Steve Jellinek, head of CMBS research at DBRS Morningstar, explores the impact of Covid-19 on the US office property sector

On a national level, the US office market is likely to see a rebound from the coronavirus pandemic-induced recession, even as net absorption has underperformed and construction remains elevated. The amount of sub-leasable space continues to shrink, declines in vacancy were seen in some major metropolitan areas in 2Q21, and office-using employment continues to grow amid the reopening economy.

As the return-to-work landscape evolves, with the average US employee spending less time working in the office, companies will trend away from traditional private office space and increase the amount of their collaborative, support and amenity space.

With robust supply-side pressure and tepid demand, office sector performance has weakened. CBRE Econometric Advisors reports that the overall US office market recorded 6.6m square-feet of negative net absorption in 2Q21, bringing the total for the trailing four quarters to 95.1m sf of negative net absorption, a level not seen since the record 97m sf of negative absorption in 2001.

Net completions are running slightly ahead of pre-pandemic levels, with 15.4m delivered in 2Q21 and another 111.1m sf underway and expected to be delivered in the next two years. Because of this, the overall office vacancy rates increased to 16.5% in 2Q21, up 3.5 percentage points year over year.

However, all is not doom and gloom in the office sector. While the incoming new supply and continuing weakened demand are expected to increase the vacancy rate over the next year, according to CBRE, the construction pipeline is heavily laden with Class A projects and will support an ongoing flight to quality. The trend of developing higher-quality space with careful attention to providing the building amenities that tenants demand is expected to buoy the performance of these newer Class A properties, which could leave a performance gap between them and older, lower-quality assets.

Going into the coronavirus-related downturn, asking rents were only slightly above the long-term average trend and not unsustainably high as they were in previous cycles, according to CBRE. Because of this, there’s less cyclical pressure on rents to return to trend beyond the supply and demand imbalance, with pre-pandemic rent levels expected to be reached by 2Q22.

Accelerated virtual working trends may affect office demand less than commonly anticipated. Although employees may spend less time in the office, the need to accommodate peak office attendance limits the number of potential reductions in space. While these decisions will play out over time as existing leases expire and office attendance levels are assessed, high-tech sectors and markets with costly commutes likely will have more employees working virtually.

The volume of CMBS office-backed loans with balances more than US$100m grew by 53% over 2019 levels, even as the volume of loans with balances less than US$50m fell 68%. These large loans boast an average LTV ratio of 57% and tend to be secured by premium assets with strong sponsorship and superior locations. In contrast, for more standard loans, originators have pulled back, as volume is down and underwriting has become more stringent. Average LTV declined for each of the past three years, to 59% in 2019 from 61% in 2016.

The recent economic downturn and the uncertain future of work have caused occupiers to delay leasing decisions, with many already reducing their space. Downside risks from coronavirus cases and hybrid working trends present a medium-term challenge, but a strong rebound from the coronavirus-induced recession - resulting in continued job growth in office-using sectors - will eventually overcome this.