Flight to quality is an inescapable term in any conversation about the office market these days. The trend of companies favoring higher-quality office buildings certainly seems to be playing out in many office markets in the U.S. and internationally, especially in Manhattan. Manhattan’s office market saw 190 leases of at least $100 per square foot in 2022, according to JLL. It was a record number of new leases at that price point that beat the previous record set not too long ago, in 2021.
The $100-per-square-foot leases last year accounted for 6.1 million square feet in Manhattan, more than doubling the size of premium leases from 2021. There were 15 leases of at least $200 per square foot and two leases at SL Green’s One Vanderbilt for more than $300 per square foot. Most of the leases at these premium price points (62 percent) were signed at buildings that were either new or recently upgraded.
Manhattan’s biggest office owners are well aware of this trend. SL Green is close to finishing its newest trophy asset in the borough, the 27-story One Madison Avenue. The building is already 55 percent leased and is expected to come online in late 2023, with IBM as an anchor tenant. SL Green just recently opened One Vanderbilt in 2020, the 1,401-foot supertall that’s now 99 percent leased. “Even though you could say the broader market has slowed on overall leasing velocity over the last three or four months, that doesn’t mean it’s necessarily true for every single building,” Steve Durels, Executive V.P. and Director of Leasing and Real Property at SL Green, recently said. “There are pockets of strength. New construction is still very strong in the marketplace, especially new construction at good locations.”
While trophy office assets like One Vanderbilt are doing fantastic, the same doesn’t hold true for other offices in New York City. NYC’s office vacancy rate has recently spiked to a record high of 12.3 percent. The average market rent in the Big Apple has also dropped to about $57 per square foot, below the $60 mark in the pre-pandemic fourth quarter of 2019. Many cite these types of figures and contrasts in office markets like New York City when referring to the flight-to-quality. According to this line of thinking, the flight to quality has shielded top-tier office buildings against the troubles that have hampered owners in other assets. Katie Keenan, Chief Executive of Blackstone Mortgage Trust, talked about how critical the flight to quality has become at a recent NYU Schack Institute of Real Estate conference. “That’s how you stay ahead of inflation,” Keenan said. “Being the newest, best asset works well.”
That’s, like, your opinion, man
We often talk about the flight to quality in the office market without explaining what exactly “quality” means. Flight to quality is a term borrowed from the investment world. It happens when investors shift their asset allocation away from riskier investments to safer ones. This is typically caused by market uncertainty and leads to herd-like behavior.
In the office market, a flight to quality entails tenants shifting to the highest-quality properties. This “flight” has been going on for some time but has grown since the pandemic started, thanks to the widespread adoption of hybrid work upending the office market. The general thinking since 2020 has been that office tenants and investors favor top-tier spaces to entice more employees to return. That means a preference for offices with a wide range of amenities, everything from on-site restaurants to rooftop terraces.
Talking about the flight to quality in the office also inevitably leads to conversations about what quality actually means. Historically the industry has separated offices into a hierarchy by designated Class A, B, and C assets. But here’s the thing: despite attempts to classify the quality of spaces, there’s no cut-and-dry official grading system. And for the most part, brokers in their individual markets don’t operate under a unifying set of definitions for each asset classification. Organizations like BOMA and NAIOP offer vague descriptions of the three asset types, but they’re simply a framework open to interpretation. It’s really all subjective, and it usually depends on whoever puts in the listing.
The asset class criteria vary from company to company, but it typically accounts for the age of the building, location, tech capabilities, rental rates, upkeep, amenities, and other factors. BOMA defines a Class A asset as the “Most prestigious buildings competing for premier office users with rents above average for the area. Buildings that have high-quality finishes, state-of-the-art systems, exceptional accessibility, and a definite market presence.” We’ll spare you the definitions for B and C assets, but let’s just say they’re in the lower tier and don’t get as high marks on their “report cards.”
Another thing to remember is that asset classifications vary significantly between markets and even submarkets within a city. For example, a Class A office in Des Moines, Iowa, probably wouldn’t get such a high rating in Boston or Los Angeles. And in a market as big as Manhattan with so many submarkets, the same can hold true even between offices in Midtown and Downtown. Since there are no universal definitions, it’s easy to see how hard it is to discern if a flight to quality is actually happening in the office market. CBRE admitted as much in recent research on the trend. The study focused on effective rents and considered concessions provided by office landlords, like months of free rent and higher tenant improvement allowances. The cities included in the analysis were Atlanta, Boston, Los Angeles, Seattle, and Philadelphia, to name a few.
CBRE said most research on flight-to-quality trends is subjective because of the lack of strict asset class definitions. Companies can and often move to better space within the same quality category, especially in “A” assets. Lease rates also don’t always tell the whole story because location, tenant mix, access to transportation corridors, and other factors play a role. CBRE analyzed more than 2,700 lease transactions across 12 large office markets since 2019 and classified buildings as either Class A or A-plus for the top tier and Class B or C for the lower tier. The study revealed that average effective rents for top-tier offices increased by 3.8 percent in 2021 and 6.7 percent in 2022. Average effective rents for lower-tier properties fell by 3.4 percent in 2021 and 1.1 percent in 2022.
Mike Watts, CBRE’s President of Americas Investor Leasing, said the study “underscores that companies are investing in their buildings to get into the top tier and stay in it.” Watts added that office owners in lower tiers may need to get more aggressive with pricing and concessions to generate sustained leasing velocity. But if the definitions are subjective, as CBRE admitted, how do we know the flight to quality is really that widespread throughout the office market?
Bargains in the suburbs
While the dominant narrative around flight to quality in the office may hold true in many places like Manhattan, it may not be as much of an overriding theme in other markets. Thomas LaSalvia, Moody’s Analytics’ Director of Economic Research, told me the flight to quality across U.S. office markets has been more prevalent in dense urban areas like central business districts than in suburban areas. “The rationale here is that dense cities tend to have long commutes,” LaSalvia said. “This makes the cost of getting to that office even higher in those places. Thus, more convincing of employees must occur – or better space is needed.”
LaSalvia’s analysis of office property performance in the third quarter of 2022 backs up his argument. Since the second half of 2021, there’s been a clear divergence in the fortunes of Class A and Class B and C office properties in central business districts, but not so much in non-CBD submarkets. The situation is similar for rent changes. Class A office rents in central business districts grew 2.1 percent from 2021 to 2022, while Class B and C rents fell slightly (0.3 percent). In non-CBD locations, LaSalvia said there was very little difference in rent performance among the asset classes. Class B and C suburban offices are “doing just fine,” according to LaSalvia, for a few reasons. Much of office B and C space in the suburbs is traditionally leased to legal, medical, or government tenants, with employees who tend to have returned to the office in greater numbers. These tenants may not be as picky about their spaces.
A similar flight to quality analysis from LaSalvia in the spring of 2022 also poked holes in the dominant narrative. Just 24 of the 82 U.S. office markets he analyzed had situations where Class A properties outperformed B and C assets. Back then, he said the flight to quality trend had merits, and some tenants found it worthwhile to trade up. But the data didn’t support a widespread proliferation of a flight to quality in terms of the performance of Class A offices versus B and C. “If trading up is occurring in substantial numbers, it’s likely occurring within the same asset class and not between classes, which is something beyond the scope of this analysis,” he wrote. Since the report was released in April 2022, I asked LaSalvia if the same holds true today, and he said, “the economics of the situation is generally the same.”
He noted that this doesn’t mean any semblance of a flight to quality isn’t happening. Some speculate that a softening labor market will bring more workers back to the office, but there’s a projected long-term skilled labor shortage in the U.S. Skilled labor will continue to have leverage for years to come, further driving a need for many top-tier offices. Climate-related legislation and ESG goals are also increasing nationwide, so tenants and landlords will need upgraded buildings to meet these mandates. Also, since 2021, many occupiers have had leases expire and have sought to trade up for better spaces.
Class B ain’t so bad
As Moody’s LaSalvia notes, the office flight to quality trend may be more prevalent in dense urban areas. This is obvious in some markets, such as Manhattan and also Washington, D.C. In D.C., the city’s struggling office market has more than 300 Class B and C offices totaling more than 35 million square feet. The city’s office vacancy rate rose above 20 percent for the first time ever in the third quarter of 2022, and the situation hasn’t improved much since then. CBRE reported that concession packages for D.C. offices rose to a new high in 2022 of $283 per square foot. That number has steadily grown in the past several years, up from $252 in 2021, $213 in 2020, and $187 in 2019. D.C. officials hope much of this older building stock can be converted into residential, but residential conversions won’t work in every instance.
The general trend in many urban office markets is that large tenants want more for less. In every major industry except for technology, JLL reports that most of the largest office occupiers have downsized their footprints since the end of 2019. Reductions have generally been moderate, and notable outlier tenants have invested significantly in office space in the last three years. Over the last several years, the trend of large office users to relocate to higher-quality spaces has also led to higher average rental rates across their portfolios. JLL’s report notes, “So, despite a net reduction in leased space, higher per-square-foot pricing has muted the impact on tenants’ total cost of occupancy.”
So, how prevalent is the flight to quality in the office market? It depends on who you ask, and it probably depends on which market or submarket you’re asking about. For Moody’s LaSalvia, the trend isn’t nearly as dominant as we’re led to believe, and it’s playing out mostly in dense urban areas and central business districts. LaSalvia notes that lower-tier, Class B, and C offices in the suburbs are, for the most part, doing just fine.
In Manhattan, glamorous office towers like SL Green’s One Vanderbilt are full of amenities and command astronomical rents like $300 per square foot. Deep-pocketed corporate occupiers are willing to pay this price. But not every office tenant is flush with that much cash and wants the best of the best. For some companies, a commodity suburban office will do just fine. For landlords hearing about the flight to quality trend so much, this may be reassuring. Building upgrades and the latest amenities are great and should be done in most cases, but not every occupier is flocking to Class A, whatever that asset class definition means, anyway.