In recent times, the U.S. office sector has experienced an unprecedented shift in supply and demand dynamics. Recent Cushman & Wakefield reports suggest that by the end of the decade, there could be an excess of 330 million square feet of vacant office space due to the impact of the hybrid work environment. From reports earlier this year, the Federal Reserve is concerned about the banking system’s exposure to office real estate loans. Many office real estate veterans opine that the office market has yet to feel the full financial impact of the uncertainties facing the office asset class.
THE CLEVELAND OFFICE MARKET
The state of the Cleveland office market may not be so dire as the Cushman & Wakefield report portends, even though the market currently struggles to balance competing forces of the hybrid work environment vs. the goal of tenants to reduce overhead by shrinking footprint vs. the flight from Class B to Class A space in order to lure new employees and retain existing employees. According to reports published by Jones Lang LaSalle, the post-Covid mass vacancy did not occur. In fact, of the new leases tracked, about 1/3 increased their footprint while another 1/3 remained stable, and about 2/3 of those committing to new long-term leases upgraded from Class B to Class A space. What happens to absorption when Sherwin Williams vacates the Landmark Office Tower is anyone’s guess, but Bedrock, who recently acquired the Tower is likely to put it to some beneficial use as part of its Cuyahoga Riverfront Master Plan.
FACTORS INFLUENCING THE CURRENT OFFICE ENVIRONMENT
Many factors have contributed to the current office environment where office buildings may be acquired for well below replacement cost. The situation is such that office debt and equity investors must not only understand risks posed by current situations, but they must also be calculating where opportunities lie for stabilization and growth. Room-sized computers, typewriters and massive paper storage requirements may have left the office decades ago, but the office buildings that were built with these items in mind are still around. Hybrid work and tech enabled collaborative spaces are only the more recent items changing the office workplace spatial environment. A general observation is that investors and office building owners must take the lead in adapting to the ongoing changes in the office market. These changes are a response to generational shifts in how office buildings are utilized and occupied, all within an environment where capital is more expensive due to high interest rates and increased scrutiny from lenders.
The Wall Street Journal reports that Wall Street investment houses are raising billions in new funds to acquire distressed commercial properties. The largest source of these is the office building sector primarily due to:
- Distressed owners who can’t afford to refinance because of higher interest rates and increased vacancies,
- Financial institutions who want to shed office property loan portfolios at discounted prices.
This new demand by these funds is expected to hasten office building sales activity in the near-term.
Like landlords, tenants are also facing increased capital costs and have generally been slower to work through their forecasted office space requirements. While many office occupiers may not understand how much of and what type of office space they need to maintain or grow business productivity on their own, there are various professionals that can help occupiers identify and prioritize needs and areas of opportunity. Current local and macroeconomic conditions have created an opportunity for strategic office building tenants to lock in office space meeting their current or forecasted requirements for a long-term at attractive price points. As conditions improve, tenants focusing on short-term objectives and utilizing short lease terms risk missing out on opportunities to lease more functional spaces at better locations and more attractive price points.
OFFICE OCCUPIER BEHAVIOR OBSERVATIONS
Locally and nationally, there has been an observed flight to quality by tenants coupled by a reduction in tenant footprint within buildings. Recent leasing activity has provided evidence that tenants are improving the functionality of their spaces by increasing technology integration and the amount of collaborative space, while also reducing their overall square footage requirement. In effect, tenants are doing more in less space by utilizing technology and incorporating flexible or hybrid work schedules. Office workers want building-wide Wi-Fi, sensor-controlled lighting and climate control and flex workstations according to a late 2022 survey by property technology firm Essenys. The long-term trend has been that firms need less space per person primarily due to technological advances in the workplace.
Office building owners who can afford a long-term view are providing tech enhancements and more; they are providing what are being called “amenitized buildings” in an effort to draw employees back to an office environment. From entire amenity floors to healthy food and beverage services, outdoor space, wellness facilities and entertainment offerings, careful planning can allow for an enriched and enticing office product commanding higher asking rents.
INCENTIVES CAN HELP
Various local, state or federal incentives are available or emerging to help equip office occupiers with capital to sustain or grow operations. For example, incentives are available for various purposes including but not limited to:
- New construction or building retrofits for sustainability and energy efficiency measures
- Rehabilitation and occupancy of troubled or vacant buildings
- Conversions of buildings to new uses
- The attraction, job retention, or growth of office tenants
Municipalities may provide financial incentives to office occupiers because it is a financially viable strategy. These incentives often result in municipalities receiving a substantial return on investment, often far exceeding the initial incentive amount. Office users in central business districts drive positive significant revenue impacts to municipalities directly through income, property, sales and parking taxes. Office users may also indirectly drive significant demand for goods and services at other nearby uses such as food and beverage, retail, hotel, entertainment among other uses.
In Cleveland, a by right property tax exemption for commercial buildings in downtown Cleveland has been publicly discussed for several years, fueled by the enormous success of Cleveland’s residential property tax abatement. If a by right property tax abatement for office buildings has been politically off limits, the time may be nigh for Cleveland to consider it.
According to Newmark’s second quarter 2023 Cleveland Office Market Overview, the Cleveland central business district’s vacancy rate is 23.8% despite converting a national leading number of office buildings to residential uses. Downtown retail and other ancillary street level businesses cannot survive or thrive without workers in downtown buildings. Those remaining core office buildings not yet converted need tailored assistance to stabilize, refurbish, retrofit and convert into ecosystems that can meet tenants with environmental, social and governance (ESG) goals and other firms that seek to grow and compete in local and global marketplaces. According to CBRE:
“[t]oday’s office tenants expect more of their buildings in terms of quality, design, location and sustainability.”
Cushman & Wakefield experts note that office tenants are seeking buildings with surrounding neighborhood elements such as: health and wellness opportunities, food and beverage options, social gathering spaces, cultural and entertainment amenities, safe and efficient public spaces, local transportation infrastructure or reasonable parking solutions. The challenge is to meet tenant demand for sustainable, tech integrated workplaces that promote well-being and collaboration and focus on tenant and visitor experiences. As the market works through what the office of the present and future looks like, it makes financial sense for cities and municipalities to invest in office development and retention efforts, especially where cities and municipalities are largely fueled by payroll taxes and other incremental taxes generated from office occupiers.
Given the success of residential living in downtown Cleveland, it seems apparent that people want to live downtown if given the product to meet their demands. Downtown Cleveland core residential rental rates have consistently grown from pre-pandemic levels due to the in-flux of renovated space, office space converted to apartments and new residential construction, which now yield a market sector average of $2.55 per square foot annually. It would only follow that more people would want to work in downtown Cleveland if competitive and desirable office buildings were available to meet their demands. Also, office occupiers battling in competitive business climates should want to avail themselves of the greater network effect benefit potential that exists in downtown Cleveland. For downtown Cleveland, the puzzle is how do City of Cleveland planners and program managers work with landlords, architects and the rest of the development community to create vibrant, attractive and productive places for office work? One piece of the puzzle could be for the City to offer strategic assistance to office building owners to incentivize them to upgrade buildings to meet office tenant demand.