Availability of office space for sublease has climbed markedly in the Tampa Bay area, where we’re based, matching a trend that is prevalent around the country. In fact, a number of large metro areas like Chicago and San Francisco have recently set records for the amount of office sublease space that’s available.
The continuing evolution of office space is causing many companies’ needs to change, and this creates a problem if an office tenant wants out of its existing building, but can’t sublease the space. In turn, this can negatively impact landlords and investors.
The good news is, there is plenty of capital available in the market, and certain types of office properties with appealing fundamentals and features still offer attractive investment opportunities.
This article highlights what the surplus of sublease space available in today’s office market means for investors and how they can best operate in the changing landscape.
Market data shows large amounts of sublease space
We’ve been tracking the availability of office space for sublease in the Tampa Bay area, which hit a watermark high in October 2022, with over 3.4 million sq. ft. available. Meanwhile, available office sublease space in the greater Washington, D.C., region at the end of February 2023 was 11.74 million sq. ft., which is an increase of 21% from the fourth quarter 2021. And, as of December 2022, office sublease availability in downtown Chicago reached a record peak of 6.8 million sq. ft., up 92.4% compared to sublease levels at the beginning of COVID-19 pandemic restrictions in March 2020.
Thankfully, the Tampa Bay and Washington, D.C., markets have stabilized in recent months, with the increase of newly available sublease office space leveling off. And the percentage of office sublease space available compared to total office space available remains relatively low in these markets, at approximately 4.8% and 2%, respectively.
Still, with more office space available for sublease in some markets than at any time in recent history, office owners and potential investors should consider certain nuances that may impact short-term and long-term decision-making, especially regarding office properties with subleases in place.
Tips for picking an office investment property in this environment
Given the amount of sublease space available in the office market, potential investors should assess the following aspects of a property under consideration:
- Length of term on lease(s): The longer the direct lease term with tenants who currently occupy the space, the better. This allows potential investors to more accurately calculate cash flow projections.
- Direct leases vs. subleases in the building: Office properties with more square footage locked into direct leases are more appealing to investors and lenders than those that have a high percentage of subleased space in the building. This is because subletters typically receive a more attractive rent rate as compared to the direct rent rate charged in the same building. When the sublease term is over and the landlord presents a higher lease rate, the subletter may move to another property charging a lower rate.
- Occupied vs. “dark” space: If a tenant has moved out of their space, even if they are still paying rent, it’s considered “dark space.” Investors typically consider office buildings with a higher percentage of occupied space more favorable than those with dark space. The renewal probability of a tenant that’s paying for space but not using it is essentially zero. Meanwhile, there is a much better chance of renewal with a tenant that occupies their space.
- Size and credit of the tenant(s): The tenant’s square footage relative to the overall building’s gross leasable area (GLA) is an important metric investors and lenders consider. The higher an individual tenant’s ratio of the GLA, the more scrutiny it will require by the investor and lender.
- Location: Have a good understanding of the general geographic area and specific submarket where the office property is located. For example, are people and businesses moving into the area or out of the area?
- Potential renovations: Tenants’ preferences in office space and amenities are evolving. Consider how much money and effort may be needed in renovations and improvements to make the space attractive to future tenants. In particular, investors considering a complete repositioning of an office property to another product type—such as multifamily or hospitality—must proceed with caution and aim for steeper discounts, given the risk associated with adapting the property’s use.
Lenders are being more cautious with office investment properties
In recent months, we’ve noticed lenders are underwriting more conservatively for office investment properties. Lenders are especially being cautious with office properties that are completely vacant or that have too much dark space, even if there’s currently a rental stream and good credit on the leases.
When they look at an office building that needs a revamp or complete repositioning, lenders want to have confidence in the plan to re-lease the space. They may also require higher reserves on the front-end to have confidence that the borrower has funds available to make the necessary improvements to get the property leased.
Converting subleased space to direct leases
Because the amount of subleased space vs. direct leases in an office building impacts the property’s valuation and cash flow, office property owners should have a good handle on when subleased space is coming up for renewal and plan lease offers accordingly.
Ideally, the landlord will be able to roll subleased space into direct leases, assuming it involves a strong long-term tenant prospect. However, as mentioned previously, office subletters typically receive a more attractive rental rate that’s often 70% to 80% of the direct lease rate. Landlords risk subletters moving out if they raise rates significantly when converting to a direct lease.
To incentivize the right subletters to convert to a direct lease when the time comes, landlords may consider offering tenant improvement allowances and other perks. Landlords can also remind subletters that moving can be expensive, and they may not find another space at their current decreased rate unless they sublease again, which means they may have to move again soon.
It’s important to understand that there are still investors who want to buy office properties, but that they want a better deal than they could have gotten 12 months ago. There is plenty of money on the sidelines that will move a deal forward, for the right price and in appealing scenarios. Office space is not going extinct—it’s simply evolving.
Source: “What Investors Should Know About Office Buildings with Subleases“
