With California recovering from the pandemic the office space market in Orange County is slowly returning to normalcy. In this piece, we’ll be taking a look at some of the key trends we expect to observe in the office space market over the next few months. It’s important to note here that, given the current global turmoil, we might see the situation change considerably - we’ll be exploring those possibilities, too.
Vacancy Rates: Higher Than Normal, But Dropping Gradually
In Q32021, Orange County office vacancy rates peaked at 12% (the highest vacancy rate in over nine years), as social distancing and lockdowns forced many Orange County businesses to shutter their onsite operations. With people out and about once again, and with work-from-home mandates largely lifted, we’re seeing a gradual return to normalcy. The current vacancy rate stands just below 12 percent. This is somewhat higher than the historical average of 10.8 percent, but it’s significant that it’s trending down. It’s not difficult to see what this means: businesses are returning to their physical, on-site locations. Taking a closer look at the numbers, though, reveals nuances that are worth exploring.
Large, High-Value Commercial Assets Continue to Face High Vacancy Rates
While overall vacancy rates are dropping, vacancies remain higher in some submarkets like the OC airport area which is dense with 4 and 5-star office towers. There are a couple reasons for this: 1) pricing and 2) a general shift away from large, open-plan offices as businesses adopt hybrid onsite / work from home policies.
From a pricing standpoint, 4 and 5-star office properties cost the most per square foot for good reason - they’re beautiful and impressive, and the rents reflect this. Average rents to impress your employees and clients are $2.81. This is worthwhile for many businesses, but if you run a business that customers never see you may opt to save 30% or more in rent and lease an office space in a 2 or 3-star building.
In some OC sub-markets vacancy is significantly lower for 2 and 3-star offices. The reason for this is that the market has not efficiently allocated total office space across all the office building classes. The 4 and 5-star office towers in some sub-markets, it turns out, have been slightly over-built with each new project besting and taking top tenants from last year’s (or decade’s) state of the art office development. The lesser (no pun intended) desirable 4-5 star office space languishes with a higher vacancy - creating opportunities for tenants to get more concessions in newly minted leases. Generally, we’re seeing a heightened preference for more cost-effective office space - now part of the DNA for businesses owners after paying rent for unused office space during the pandemic, while still successfully operating their businesses.
The second reason why we’re seeing higher vacancy rates at 4 and 5-star office properties is a more general, national shift towards hybrid workforces. If the pandemic had hit a decade ago when video conferencing and cloud collaboration technologies were yet to mature, work from home would’ve been a necessary trade-off to have some level of continuity in place. It would’ve likely been abandoned as soon as lockdowns lifted. In today’s world, though, studies indicate that work from home staff can be more productive than those who remain on site. Consequently, many businesses are evaluating whether they need to return to large, expensive open-plan offices when their workforce can deliver just as well from home. While most benefits would stand to benefit from scaling down their office space needs, most would still want to retain a physical presence, which shows in the lower vacancy rates for cheaper and smaller spaces.
The Leasing Market Moves Towards Normalcy
The leasing market in Orange County is starting to resemble how things were prior to the pandemic. We’re seeing vacancy rates on leases coming down sharply from a peak of over 12 percent in 2021. Estimates from the Costar Group indicate that vacancy rates will remain in the 11 percent range for the next three to four years. This is somewhat higher than usual since vacancy rates for leases stayed under 10 percent between 2016 and 2020.
Estimates, however, indicate that vacancy rates for leased properties will remain somewhat high over the next few years. This is because of an unprecedented amount of space being subleased, often by businesses looking to rationalize rental costs while retaining some of their office space. The mismatch between 3.3 million square feet of space available for subleasing and actual demand will mean that lease vacancy rates will likely stay in the 11-12 percent range over the medium term.
Rent Growth is on the Rebound
During the pandemic, rent growth took a hit, dipping to -5 percent in 2021. High-end properties were impacted even more severely, with 4 and 5-star spaces experiencing a nearly 10 percent decline in rent rates, on average. Rent growth is bouncing back now, though it remains relatively low at -0.8 percent. Lower-end properties are already experiencing positive growth, however.
Construction Work Remains Muted
Orange County typically sees 2.1 million square feet of projects under construction in any given year. Construction levels collapsed last year and in 2022, we’re only seeing around 1 million square feet of work under construction - less than half the typical rate. Costa Mesa and Irvine account for most of the square footage under construction. A single, massive Costa Mesa project - The Press - accounts for close to half of all construction work in the county, with a number of smaller projects in Irvine making up another 40 percent.
Overall, we expect a few years to pass before the volume of construction work picks up in a meaningful way. In large part, this has to do with the demand situation. Orange County is expected to have higher than average commercial property availability over the next few years, because of relatively low demand and a large amount of space being sublet. There’s more space available than the market needs. This is due to businesses downscaling their office space needs - both because of how effective WFH has proven to be across many industries - and a reduced ability to pay relatively high rent rates.
Commercial Property Sales: Lower Sale Volume, Higher Rates
The volume of commercial property sales remains low in 2022, with roughly 350 trades compared to the average of 400. However, the total value of commercial property sales, at $2.7 billion, is actually higher than the five-year average. This mostly has to do with a select number of high-value deals by institutional players. It is possible that sales value will remain higher than average over the next few years, as the businesses actually able to pay in the current economic environment will inherently be larger and have greater needs.
We believe that the Orange County office market is set to make a solid recovery over 2022. Key Indicators remain below pre-pandemic highs, but we expect the situation in terms of rent growth and vacancies to stabilize. One factor, however, that could have a significant long-term impact is just how effective is work from home? The jury is still out. During the pandemic businesses across many industries saw early feedback that work from home arrangements do not have a negative impact on productivity in most cases - this could lead to a prolonged period of soft rent growth and higher-than-average vacancies. But. we still don't know the long-term work from home results.
Global externalities are another key factor to consider. Southern California on the other side of the globe from Ukraine. However, the potential impact that the war could have on gas prices has the potential to work against economic recovery. A prolonged conflict situation could have a negative impact on US businesses.