potential distress and which areas are at higher risk of feeling the consequences.

Empty Offices are Hurting More Than Landlords

Office valuations are dropping and hurting the areas (specifically metros) that used to rely on the economic stimulus of commuting workers and property taxes from landlords.

And across the board, underutilized buildings are diminishing the vibrancy of urban centers. The previous symbiotic relationship between office spaces and local businesses has historically fueled urban economic growth. Now, the lack of foot traffic and business activity can create a domino effect, potentially leading to a decline in demand for commercial real estate, reduced rents, and even vacancies. These factors contribute to a negative feedback loop of declining office valuations and, consequently, reduced tax revenue.

Falling Office Valuations are Draining Cities

Cities overly dependent on revenue from property taxes face the most heightened risks when commercial real estate values decline or when buildings remain underutilized.

This problem is amplified because the effects of hybrid work do not appear to be slowing. Working around this new normal is essential because office sector distress is slated to get worse in coming years. And the cities in the hottest seats right now are the metros most reliant on commercial taxes.

Cities with highest the reliance on commercial taxes for generating revenue:

Boston- 36%

Dallas- 26%

Atlanta- 19%

And as low demand puts a gradual decline on the property taxes a city can collect, another concerning cycle emerges. Without the revenue from property taxes, essential services suffer, and a city eventually becomes less alluring. This, in turn, lowers demand for commercial properties. With reduced demand, vacancies increase, property values drop, and tax revenue further declines. But the above-mentioned cities aren’t the only ones at risk of such a fate.

Across the country, our most notable metros are facing unprecedented levels of distress in the office sector.

New York City is also victim to a shifting landscape of low office demand. It’s been estimated that over the next six-years, (in the worst-case scenario) Manhattan can witness a 44 percent decline in the value of office buildings. In context, this equates to about $50 billion. 

Higher Quality Buildings Buffered Against Devaluation

In total, the country may have a $500 billion problem on its hand in the coming years. But, in analyzing which markets are most at risk of feeling this burden, other patterns emerge.

Property tax reliance isn’t the only mark of how likely a city is to survive the Office Apocalypse. There’s a
significant gap in demand across higher and lower quality office buildings.

Since the Flight to Quality, older or outdated buildings are increasingly becoming stranded assets. In turn, metros with higher concentration of Class B or C assets may be in for more turmoil. Because as loans are coming due, older properties are consistently the property class with the highest outstanding balances.

“Of the 1,017 total offices with maturities this year, the 447 buildings constructed between 1980-2000 accounted for the largest portion of the outstanding balance, a value of $7.5 billion. On the flip side, there were only 45 buildings constructed before 1950, which accounted for $3.7 billion,” according to Trepp. 

 Source: Trepp 

So if we use this data for a gauge, we can understand how deeply entrenched this issue is since two-thirds of office loans with maturities in 2023 have yet to mature. There has already been significant losses in the first (and smaller) round of due dates, representing a value of about $14.5 billion. If lower class buildings have higher rates of delinquency, cities with higher populations of these classes are going to be under more water if nothing is done.

To make it worse, these are the properties who are facing the most necessary renovations as sustainable legislature hits commercial buildings. Making landlords update buildings to achieve carbon-neutral status or face intense fines is like dancing on their grave. Read about whether New York's Local 97 Law is realistic.

What’s Going to Happen with Empty Offices? 

Such high levels of distress and delinquency in the office sector can trigger more bank bailouts on the horizon. So, the pressure to do something about it is mounting.

Converting empty office buildings to housing sources is a popular suggestion. The value of commercial properties has fallen 12% over the last year, while on the other hand residential values have climbed over 50% since a pre-pandemic 2018. In turn, this property type has shown consistent returns in tax revenue rates.

However, converting empty offices to housing is a slow, complicated, and expensive solution (if you can even call it that.) And, in reality, the number of buildings that could qualify for conversions are too few to have a widespread positive effect. So this is no panacea.

So, a recent suggested alternative is that commercial property taxes are raised. In this case, the excess would likely be passed through to tenants since landlords are already widely defaulting.

If tenants are on the hook for elevated property taxes, especially those maintaining hybrid schedules, may not see an office lease as worth the investment. Or, like we’ve already seen happen, they’ll move to cities and areas with low taxes and are business-friendly. 

But the fact that raising property taxes on tenants is a part of the conversation highlights the fact that we are navigating an entirely new leasing landscape. 

Corporate tenants have new worries, and this should affect the due diligence you conduct when ensuring that your new lease has safeguards. According to Darrel Wheeler of Moody's Analytics, “If you have a net lease any new fines may qualify as billable expenses which could create an interesting discussion about whether that can be charged back to tenants."

New leases should reflect protections for tenants from excessive pass throughs and other looming financial risks.

Negotiate Office Leases with Safeguards

Safeguards against unpredictable valuations and pass-through expenses have become paramount, ensuring a more secure financial footing for tenants amidst these challenges. Because amidst persistently low attendance and declining valuations, the repercussions extend beyond commercial landlords.

In one respect, this is a tenant-favored market. Commercial tenants (especially of a certain breadth or footprint) can take advantage of declining valuations to negotiate for a more favorable lease. This can mean better terms, prices, or more premium amenities and concessions. However, the environment is not without risk. Commercial tenants face new challenges in defending themselves. Luckily, they are not alone. True Tenant Reps™ are trusted allies and experts in shielding commercial tenants from financial complications.

In the face of fluctuating valuations and uncertain market conditions, True Tenant Reps™ at iOptimize Realty® are adept at crafting lease agreements that provide stability, flexibility, and favorable terms, ensuring that businesses can navigate this evolving landscape with confidence and resilience. Learn how True Tenant Reps™ find the best office for the best price in the free course below.