The COVID-19 pandemic has ushered in a new era of hybrid work, making it the new norm for businesses worldwide. As a result, the demand for office space has significantly decreased, leading to a steady decline in its value. This shift has profound implications for building owners and cities that rely on property tax revenue and the economic vitality generated by office workers. In fact, a recent survey conducted by BCG reveals that many office buildings are now at risk of becoming “zombies” due to low utilization, high vacancy levels, and diminishing financial viability.
Compounding the challenges faced by building owners are rising interest rates, which are adding significant financial pressure. The cost of new debt will be considerably higher, and when combined with lower property valuations, some owners may find themselves owing more than their buildings are actually worth. This precarious situation could trigger a wave of defaults, suddenly turning lenders into owners and managers of office buildings.
Moreover, technological advancements such as generative AI are further reducing the need for traditional office spaces. Events are unfolding rapidly, necessitating immediate collaboration between property owners, city leaders, and lenders to address the impending challenges.
The term “zombie buildings” refers to those with utilization rates of 50 percent or less due to high vacancy rates and unused leased space. Many buildings have already reached this threshold. BCG’s research indicates that average vacancy rates have surged from 12 percent to 17 percent, while utilization has plummeted from 70 percent to 42 percent. This decline can be attributed to a substantial amount of leased space falling into the “at-risk” category—space unlikely to be renewed.
The at-risk category emerged as a result of the sudden shift in the office market during the pandemic. Many tenants opted for short-term leases, waiting for a clearer understanding of the future of work. Prior to the pandemic, corporate leases typically spanned five to ten years, whereas most leases today are for less than five years. Consequently, 60 percent of office leases are set to expire within the next three years.
Assuming these trends persist and organizations adapt to new demand levels, utilization may experience a slight increase from current depths. However, it is estimated that only 60 percent to 65 percent of the existing office space in the United States will be necessary. This implies that approximately 1.5 billion square feet of office space could become obsolete, resulting in a revenue loss of $40 billion to $60 billion for building owners.
Naturally, not all of the 1.5 billion square feet will become vacant. Landlords are already resorting to offering incentives such as months of free rent to prevent tenants from abandoning their leases, hoping that they will commit to the space in the future. It is possible that downtown office rents may eventually decrease enough to entice companies previously priced out of these areas. However, this would merely shift the occupied space rather than create a net increase.
It is important to note that not all office buildings will be affected equally. A “flight to quality” is expected, with preference given to amenity-rich office buildings in attractive locations, offering amenities like mass transit access, excellent restaurants, and green spaces. Additionally, buildings occupied by tenants requiring on-site work will largely be shielded from the impact. Conversely, older buildings with cubicle-based layouts, catering to office workers but lacking modern amenities, will suffer the most.
Beyond increasing vacancies and lower utilization rates, rising interest rates pose an additional threat to office buildings. Companies borrowing at floating rates or requiring refinancing will face significant financial strain, as new debt becomes substantially more expensive. For property owners, the equation is straightforward: as interest rates rise and financing becomes scarcer and costlier, office building values will decline.