Halloween is upon us and that means the return of those familiar, scary monsters that come into focus this season. When it comes to commercial real estate, sublease space is the boogeyman haunting the hurting office sector. Relying on long lease terms to see buildings through the pandemic, the office sector has been biding its time, hoping workers come back before tenants have to make a renewal decision. The relative calm in the office leasing market was not mirrored by the sublease market, which saw inventory ratchet up to record highs. To recover from soaring vacancy rates, office markets across the country will first need to devour historic levels of sublease space that so far have only seen nibbles.
Sublease space is a boogeyman because while it’s not a direct threat, its lingering presence disturbs the market. By definition, a sublease is still being paid for and technically counts as occupied space on a building’s balance sheet. Companies listing sublease space is a sign that tenants need to downsize or worse, won’t renew. In that way, sublease space acts as somewhat of a canary in a coal mine, the first sign of danger. Because the space is under contract, landlords can’t take it back or make concentrated efforts to lease it themselves. The problem is sublease space also hampers recourse to the issue at hand as tenants list space to save money on real estate costs and cannibalize the actual office market. Whatever demand for office space exists in such a tight market gets drawn to discounted subleases, helping the original tenant save a few bucks but offering no net leasing gains for the landlord.
House of horrors
Remote work policies have fueled the largest expansion of sublease space in over a decade. Sublease space totaled 160 million square feet across the United States’ top 53 office markets, according to CBRE research. Economic downturns typically produce sublease space, but our current downturn which also involves a historic shift to remote work has catalyzed sublease listings to concerning levels. The good news is office markets are stabilizing as occupancy losses stop and sublease listings slow, and in some areas, have even shrunk. Far from a positive sign of recovery, it’s at the very least a bottom from which to build back.
Overall U.S. office leasing activity is up by 28.7 percent but absorption is still negative, according to the latest JLL research. Total gross leasing activity reached 34.7 million square feet in Q2, the first time over 30 million since the pandemic began. That total is still 41.6 percent below pre-pandemic quarterly averages, a clear sign that a full recovery is still a long way off. “Conditions are challenged by elevated levels of sublease space,” JLL researchers wrote in their latest office report.
The rate of sublease space expansion slowed for the third consecutive quarter. The gap between advertised sublease space and truly vacant space also stabilized, sitting at 48 million square feet for three consecutive quarters. CBRE’s research found sublease space was down 1.5 percent in August, its first monthly decline since the pandemic’s onset.
“This is a good sign for the office market and the economy in general, though it still will require a lot of activity and time to materially reduce the large volume of sublease space that has been put on the market during the pandemic,” Julie Whelan, CBRE Global Head of Occupier Research said in the firms’ report. “Other indicators, like new lease signings, have been improving in recent months. But the improvement of the overall office market should really gain traction after the sublease backlog has been pared meaningfully.”
What office brokers don’t want to hear is that improvements in the sublease markets may come down to occupiers simply removing space rather than new leasing. JLL research shows nearly 82 percent of sublease space taken off the market came from tenants taking backspace, reversing de-densification trends fueled by remote work. What new leasing does exist is increasingly favoring sublease space, accounting for 25 percent of new office deals, up from pre-pandemic averages of around 10 percent. Competing with sublease space means offering concessions because lowering rents can have a negative impact on building valuation and, worse case, even trigger loan covenants. Historically high concessions have pushed net effective rents to 14.7 percent below pre-pandemic levels.
Sublease space markets are highly localized. Popping open the hood of the overall sublease market shows certain major markets are seeing significant improvements. Sublease listings are down 8.2 percent in Seattle, 6.3 percent in San Francisco, and 2.2 percent in Boston, all cities with healthy tech sectors. Cities like Dallas, Philadelphia, and Los Angeles are still seeing growing sublease markets.
What to do with all of this sublease space is a particularly hard problem to solve. Deals have so much hair on them it’s hard to make them work, especially in a timely manner. At a certain point, sublease space becomes un-leaseable. Prospective sublease tenants usually won’t sign a deal for less than six months, some won’t go less than 24. Whatever the time frame, every sublease deal has a ticking clock counting down the original lease, creating a moving target for brokers to hit. Subleesses may be able to afford the space at the sublease rate but run into problems when renewing at the full rate. Sometimes the space is turn-key with furniture included, sometimes it’s unfinished requiring significant tenant improvements, further complicating deals. Sublessees are reliant on an intermediary to deal with issues. A sublessor in financial trouble risks having the entire lease voided in the event of delinquency or bankruptcy.
Some tenants are not operationally outfitted to become landlords themselves. Other times there are provisions in the leases that require any sublessee to be vetted and approved by the landlords. Often the fastest way to fill vacant space is by simply turning it back over to the landlord who can strip it down, improve it or market it aggressively in their own right. Office landlords are eagerly waiting for some significant portion of sublease space to turn back over to their control so they can begin to tackle impending vacancy issues in earnest.
Fighting back against the sublease boogeyman is predicated on a return to normal office occupancy. If companies shifting to remote policies plan to significantly downsize their office footprint, the sublease market will continue to spook the office leasing sector. If the sublease market stays oversized for long or grows even larger from remote work-based downsizing, historic vacancy rates will become historic problems. The boogeyman looms larger than ever.