by Wolf Richter, Wolf Street:

“Sublease Pandemic?” Office leasing activity plunged or collapsed, depending on city, even as companies dumped huge amounts of suddenly unneeded office space on the sublease market.

In the third quarter 2020, the commercial real estate segment of office space in Houston, Manhattan, Chicago, San Francisco, and Los Angeles – each representing a different area of the US with different economic dynamics – has gotten hit hard by the stunning shift to work-from-home (WFH) and the sudden corporate realization that, after years of hogging all available office space for future use, they need to get rid of this space.

There are big differences between the cities. But all of them are getting hammered by a tsunami of sublease space, where companies that leased the space long-term need to shed this space, and the only way of shedding it, other than defaulting on the lease, is to put it on the market and sublease it. These companies will take lower than market rents, thereby driving down overall rents. A surge of sublease space is toxic for commercial real estate.

“Total availability” – sublease availability plus availability of space directly leased by landlords – has soared in all five markets, as has the “total availability rate” (availability divided by total office space), while leasing volume has either plunged or outright collapsed. With transactions nearly frozen during a supply glut, pricing is hard to nail down and will take longer to shake out.

Manhattan wheezes under the weight of sublease space.

Sublease space soared by 2.5 million square feet (sf), including 191,000 sf from Starr Companies at 399 Park Avenue and 147,000 sf from Omnicom Group at 1 Hudson Square.

This drove overall market availability in Q3 to 13.3%, even as leasing activity plunged by 45% year-over-year to 4.7 million sf.

Class A asking rents fell 5% year-over-year to $93.43 per sf per year; but the “taking rental rate” – the rate at which leases are actually signed – fell to $84.39 per sf. Overall asking rents dropped 3.1% to $80.29 per sf, “due largely to the pricing impact of sublease additions rather than a shift in direct availability repricing,” Savills Research reported. By submarket, rental rates ranged from $122.38 per sf at Plaza North to $56.31 per sf in the Financial District.

In addition, average concessions jumped by about 25% to 14.3 months of free rent. Plus, tenant improvement allowances rose by 5% to $115.87 per sf.

“Even if owners remain hesitant to significantly lower direct asking rents, the reality is that the gap between asking rents and taking rents is widening, and generous concessions will result in declining effective rents,” Savills said.

That the lease activity didn’t plunge even more was due to Facebook signing the largest lease of Q3 for 730,000 sf at the redeveloped James A. Farley Building in Midtown.

“Evidence is mounting that occupiers may seek a more permanent WFH shift, which could lead to a 10-20% structural reduction of aggregate demand for office space across the market,” Savills said.

“When discussing WFH in quarterly earnings calls, more than 80% of S&P 500 companies expressed positive sentiment. Even a more permanent shift of WFH for just one-to-two days per week across these companies could drive a potential reduction in space demand of 9-18%,” Savills said.

“Trophy assets will benefit from a flight-to-quality trend as organizations transition the use of office space from ‘performing work’ to centralized collaborative meeting places for culture and innovation,” Savills said.

San Francisco got rug pulled out from under it, leasing volume collapsed.

Leasing activity collapsed by 88% year-over-year, and by over 50% from Q2, to a minuscule 300,000 sf. There was only one lease over 50,000 sf.

Sublease, already high in February, has more than doubled since then, to over 7.5 million sf, the highest in San Francisco’s history, according to Savills Research.

Overall availability, driven by sublease space, soared to 17.7%, more than double the 8% availability in 2015. Availability ranged from 13.4% in the Financial District South to 34.8% in the Jackson Square submarket.

“This glut of lower-priced sublease space has spurred some repricing,” Savills said. Overall asking rents fell 6.5% year-over-year to $75.98 per sf per year. Class A asking rents fell 10.8% year-over-year to $79.55 per sf.

However, with leasing activity having collapsed to near nothing, there hasn’t been “opportunity for true price discovery, and quoted rents remain artificially high in relation to the tsunami of sublease inventory and rapidly rising availability,” Savills said.

Some of the companies that have put office space on the sublease market, after re-evaluating their space needs, include Twitter (100,000 sf at its HQ) and AirBnB (61,000 sf).

And Pinterest, which had signed the largest lease in San Francisco in 2019 (490,000 sf), recently agreed to pay nearly $90 million to terminate that lease.

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