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‘1.5 billion square feet of office space could become obsolete,’ report says

The pandemic normalized work from home. But many companies have permanently gone remote, putting the pressure on office spaces across the U.S.

That post-pandemic pivot has sent office real estate into a downward spiral. The drop in demand for office space is turning up the heat for many office landlords as their buildings face the risk of becoming “zombies,” according to a new report from Boston Consulting Group released on Thursday.

Many office spaces are at risk of becoming obsolete due to low use, high levels of vacancy, and their financial viability is “quickly slipping away,” the report said. Rising interest rates and the need to refinance trillions of dollars of maturing debt in the next few years will also add a layer of uncertainty and possibly even lead to “a wave of defaults,” the company said, and lenders could become owners of office buildings.

Boston Consulting Group estimated that 60% to 65% of current U.S. office space will not be needed. “That means about 1.5 billion square feet of office space could become obsolete, which would translate into $40 billion to $60 billion of lost revenue for building owners,” the report said.

Office spaces are already on the path to extinction

Big office landlords are already seeing a drop in cash flow, according to Barclays

researchers. Based on first-quarter earnings reports, net operating income fell year-over-year at half of the 18 public real-estate investment trusts that are focused on office buildings. 

And the amount of office space that’s available to be leased is climbing. In Manhattan, roughly 94 million square footage is available for lease, which is a record, according to separate research by Colliers.

Vacancy rates have barely increased since the pandemic ended, and utilization has fallen, the Boston Consulting Group said. Leases are also becoming an issue: Before the pandemic, the average corporate lease was between 5 to 10 years, the company noted, but most leases at present are less than 5 years. “As a result, 60% of office leases are set to expire in the next three years,” the company stated.

Winners and losers in the office real-estate space

To be clear, not all of that office space will become vacant and unused. Landlords may offer concessions like months of free rent to keep tenants happy and committed to their leases, the Boston Consulting Group added. In fact, it’s even possible that rents of offices downtown will drop so far that companies that were once “priced out of those areas” may come back, they added.

The winners among offices would most likely be those rich with amenities, in attractive locations near mass transit and good restaurants and other services, the report stated. 

The “zombies” are likely to be concentrated in big cities, the Boston Consulting Group said, including New York, San Francisco, and Washington D.C. “Cities with a higher concentration of office buildings than residential and retail, and those whose economies rely on industries amenable to remote work (technology and finance, for example), face greater exposure and risks,” the report said.

In addition, “gateway cities that experienced some of the heaviest inflows of investor capital over the past decade — and that witnessed record-breaking office building valuations as a result — will be hardest hit,” the report added.

The tech sector in particular has been a main driver of growth for office landlords, a separate report from Savills, a U.K.-based real-estate company, found. Tech companies leased more than one-fifth of U.S. office spaces over 20,000 square feet between the first quarter of 2020 and the last quarter of 2021, as seen in the chart below. But leasing by tech companies has fallen to just 7.8% in the first quarter of 2023.

Government revenue impacted by decline in office real-estate

Ultimately, a decline in commercial real-estate also affects the government.

When commercial landlords lose money, that also impacts the public sector. In New York, property taxes on buildings supply about a third of the city’s revenue, with 40% of that coming from commercial buildings, a separate report from the New York Times noted.

The latest report from Boston Consulting Group estimated that a drop in revenue will also result in lower property taxes and public-transit revenue of between $15 billion to $25 billion nationally. Sales tax is also expected to see a drop.

This story originally appeared on Marketwatch

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