‘While the cyclical downturn in economic growth will hit tenant demand across all sectors, offices face the dual threat of a weaker labour market and hybrid working. Leasing activity is increasingly dominated by tenants moving to better quality buildings, albeit in some cases reducing space. This is driving a dislocation in the market; investor sentiment remains positive on prime CBD offices, particularly in core European and Asia-Pacific markets where they are in short supply. But the definition of prime is being squeezed, and there is little appetite for secondary stock for fear of ‘catching a falling knife amid rising obsolescence risk.’

In 2022, over US$305 bn was invested in the office sector, accounting for 25% of the global commercial real estate market. Most of these transactions were completed in the first half of the year, representing deals that were most likely originated when the market was still in an upcycle in late 2021. As the year progressed, many institutional investors stepped away from the market, with transaction volumes in the second half of 2022 falling by nearly than 50% on the year (Chart 9).

Although investors continue to favour best-in-class offices, it was inevitable that pricing had to adjust to the higher interest rate environment. Across the US and Europe, prime yields have shifted outwards by around 50-100bps over the last 12 months. Core European markets such as Frankfurt and Paris, which were trading at sub-3% yields at the beginning of the year, have seen the largest decline in values (20-25%), while higher yielding US cities were better positioned to absorb the rate shock.

In Asia Pacific, the period of price discovery has been lagging behind that of the US and Europe. South Korea and Australia are exceptions, underpinned by a rising cost of local debt, but pricing was unmoved through the year in Hong Kong, Mumbai, Singapore, and Tokyo. The Dubai market is also showing some resilience, even though borrowing costs are anchored to the US. Growth dynamics in the Middle East remain positive, encouraging investors to retain capital domestically rather than diversify abroad.

A dual threat to tenant demand

We believe the current downcycle in pricing has further to run. This is partly due to the arithmetic to interest rates; in most markets, leveraged cash-on-cash returns are currently below the prevailing risk free rate of return. Tokyo stands alone as the only core market where investors can use debt to boost their returns. We’re also likely to see more focus on the occupational market, and we see downside risk to leasing activity this year.

Labour markets have been resilient to date, but employment is a lagging economic indicator, and already we are starting to see evidence of an inflection point, which is feeding through to a slowdown in leasing activity. Recession represents an opportunity for tenants to revisit their space requirements – incorporating now established hybrid working patterns more explicitly in their future plans – compounding the downturn in occupational demand. Fortunately, while hybrid working means less office space is required, the impact is mitigated by midweek peaks in occupancy and increased requirements for communal space. In Europe, we expect the demand to fall by around 10% in the long term.

Tenant quality will be a further differentiating factor in a recession; corporate distress was notably absent from the 2020 recession, but business insolvencies are beginning to rise again, and corporate bond spreads are widening on increased counterparty risk. For investors, this means a greater understanding of the quality of tenants and their forwardlooking prospects, underpinned by balance sheet strength and resilient cash flow. This will be important for lenders too, who will be underwriting loans based on much lower interest coverage ratios than the market has become accustomed to in recent years.

The risk is most acute in the US. Tech firms have dominated office leasing activity in recent years, but they are now returning swathes of sublease space to the market in hubs such as San Francisco. Across the country, around 174mn sqm of sublease space was on the market at the end of last year, a record high. Asking rents have yet to fall, but landlord concessions are at peak levels in many cities. Lease lengths have also shortened significantly in recent years; the share of very short leases (one year or less) was around one-third in 2021, up from 15% in 2019, which will speed up any down adjustment in occupation markets.9 Sentiment is weak on offices as a result; listed REITs were trading at a near 40% discount to NAV at the end of January, 2023, compared with an average of 12% across all sectors. European markets are also leveraged to the tech sector, as well as financial services, and landlords are also having to raise concessions to attract new tenants to maintain rents. But hybrid working is less entrenched than in the US, and vacancy rates are much lower, particularly in core markets such as Paris and Berlin. In Asia Pacific, office utilisation has broadly returned to pre-pandemic levels across many cities, and the outlook for economic growth is more resilient. China’s reopening may support a recovery in Beijing and Shanghai, which looked vulnerable to rising vacancy rates before authorities disbanded zero-Covid rules (net absorption in Beijing hit a decade low in 2022), as well as Hong Kong, where the Mainland increasingly dominates both investment and leasing activity.

When firms do downsize, they generally take up higher quality space. This challenge is not unique to the office sector, but it is more pressing, owing to the glut of aging buildings, and rapidly changing tenant requirements. In the US for example, only the newest buildings have seen a positive rate of net absorption in recent years (Chart 11). Occupier demand in Australia is also showing a strong preference for best-in-class buildings.

The best buildings are in short supply globally. Developer sentiment remains cautious, and the pipeline is being squeezed by higher debt costs, economic uncertainty, and build cost inflation. In Europe, Amsterdam, Berlin, London, Madrid, and Paris look particularly attractive given major imbalances in supply and demand. In Asia Pacific, rents are showing signs of a nascent recovery in Tokyo across the best located buildings, following a three-year down cycle. And Seoul is expected to remain a landlord’s market despite a notable slowdown in take-up, given very little onboarding of new stock, underpinning annual rental growth of 3-5% over the next few years. So while the office market seems yet to hit its bottom, some liquidity will be sustained by competition for the best assets. Investors remain willing to exchange on prime buildings at relatively tight spreads, perhaps securing some discount relative to the recent past, confident in the ability of these assets to achieve strong income growth in the future. Stability of income is increasingly important, with the Weighted Average Unexpired Lease Term (WAULT) quickly becoming the main KPI for new deals.

The ‘best’ vs. the ‘rest’

For the owners of secondary assets, obsolescence risk is a growing concern. Buildings with the top sustainability ratings command a 25% price premium in London and a 35% premium in Paris and Sydney. This growing bifurcation in pricing will lead to a tipping point at some point, encouraging value-add and opportunistic investors back into the market with experience in retrofitting or repurposing assets. This will be the catalyst for a more sustained increase in investment volumes.

European markets are an obvious target for this strategy. The regulatory environment is more advanced, and much of the existing stock of buildings is not fit for purpose; across major UK markets for example, around 87% of office stock will be redundant by 2030 under proposed Minimum Energy Efficiency Standards (MEES) regulation.12 Some Asia Pacific markets also look interesting, such as the land-constrained Singaporean market.

The value-add proposition is less obvious in the US. Major office markets are already suffering from a glut of supply; nationwide, the average availability rate of CBD offices was 22.7% in the final quarter, rising by 8.6ppts from pre-pandemic levels, with markets such as LA even higher. It will take time and a sustained period of leasing activity to bring this back to historical norms. Instead, opportunistic investors may be more inclined to look at repurposing empty office space into multifamily, or alternatives such as life sciences, medical offices, and even hotels, particularly in cities where legislation is being introduced to encourage this trend (e.g., Chicago, New York, LA).

In Asia Pacific, investor activity is likely to remain more broad-based; the regulatory environment lags Europe, and tenant demand will be supported by more favourable structural trends around economic growth, demographics, and urbanisation. There are exceptions to this; in Hong Kong, there is nearly 18mn sqft of Grade A office space in the pipeline for the next five years, which would take a decade to absorb based on historical take up rates. An abundant supply pipeline in Taiwan will likely lead to strong downward pressure on rents, even for Grade A stock.