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Daily Intelligence Briefing

Tuesday, July 2, 2024

Identifying Change-Driven Investment Themes

The Daily Intelligence Briefing is published by McAlinden Research Partners. The report is provided to Hedge Connection blog readers once per week for free. Below is just one of the five sections that delivers Change-Driven Investment Themes everyday.

I. Today’s Thematic Investment Idea

A deep dive into a market driver with alpha generating potential.

Projections Show Office Vacancy Rates Yet to Reach Peak, Downsizing Takes Hold of New Lease Deals

Summary: Though the expansion of vacancy rates in some of America’s major office markets has begun to slow, more downside may still lie ahead for property managers. Forecasters like NAIOP see negative net absorption (more square footage becoming vacant than being leased) continuing across the US for another year while Moody’s now projects a peak in availability of office properties to arrive in 2026. 


In-office attendence has been stuck near 50% of total capacity for a year and a half. While the majority of workplaces now have policies that require workers to spend at least as much time in the office as they do working remotely, many companies are maintaining office spaces that are larger than necessary. Insights from JPMorgan show that downsizing has gained traction among companies agreeing to new leases.


Related ETFs and REIT: Boston Properties, Inc. (BXP), iShares CMBS ETF (CMBS), ProShares Short Real Estate (REK)

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In the first quarter, 57 office markets tracked by CBRE experienced negative net absorption, meaning more space was vacated than leased. That pushed the total office vacancy rate to a fresh 30-year high of 19%. As the latest quarterly leasing data for major cities across the US becomes available, it is clear that vacancy has remained elevated across many markets throughout the Q2, and some are continually registering record highs. In the tech hub of San Francisco, the vacancy rate grew to a record 37%, up from 36.4% in the prior quarter. Though the growth of AI companies has helped to blunt the cratering of demand for office space in the city, more square footage is still being vacated than leased. The latest quarter’s figures are equivalent to a net decline (or absorption) of about -442,000 sq ft, according to CBRE data. Though there is less of a drought in Washington DC, which has seen vacancy soar to 22.4%, this figure represents a record high. DC’s market, populated largely by agencies of the federal government, experienced a higher rate of negative net absorption at -537,000 sq ft in Q2.


It is not so bad in all commercial real estate markets, however. The nearby city of Baltimore broke a streak of five consecutive quarters of negative absorption, leasing about 39,400 sq ft more than what was vacated in the city. Its overall vacancy rate remained unchanged at a record high of 19.2%. In Manhattan, the heart of New York City’s massive financial industry, Avison Young reports that the overall office availability rate fell slightly to 19.6% in Q2 from 19.7% in the quarter prior. The city has struggled for years to get office leasing back on its feet as square footage of Manhattan renewals and extensions by the finance, insurance and real estate sectors (also known as FIRE) declined by almost -27% from the pre-pandemic years 2017, 2018 and 2019 to the most recent three years on record, covering 2020 to 2023. Per CompStak, that drop-off is equivalent to a gap of -1 million sq ft between each of those two periods.


Despite an apparent decline in the velocity of the office exodus, some see the carnage continuing on for years to come. NAIOP, the Commercial Real Estate Development Association, has forecast US office space absorption to remain negative through the second quarter of 2025, with that rate gradually slowing by the end of that period. Moody’s published a particularly gloomy forecast for US office properties, suggesting that one-quarter of all space will be vacant by 2026, slicing commercial-property values by as much as $250 billion. These estimates are predicated upon the persistence of work-from-home (WFH) and hybrid work arrangements, which has reduced the amount of space office workers need by -14% compared to pre-pandemic levels. In the highest WFH scenario modeled by Moody’s, office vacancy would be expected to soar toward 28.4% next year.


Average office attendance across 10 major US metros was gauged at 51.1% in mid-June by Kastle Systems, which manages office security and tracks attendance activity across 2,600 buildings. That is up significantly from just over 30% at the start of July 2021 but has largely plateaued near current levels since the start of 2023. New data from CBRE Americas Consulting shows that the majority of 343 US companies they track have policies that dictate workers be in the office at least as much as they’re working remotely. Still, just 14% of workers are back to working under full-time office arrangements. About 44% of the companies have a policy categorized as mostly remote (3+ days per week), employee choice, or fully remote. Low attendance compared to what companies have capacity for, combined with a drought of workplace policies that require frequent regular office attendance suggests that many companies could look to downsize their physical presence in the future. According to JPMorgan interviews with Newmark, that is exactly what is happening, as new leases across the country are taking 14% less space on average compared to before the pandemic. Such downsizing is bound to reduce income for properties as tenants pay lower rates for less space.


According to a Fitch Ratings report from June, a continuation of excessive vacancy rates and declining income from will “exacerbate refinancing challenges, leading to rising loan delinquencies and transfers to special servicing for potential workout or modification.” Fitch raised its office delinquency forecast to 8.4% by the end of 2024, which would surpass the peak Financial Crisis delinquency rate of 8.1%. Investors can gain exposure to commercial property via the iShares CMBS ETF (CMBS), Boston Properties (BXP), an office-focused REIT, as well as the ProShares Short Real Estate (REK).


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