Back around 2000, oh so long ago, e-commerce was 0.8% of total retail sales. Now, it’s about 15%. One result is that the shopping space in bricks-and-mortar regional shopping malls has declined sharply. In the next decade or so, could the new work-from-home patterns lead to a similar decline for commercial office space?
Tom Doolittle and Arthur Fliegelman of the Office of Financial Research sketch out this possibility in “Work-from-Home and the Future Consolidation of
the U.S. Commercial Real Estate Office Sector: The Decline of Regional Malls May Provide Insight” (OFR Brief Series 23-03, August 24, 2023).
(The Office of Financial Research is an independent bureau within the US Department of the Treasury. It was established by the the Wall Street Reform and Consumer Protection Act of 2010 (commonly known as the Dodd-Frank act)(, with the goal of providing data and analysis on financial sector issues, especially those relating to aspects of financial stability.)
Here are the rising sales of e-commerce and the correspondingly declining sales of department stores in the last two decades. The OLR writes: “The number of U.S. regional malls peaked in 2006 at 1,522 (with nearly 1.4 billion square feet of GLA) and has since declined to 1,148 (with 1.0 billion square feet of GLA). The last regional mall built in the U.S. was completed in 2014, nine years ago.” GLA is the abbreviation for “gross leasable area.” There was also a negative feedback loop: “[A]s consumers chose not to shop at regional malls with fewer shopping options and sales at those malls declined further, catalyzing an additional exodus of tenants.”
Could a similar dynamic unfold for office space in an economy where work-from-home has become a viable option, at least some of the time, for a large share of workers? The official office vacancy rates is about 19%, up only modestly in the last couple of years. But the figure understates the issue, because a very large quantity is not technically vacant–that is, a firm is still paying to lease the space–but the firm is looking to “sub-lease” some of its space to another user, because it isn’t actually using the space. This figure show that the “occupancy” rate has risen since the pandemic hit in March 2020, but it’s still only around 50%.
A high desire for subleasing is a sign that when the original lease runs out, it probably won’t be renewed. OFR writes:
[D]emand for office space is actually weaker than reported due to the growth in office space available for sublease by firms that no longer need the space. Although
office space available for sublease remains rent bearing for a building owner, it portends lower future demand for office space because sublease space competes for tenants with existing vacant space, limiting its future absorption. It also signals that current tenants may renew their future leases for less space — also reducing
future demand. The amount of subleased office space has grown by nearly 130% since Q2 202011 to 210 million rentable square feet. As a point of comparison, during the Great Recession, available sublease space in the U.S. peaked at 147 million rentable square feet in Q2 2009.
If you add vacant unleased office space to the space available for subleasing, OFR calculates that the combined “structural” vacancy rate for office space is about 50%.
However, the effects of higher office vacancies are likely to unfold in slow motion. The average length of a commercial office space lease is 7 years, and leases of 10 year or more are not uncommon. Thus, the owners of many commercial office spaces are still getting (mostly) paid, and in turn, they can still make the payments on the loans they took out to buy the building.
The authors write: “The CRE office sector is currently estimated to be nearly $3.2 trillion, which is nine times as large as the regional mall sector was at its peak.” Thus, it is quite possible that investors in this sector could be exposed to losses of several hundred billion dollars in the medium-term. In addition, “[c]ommercial property taxes compose up to 10% of a city’s annual tax revenue, and the lion’s share of such taxes are on office buildings,” so city budgets would suffer as well.
Could the office buildings be converted to residential buildings? Maybe a few of them, but probably only a few. The OFR report notes:
[I]t is generally not cost-effective and may not be possible to redevelop marginal office buildings into apartment buildings. Multifamily buildings require more external surface area to internal area to accommodate windows for bedrooms and living areas than is required for office buildings, especially those with internal offices. Furthermore, the required replumbing, electrical, and life safety upgrades necessary to repurpose marginal offices are not cost-effective without subsidies. Often, the highest and best use for a marginal office building is demolition and using its land as surface parking, park area, or nothing at all.
I sometimes say that one of the main shifts of the pandemic is that a large share of what had been residential real estate was converted to commercial real estate–that is, it was converted to home offices. When people buy a house or rent an apartment now, one of the very real considerations–along with the standard kitchen, living room, bedrooms, and bathrooms–is where the home office will be. The real estate market will be living through the evolution of that shift for years to come.