Office Towers Are Falling Like Dominos

On today’s show we are taking a look an how office buildings are falling over like dominos. Of course I’m speaking in metaphors.

About three years ago I was presented with the opportunity to purchase a medical office building that was 50% vacant. The price was great. The building was owned by 8 partners that included doctors within the building, a dentist and a pharmacist.

This 27,000 square foot building had a lot of potential. The increasing number of small businesses that provide independent consulting services to government and the tech industry would be perfect for such a building. Technology startups would be perfect tenants. The vision painted by the seller was amazing.

Well, I didn’t quite see the vision. I saw a dying building. The dentist who was a part owner in the building rented space across the street in a brand new construction ground level commercial space with more parking and large modern windows. Dentists are great tenants. They put a ton of money into tenant improvements. They put lead lining in the walls to provide Xray shielding. They install plumbing, high pressure compressors for their air drills, air handling. A dentists office is not a transient tenant. Once they’re in, they’re not moving. But here we had a dentist who was a part owner in the building who had a financial incentive to not only have a thriving dental practice, but also a successful business. When the dentist moved across the street, it said to me that the dentist saw the building as a liability to his business, not an asset.

That was all I needed to know and I didn’t buy the building.

Fast forward to 2021 and in hindsight that decision not to buy is looking better than ever. Office buildings all over North America are experiencing falling occupancy. Our market was already oversupplied with office space. Office vacancy was averaging 12% for the five years prior to the pandemic. By 2019 vacancy was 8% just prior to the pandemic, and then we saw vacancy steadily increase throughout 2020. But understand that commercial office leases are usually multi-year leases. Decisions to vacate space made in 2020 may not appear in the market until this year, next year, or the year after.

A year ago, Interrent REIT purchased a 50 year old 11 story office building for $21.8M on the edge of the downtown with a plan to convert the building into 153 apartments. A 50 year old office building would have a difficult time competing with new product in the downtown core. It would take a substantial refit to turn it into Class A space. Even then, it would never capture top rental rates. When you layer the high rate of vacancy on top, maintaining the building as an office building would not make financial sense.

In the latest news, the developer of a planned new office tower in San Francisco announced that Salesforce has apparently withdrawn from plans to lease a major block of space at a planned San Francisco office tower, according to comments made by one of the developers during a public hearing Monday.

At that meeting it was disclosed that the “initial lease commitment” that the developer had for the unbuilt 61-story Transbay Tower “is no longer in hand.”

Another project, Oceanwide Center — a 2M SF project near the Salesforce tower was proposed to be the city’s second tallest tower. Construction is now stopped.  The GC is a company called Swinerton. There is currently a dispute on the roughly $60M that is allegedly owed to Swinerton on that project.

It doesn’t matter whether we’re talking about a 27,000 SF medical office building, or a 1.5M square foot project, all of these offices are struggling. These buildings are an endangered species with the pre-pandemic economic model. It’s going to take some price discovery to find the new equilibrium of fair market value.