[RealBeat] Has Remote Work Caused a Crisis in US Commercial Real Estate? [OfficeShift](19)

Office Vacancy Rate Hits Record High... San Francisco Approaches 25%
Big Tech Companies like Amazon and Meta Halt Construction and Lease Contracts

Editor's Note[Jjinbit] is short for 'Jung Hyunjin's Business Trend' and 'Real Business Trend,' a segment that showcases trends in the changing nature of work. The segment within Jjinbit called 'Office Shift' carefully examines the changes in offices triggered by the COVID-19 pandemic and aims to lay the groundwork for finding answers to new work styles through experiments we have experienced together. It will be delivered to you every Saturday and Sunday morning. After 40 installments, it will also be available as a book.

[Photo by Unsplash]

A 'warning light' has turned on in the U.S. commercial real estate market. The banking crisis triggered by the collapse of Silicon Valley Bank (SVB) has raised concerns in the market about whether it will spread to the commercial real estate sector. This is because 70% of U.S. commercial real estate loans are made through small banks.

Morgan Stanley recently analyzed that $1.5 trillion (about 2,000 trillion KRW) in commercial real estate loans will mature by 2025, expressing concern that "it is unclear which financial institutions will be able to refinance or extend these loans." They forecast that the sharp rise in interest rates amid the plummeting real estate values of collateral assets such as office buildings, hotels, and retail spaces will cause significant damage.

Lisa Shalett, Morgan Stanley's Chief Investment Officer (CIO), explained in a letter to investors that office real estate assets have already faced 'long-term secular headwinds' due to remote work and are currently completely collapsed with vacancy rates at their highest in 20 years, according to U.S. Fortune. This means that the root of the current turmoil unsettling Wall Street lies in the spread of remote work.

[Image source=EPA Yonhap News]

Has remote work shaken the U.S. financial market?

◆ Even a 'beauty pageant' was held... Amazon declares halt to construction of second headquarters

Consider the case of Amazon, a leading U.S. big tech company. In 2017, Amazon decided to invest heavily to build a second headquarters. Major U.S. cities fiercely competed over the construction site. There was great anticipation that a building capable of accommodating tens of thousands of employees in the city center would revitalize surrounding commercial districts and significantly boost the local economy. Everyone eagerly offered various incentives such as tax breaks. Foreign media described the competition as a 'beauty pageant' judged by Amazon. After 14 months of competition, Virginia ultimately won.

However, six years later, the atmosphere has completely changed. Last month, Amazon announced a temporary halt to the construction of its second headquarters. The trigger was remote work, which spread due to COVID-19. As the number of employees coming to the office drastically decreased, the need for office space diminished. Cost-cutting was also demanded amid slowing sales and recession fears. The workforce sharply declined due to massive layoffs. Amazon stated it would hire employees in Virginia as promised and use the buildings constructed so far. However, it became unclear when some of the buildings would be completed. Plans to expand offices in Nashville, Tennessee, were also halted.

The construction site of Amazon's second headquarters in Virginia, USA
[Image source=Reuters Yonhap News]

The construction site of Amazon's second headquarters in Virginia, USA
[Image source=Reuters Yonhap News]

"Remote work seems to have killed it (Amazon's second headquarters construction)," said Jim Bianco, head of Bianco Research, on Twitter shortly after the news broke. The remote and hybrid work that spread during the pandemic has led to a real reduction in office space. Now, this change is spreading into a crisis in the U.S. commercial real estate market.

◆ Vacancy rates at 'all-time highs'... "The end of office real estate"

The process by which Amazon decided to halt construction of its second headquarters helps us understand what is happening in the current U.S. commercial real estate market. With more employees working from home due to the pandemic, the need for office space has decreased. Companies have begun terminating office lease contracts. Currently, office occupancy in the U.S. is estimated to be at 50% compared to pre-COVID-19 levels. This means only half the office space is needed compared to before the pandemic. Vacancy rates for offices unable to find tenants have sharply increased, naturally lowering real estate values. This has led to concerns about defaults on commercial real estate loans.

Office vacancy rates in major U.S. cities such as San Francisco and New York are hitting record highs daily. According to a report by global real estate consulting firm Cushman & Wakefield, the office vacancy rate in San Francisco, a core city in Silicon Valley, is approaching 25%. Until 2019, before COVID-19, the vacancy rate was less than 5%. Vacancy rates, which began rising in 2021 before big tech companies started layoffs, have continued to increase even as the pandemic has become endemic.

Among all commercial real estate, the decline in office values is particularly pronounced. On the 10th (local time), CNN cited U.S. commercial real estate data firm Trepp, reporting that office asset values fell 5.7% compared to a year earlier. During the same period, industrial real estate such as warehouses, hotels, and apartments increased in value by 12.6%, 5.6%, and 4.3%, respectively. This means the decline in office values is at the core of the current turmoil in the commercial real estate market.

Which companies have downsized their offices? According to The New York Times (NYT), Meta Platforms, Facebook's parent company, terminated leases for offices in key Bay Area locations such as San Francisco, Fremont, and Sunnyvale. They announced plans to reduce office space in February and have since implemented them. Salesforce also announced last year that it would reduce about one-third of its office space in a 43-story building in San Francisco. Local media reported that Salesforce is subleasing much of its office space in the Salesforce Tower downtown to other companies.

Microsoft (MS) decided to use its office in downtown Bellevue, Washington, only until the lease expires in June 2024. Twitter, acquired and operated by Elon Musk, became problematic after massive layoffs and cost-cutting measures led to unpaid rent for offices in San Francisco and London.

Arpit Gupta, a professor at New York University, and others have called this the 'apocalypse of remote work and office real estate.' This was the title of a report analyzing U.S. commercial real estate values submitted to the National Bureau of Economic Research (NBER), a U.S. nonprofit research institution, in September last year. The researchers estimated that rental income decreased by 17 percentage points from January 2020 to May last year, resulting in an estimated $453 billion loss in U.S. commercial real estate value. The word 'apocalypse' reflects how drastically office demand has been shaken since COVID-19.

This phenomenon is particularly evident in the U.S., where remote work rates are high, but it also appears in other regions. According to global statistics firms Statista and CBRE, office vacancy rates in central London rose from 5.7% in 2019 to 8.6% last year. Bloomberg reported that office vacancy rates in Dublin, Ireland, home to many global IT company headquarters, increased from 8% in Q1 last year to 13% in Q1 this year. Toronto, Canada's largest city, known for a remote work rate as high as the U.S., also recorded a record high office vacancy rate of 15.3% in Q1 this year.

◆ Will U.S. workers stop remote work? Office changes also alter city landscapes

In the U.S., where remote and hybrid work are still actively adopted, it is difficult to predict when the upward trend in vacancy rates will stop. Although companies such as Apple and JP Morgan have urged employees to return to the office, even mentioning possible layoffs, office occupancy rates have not easily increased. The nationwide office vacancy rate in the U.S. was 18.6% in Q1 this year, up 550 basis points (1 bp = 0.01 percentage points) since Q1 2020. Cushman & Wakefield's report released on the 11th forecasted that vacancy rates across the U.S. will continue to rise through this year and only stabilize next year when the economy is expected to recover.

These changes in offices affect not only companies and workers' lives but also the local economies near office buildings. Employees commuting to and from work drink coffee at cafes, enjoy lunch with colleagues, and have a beer in the evening, all of which keep the local economy running. This is why cities and local governments across the U.S., including Virginia, competed to attract Amazon's second headquarters. The presence of offices is closely linked to the urban ecosystem.

Bloomberg analyzed data from the research group WFH Research in February and reported that the number of office days for Manhattan workers in New York decreased by 30% annually, resulting in at least a $12.4 billion drop in spending near workplaces. The average spending per worker near offices in New York decreased by $4,661. In San Francisco, it was $3,040, and in Chicago, $2,387. Bloomberg noted that spending sharply declined on Mondays and Fridays, days when office attendance dropped significantly.

In the U.S., local governments have been providing tax incentives considering the contribution of corporate offices to the local economy, but the spread of remote work has forced them to reconsider these policies. Property tax revenues collected by local governments also decline due to falling real estate values.

In response, mayors of San Francisco and New York have emphasized the need for workers to return to offices whenever they appear in public since last year. In these two regions with particularly high vacancy rates, city and state governments have announced plans since last year to convert office spaces in downtown areas into residential spaces. This is a measure to address the shortage of housing and surplus office space, but legal issues remain unresolved, making even this difficult. In Washington D.C., where some government employees still work remotely, there is pressure on President Joe Biden and Congress to have them return to offices.

* Tomorrow at 10 a.m., the article '[Jjinbit] U.S. Offices Surplus, Korea Faces Shortage 'Chaos'... Why the Difference? [Office Shift] (20)' will be published. Seoul's office vacancy rate is around 2%. We asked experts from global real estate consulting firm Cushman & Wakefield why there is such a difference compared to the U.S. and other global markets. If you are curious, please check tomorrow's 'Jjinbit - Office Shift.'