More office space is being removed than added for the first time in at least 25 years

The U.S. office market is showing signs of recovery as demolitions and conversions are set to outpace new construction for the first time in at least 25 years, according to CBRE data, with 23.3 million square feet slated for removal versus 12.7 million square feet of new builds this year. This contraction in supply, coupled with increasing demand evidenced by positive net absorption for the last four quarters and an 18% increase in office-leasing activity in Q1, is expected to lower vacancy rates and stabilize rents, particularly benefiting owners of prime Class A office space and major office REITs. While the conversion trend faces headwinds like dwindling ideal buildings and high construction costs, the reduction of obsolete space is viewed as a positive for the overall commercial real estate market.

Analysis

The U.S. office market is exhibiting signs of reaching an inflection point after a prolonged period of distress, characterized by a significant structural shift in supply dynamics. According to CBRE Group data, 2024 is projected to be the first year in at least a quarter-century where office demolitions and conversions, estimated at 23.3 million square feet across 58 major U.S. markets, will outpace new construction of 12.7 million square feet. This net reduction in office footprint is a direct response to the sustained impact of remote work culture, which pushed office vacancy rates to a record high of approximately 19%. However, early indicators of recovery are emerging: net absorption has been positive for four consecutive quarters, and office-leasing activity saw an 18% year-over-year increase in the first quarter. These trends are anticipated to contribute to lower vacancy rates and stabilize rents, particularly benefiting prime Class A office spaces and major office REITs such as Vornado (VNO), BXP (BXP), Alexandria Real Estate Equities (ARE), and SL Green (SLG), where rent recovery is already evident. While the conversion of obsolete office space, with 85 million square feet being readied for future projects and approximately 33,000 residential units created since 2016, is a positive long-term development, the trend faces headwinds including a diminishing inventory of ideal conversion properties and elevated costs for construction labor, materials, and financing, suggesting a gradual rather than rapid market improvement.

Key Decisions for Investors

• Investors should consider selectively evaluating opportunities in office REITs with strong portfolios of Class A properties in prime markets, as these are poised to benefit first from the anticipated stabilization in vacancy and rents.
• It is advisable to closely monitor leading indicators such as net absorption trends, office utilization rates, and the actual pace of office space conversions versus new supply additions to confirm the sustainability of this market shift.