When the unexpected pandemic shocked the country in March 2020, strict quarantine mandates and shelter-in-place orders forced businesses to transition out of office space and restructure operations to a remote working platform. The office market and its users felt an immediate impact. The second quarter of 2020 marked the sharpest downturn in office market activity since the Global Financial Crisis (GFC) and showed just how uncertain real estate investors across the country were about the overall future of the market. Microsoft Teams and Zoom conference calls seemed to be the new norm for the foreseeable future as the office market struggled throughout the ensuing year. Do the discoveries of the past year spell the end of the office market as we know it? Alternatively, will 2020 become a blip in history followed by a return to the market that we remember?

The Impact of Remote Working on Office Space

Undoubtedly, the largest impact on office vacancy rates and demand was due to the mass transition to the work-from-home (WFH) platform. This, in large part, was due to America’s Big Tech companies making the swift transition to remote working. According to CoStar Group, the U.S.’s five largest tech companies (Amazon, Facebook, Apple, Microsoft, and Alphabet), currently occupy approximately 589 million square feet of office space; a total greater than all of the office space in New York City. Not surprisingly, this was a huge hit to the office sector with these tech giants paving the way for the new WFH platform. Industry competitors and other sectors quickly followed suit to keep up with the competition.

U.S. office vacancy rates jumped from 12.3% in 1Q 2020 to 16% in 1Q 2021, Figure 1. It is worth noting however that out of this 3.7 percentage point spike, 1.28 accounted for the newly added office space and the remaining 2.42 resulted from the fading demand of office space. Moreover, according to the national VTS Office Demand Index (VODI), an index that tracks tenant tours both in-person and virtual for office space across the nation, demand fell by 85% in just three months (February – May) following the start of the pandemic. Consequently, the office market suffered its worst absorption since 2009 according to the CBRE data in Figure 2. Adding fuel to the fire, employers saw increased productivity since transitioning to WFH. In PwC’s U.S. remote Work Survey, 52% of employers say average employee productivity has improved. Rightfully, office investors and landlords questioned if the impact of new WFH or some hybrid model environment would continue to adversely affect future absorption and space demand.

Putting Things Into Perspective

What does the future have in store for the office market and its users? How will the sector recover, or can it recover? These seem to be the questions surrounding the industry today, but as the old saying goes, “History tends to repeat itself.” Has the office sector been in a similar situation in the past? Let’s put the current conditions into perspective. Figure 3 reveals the ups and downs of the US Office Vacancy Rate over the past 20 years. Last year was not the first time that this sector faced a challenging market.

Figure 3 — Source: CBRE — Economics Advisors as of June 2021

The office market has been no stranger to “black swan” events such as the Tech Bubble, the Global Financial Crisis (GFC), and now, the COVID-19 pandemic. Although these disruptive and rare scenarios are all different, one thing remained constant for office investors and owners alike; uncertainty. Interestingly, after each of these difficult moments in history, the office market seemed to persevere and regain momentum. Office tenants were able to take advantage of tenant-favorable conditions in the wake of stagnant market activity. As we watch the aftermath of the COVID-19 pandemic unfold, we can find value in understanding the recovery cycles and how the office market remained resilient through these past unexpected shocks.

Tech Bubble

In the early 2000’s the combination of the Tech Bubble bursting in 2000 and the 9/11 terrorist attack in 2001 left the office sector with a frighteningly uncertain future. From 1995 to 2000, internet-based companies gained quick control over the market as investors’ excitement in the new tech movement drove share prices and the NASDAQ Composite index to record numbers. However, this speculation and “no income” valuation led to the multi-year inflation followed by the sudden bursting of the dotcom bubble, which occurred in March of 2000. Massive selloffs of internet firm stocks caused a drop in office demand and the 9/11 terrorist attack the following year increased fear and uncertainty. The combination of these events caused a massive shock to the office sector.

Figure 4 — Source: CBRE — Economics Advisors as of June 2021

As more and more internet companies declared bankruptcy, more and more office spaces were left vacant. In one year, vacancy rates skyrocketed from 9.9% in 1Q 2001 to 15.3% in 1Q 2002, Figure 4. Additionally, in an effort to become the next “Silicon Valley,” major cities focused on building highly desirable office properties to attract internet firms. Unfortunately, this recently built office space proved to be unneeded. Subsequently, in 1Q 2001 the office market experienced negative net absorption. By 3Q 2001 the sector had cumulative negative absorption of 41.6 million square feet.

With what seemed to be the end of the office market, new opportunities arose for office occupants. Strong credit tenants took advantage of the flexible leasing negotiations and lower asking rental rates, resulting in the gradual recovery of the office market towards the end of 2003. With falling vacancy rates and increased absorption rates, the sector regained momentum and experienced a better-than-expected recovery over the next four years.

Global Financial Crisis

The Global Financial Crisis was the next “black swan” event that had a material impact on the office market. Subprime lending, lax policy restrictions, and borrowers defaulting on their mortgage payments all contributed to the decline of the over-built housing market. After the financial juggernaut Lehman Brothers declared bankruptcy, credit spending came to a screeching halt causing a market-wide panic. This was particularly concerning to office property owners because so many office tenants are affiliated with the financial sector: bankers, accountants, lawyers, etc.

The single-family housing market took the biggest hit, yet the commercial real estate market did not come out of the recession unscathed. Because the recession was credit-driven, cautious lending activity and extremely low confidence in credit caused a prolonged uncertainty in the office market. During 2008 and 2009, office vacancy rose by approximately 400 basis points to 16.3%. The steepest rise in vacancy began during the quarter that Lehman Brothers failed Figure 5. From the recession of 2009, office values dropped from their peak of $202 per square foot down to a low of $137 per foot.

Figure 5 — Source: CBRE — Economics Advisors as of June 2021

However, the office market remained resilient once again and steadily improved. It took five years, but the sector recovered to its pre-Lehman occupancy by the end of 2015. Owners of existing office buildings lowered rents and developers deferred starting new office projects following the recession. These adjustments affected near-term value negatively but also attracted new tenants, gradually rebuilding the sector. Starting 2Q 2010, office values started to rise from the recession-driven lows, occupancies recovered and development of new properties restarted.

The Current Situation/ Conclusion

Just in the past 20 years, the office sector has twice been shocked by outside forces. Both events negatively affected fundamental performance. Following both events, the sector adjusted, repositioned, and recovered. Where does this leave us today?

Despite the initially perceived increase in productivity that companies experienced using the WFH model, face-to-face interaction between clients and employees cannot be matched. Some CEOs are now concerned about permanently changing to remote work. In an interview with The New York Times, Microsoft’s CEO, Satya Nadella, warned that “without face-to-face interaction, companies risk losing out on a connected workforce, which could also impact things such as mentorship programs, team building activities and the like.” Netflix’s CEO, Reed Hastings, shares a similar view on working from home and explained to the Wall Street Journal, “I don’t see any positives. Not being able to get together in person, particularly internationally, is a pure negative.” These are comments from two tech company CEOs who we might expect to be the most open to remote working.

Without face-to-face interaction, companies risk losing out on a connected workforce, which could also impact things such as mentorship programs, team building activities and the like.

Moreover, Ryan Reynolds, a senior vice president with CBRE Group Inc. in Tampa, says that splitting the workforce to spend 50 percent of the time at home and 50 percent in the office is not as simple as it seems. “Remote working logistics is just as much an HR conversation as it is a real estate conversation. Until you figure out the HR side, it is hard to determine your real estate needs.”

As more and more people are receiving the vaccination and states begin to roll back lockdown restrictions, moving back to the office is becoming more and more likely. In Tampa, Reynolds says that deal volume is increasing week by week. One of the biggest factors for increased demand/ activity is the state’s responsiveness. Most surprisingly, even the most unlikely tenants are making commitments to occupying office space in the most unlikely places. In the middle of the pandemic, Facebook signed a 730,000 square-foot lease in Midtown Manhattan. Additionally, Amazon plans to expand its office space by 900,000 square feet across different markets over the next couple of years. On a national level, we see space demand increasing as well. In a March 2021 report, the VODI reported that office demand across the U.S. is now just 38% below the pre-pandemic level as opposed to the 85% drop one year ago.

Ultimately, competition will determine the strategies and operations among market participants. This was evident last year when COVID-19 forced companies to transition to the online WFH platform to keep up with the competition. Although it might take a few years to rebound, the recovery cycle will likely follow a process similar to the one that followed the tech bubble. Once conditions normalize to a pre-crisis environment, the market will once again begin to regain momentum and make a steady push back to equilibrium.