U.S. Office Outlook Report | Q1 2023

The softening in U.S. office market fundamentals, seen in Q4 2022, accelerated in the first quarter of 2023. As a result, net absorption remained negative and occupancy losses increased, while vacancy rose at a faster pace, and sublease space hit a new record high.

The U.S. office vacancy rate stands at 16.1%, an increase of 40 basis points in the first quarter. Vacancy is still slightly below the prior peak of 16.3%, seen at the height of the Global Financial Crisis (GFC) but looks set to equal, or exceed this level by mid-2023 with further upward pressure to follow.

Net absorption, which measures the change in occupied office inventory, was positive in only 24% of the metro office markets tracked in our national survey, down from 43% in the fourth quarter. National office absorption totaled negative 25.4 million square feet in the first quarter, having turned negative in the 

fourth quarter to the tune of 14.1 million square feet.

Reflecting this shift in fortunes, 17 metro markets posted more than half a million square feet of negative absorption in Q1 2023, up from 12 markets in Q4 2022. Metro occupancy losses in the first quarter were led by Boston (negative 3.3 million square feet), New York City (negative 2.7 million square feet), and Chicago (negative 2.3 million square feet). Positive absorption was modest and led by Las Vegas (230,800 square feet) and Miami (207,770 square feet).

There is a record 254 million square feet of sublease space available across the U.S. office market, up from 242.8 million square feet in Q4 2022, and significantly higher than the prior cycle’s peak of 143.3 million square feet seen in Q2 2009. As firms continue to evaluate their post-Covid real estate needs, sublease space will remain a cost-competitive, short-term option until there is greater clarity on economic and business direction.

Construction activity continues to slow. Currently, 93.5 million square feet are underway, down 43% from this cycle’s peak of 164 million square feet in Q3 2020. The New York metro area has by far the largest amount of ongoing construction, at 15.5 million square feet, followed by the San Francisco Bay Area with 9.5 million square feet, which is mostly focused on Silicon Valley, and Seattle with 7.9 million square feet.

Asking rates are, by and large, showing little change. However, the gap between asking and effective rents remains significant, with generous concessions on offer. For example, tenant improvement allowances of $100 per square foot or more are available in 10 of the 15 leading U.S. office markets when a tenant signs a new 10-year lease on Class A space.

Similarly, two-thirds of the leading markets are offering 10 months or more of rent abatement on such transactions.

There is considerable debate and speculation regarding the future of the U.S. office sector. Unfortunately, the return to the office remains slow. Most tenants are adopting hybrid working with a minimum of three days in the office per week emerging as the common standard. However, some employers are mandating a full-time return to the office.

Is a market correction ahead? Firms continue to recast their property strategies, focusing on how much space will be needed going forward, how it should be utilized, and where it should be located. As a result, tenant downsizing has become pace reductions of at least 20% to 30% being implemented by large occupiers. While existing lease obligations will temper the pace of such changes, the net result will be sustained upward pressure on vacancy.

Pending a resurgence in demand, vacancy rates and sublease availability are set to continue to rise over the rest of 2023, placing increased pressure on rents. In addition, retrenchment in the finance, government, and tech sectors, which had been key drivers of leasing volume pre-Covid, could compound this trend.

As leases expire, the return of sublease space will also create a challenge for landlords in terms of both a drop in revenue and how to position and price such space. Class A downtown sublease space is being offered at a 29% rental discount to direct space across the leading markets.

With repricing already occurring on the sales side, it seems only a matter of time before it takes place in the rental market driven by the triple-hit of downsizing, sublease space, and rising vacancy rates, as landlords become increasingly aggressive to secure tenants.

Where’s the upside? Performance and demand differentials are expected to widen. Bifurcation should be most evident between space class and age, but will also occur between and within markets, and different business sectors. Opportunities should become more selective, but the quality will win out as firms seek the optimal work experience to retain and attract the best talent and bring employees back to the office.

Environmental, Social, and Governance (ESG) initiatives offer owners an additional opportunity to differentiate their assets from the pack.

U.S. Economic Outlook

Current economic headlines remain dominated by high, but declining, inflation and the Federal Reserve’s (Fed) policy response. December’s Consumer Price Inflation (CPI) – the principal measure used by the Bureau of Labor Statistics (BLS) – reached a 6.5% annualized rate, down from the 40-year high of 9.1% in June 2022, but still significantly elevated. Encouragingly, the most recent data shows that the annualized inflation rate has decreased to 4.9%. Looking forward, CPI is expected to continue to fall. Consensus Economics projects that CPI will be around 4.3% at the close of 2023. This is still elevated compared to the 10-year average of 1.8% from 2011 to 2020.

To curb inflation, the Fed has continued to raise interest rates, albeit at a reduced level. May’s 25 basis point increase brought the Fed’s target range to 4.75% to 5%. Rates are expected to remain at this level throughout 2023. Following the encouraging 2.9% annual GDP growth rate in the fourth quarter of 2022, the U.S. economy has cooled. The U.S. is unlikely to repeat this performance in 2023. Rising interest rates continue to fetter economic growth. Annualized GDP growth of just 1.1% in Q1 2023 has increased the odds of a mild recession this year.

Comparison with Previous Cycles

While the factors that drove each recession are different, how does the office market performance in the Covid-19 downturn compare with the GFC of 2008 to 2010 and the dot.com crash from 2000 to 2002?

• The sharpest difference is in occupancy losses. Cumulative net absorption in the current downturn stands at negative 175.9 million square feet, compared to negative 92.8 million square feet during the GFC and 61.5 million square feet in the dot.com crash. Further occupancy losses are anticipated in the current cycle, driven by a combination of a subdued economic outlook, business retrenchment, and tenant downsizing.
• The U.S. office vacancy rate stands at 16.1%, 20 basis points below the all-time peak of 16.3% seen during the GFC. Given the pace and scale of recent increases, the vacancy rate could exceed this level by mid-2023 with the prospect of further increases in the short-to-medium term until there is an uptick in tenant demand.
• The amount of sublease space currently on the market is at an all-time high of 254 million square feet. During the GFC sublease space peaked at 143.3 million square feet. Further increases are expected until sufficient leases expire, and the space is returned to landlords. This is unlikely to reduce overall availability.
• Asking rents are largely holding up, but there has been a significant increase in tenant concessions in most leading markets, widening the delta between asking and effective rents. During the GFC Class A CBD asking rates fell by
  25% accompanied by a 9% fall in Class A suburban asking rents. It seems only a matter of time before landlords begin to reduce asking rents to secure tenants in a tepid leasing market.

Vacancy Increases Once More

• The U.S. office vacancy rate stands at 16.1%, up 40 basis points from the fourth quarter.
• Vacancy in this cycle looks set to exceed the record peak of 16.3%, seen at the height of the Global Financial Crisis.
• Central business district (CBD) vacancy rates rose by 60 basis points in Q1 2023 to 16.8%, while suburban levels increased by 40 basis points to 15.8%.
• South Florida and Jacksonville have the lowest metro vacancy rates outside of the tertiary markets, with both at 10.3%, followed by Birmingham (10.5%) and Memphis (10.6%).
• Houston has the highest metro vacancy rate at 23.1%, followed by Austin (22.2%) and Indianapolis (21.1%).

• Average Class A full-service office asking rates increased by 0.6% over the 12 months ending Q1 2023 to $41.40 per square foot.
• Class A asking rates in CBD markets average $52.58 per square foot, down by 1.2% over the past 12 months. Conversely, average Class A suburban asking rates stand at $34.83 per square foot, up 1.8% over the corresponding period.
• The gap between asking and effective rates remains significant. Tenant improvement allowances of $100 per square foot or more, accompanied by up to 10 to 18 months of rent abatement, are available for Class A space in several leading metros.

Absorption Remains Negative

• U.S. office absorption totaled negative 25.4 million square feet in Q1 2023, compared with negative 14.1 million square feet in Q4 2022.
• Less than a quarter (24%) of markets tracked in our survey saw positive absorption in the first quarter, down from 43% in Q4 2022.
• Occupancy gains were modest in the first quarter. Las Vegas saw the greatest amount of positive absorption at the metro level in Q1 2023 at 200,890 square feet, followed by Birmingham (173,319 square feet) and Huntsville (171,713 square feet).
• On the downside, 17 metro markets posted more than half a million square feet of negative absorption in Q1 2023, led by Boston (negative 3.3 million square feet), New York City (negative 2.7 million square feet), and Chicago (negative 2.3 million square feet).

Supply-Side Risks Continue to Recede

• The amount of office space under construction in the U.S. stands at 94.5 million square feet, down 43% from this cycle’s peak of 162.6 million square feet in Q3 2020. The amount of space completed in Q1 2023 was 16.9 million square feet.
• CBD markets account for 52.3 million square feet underway, with 41.1 million square feet taking place in the suburbs. In addition, the pace of construction in CBD markets is greater, equating to 2.5% of inventory compared with 1% in the suburbs. The national level is 1.5%.
• The New York City metro has by far the greatest amount of construction underway at 15.5 million square feet, followed by the San Francisco Bay Area (9.5 million square feet) and Seattle (7.9 million square feet).

• Total sublease space available at a national level increased by 11.2 million square feet in the first quarter to 254 million square feet.
• San Francisco still has the highest sublease availability rate among the leading markets, by a fair margin, at 9.2%. Seattle is next, at 5%, followed by Boston at 4.9%. The average across the 15 markets is 4.1%.
• In an analysis of rental discounts for Class A sublease space over Class A direct space across the leading office markets, the average discount is 29%. Washington, D.C. leads all markets with a 53.1% discount followed by Chicago at 41.8%.

• Total office sales volume in Q1 2023 was $10.7 billion, down 68% year-over-year.
• Total office investment over the past 12 months was $90.6 billion, down by 43% over the corresponding period to Q1 2022.
• Suburban properties continue to attract the most capital, with buyers placing $8.1 billion in assets in Q1 2023 compared with $2.6 billion in CBD locations.
• Average pricing in Q1 2023 was $214 per square foot, with levels at $274 per square foot in CBD markets and $200 per square foot in the suburbs.
• Further price decreases are expected in the face of higher interest rates and asset repricing, clear evidence of which is now occurring.

Click here to download the full report as a PDF