The commercial office market is facing a chilly climate due to a confluence of factors. Historically high vacancy rates in major cities, particularly in relation to the pre-pandemic era, are a cause for concern. This surplus of available office space combined with rising interest rates is creating a challenging environment for commercial office investment.
High vacancy rates indicate a decrease in demand for office space. This can been fueled by the embrace of remote work models, a slowdown in the economy, increase of new next generation office buildings, or a combination of all of these factors. Rising interest rates make borrowing money for commercial office investments more expensive to purchase and/or refurbish, further dampening investor enthusiasm.
As of July 2024, Variable Rates currently range from around 6.14% to over 7.46%. Keep in mind, this can vary depending on the lender and the specifics of your loan. Fixed Rates can range from around 6.12% for a 1-year term to over 7.74% for a 5-year term. Again, the exact rate will depend on the lender and your loan details.
Investors in the commercial office sector are seeking higher yields in the current climate with the increase in interest rates coming at the same time as a softening in occupier demand which adds greater amount of investment risk into this asset class.
The spread between yields and the cost of debt historically has ranged from 250 – 350 basis points, so when interest rates increase, so does the required investment risk premium which is driving the value of office assets down.
Generally speaking, older office buildings require investment in building upgrades to keep up with the standard that tenants come to expect from commercial office buildings, this is essential to retain existing tenants, but also to attract new tenants.
Some investors are adopting a wait-and-see approach, hoping for a correction in the market. Others are looking at different types of commercial real estate, such as industrial properties or warehouse space, which are in high demand due to the growth of e-commerce.
The long-term effects on the commercial office market remain uncertain. A complete shift away from offices is unlikely,but the demand may settle at a lower level compared to pre-pandemic times. Landlords and developers may need to adapt by offering flexible lease options, creating co-working spaces, and catering to companies with hybrid work models.