Price declines for the U.S. office market have led to hand-wringing by investors and policymakers with worries over financial instability as prices fall. Will pension funds be able to live up to their commitments given potential losses on office investments? Will lenders remain solvent as office loans mature? These questions are being debated strenuously, but stakeholders need to understand that not all office buildings are the same and worst-case scenarios are not playing out everywhere.
The RCA Commercial Property Price Index (RCA CPPI) for offices fell 16.1% from a year earlier in the fourth quarter, but this price decline has not been enough to get the market to clear. Sales of office assets stood 66% below the average fourth-quarter level in the five years before the COVID-19 pandemic. Unless some outside force drives sudden new excitement around office investment, current owners of assets will likely need to endure further price declines if they need immediate liquidity for their holdings of office buildings.
Bringing back buyers
Tenant demand for office space has been sharply reduced since 2020. Leasing-market professionals report record-high vacancy in office buildings, which reduces the income potential for these assets. With lower income, potential buyers will ascribe less value to office buildings while current owners hold out hope for some improvement in demand and pricing.
We can use the MSCI Price Expectations Gap to measure how much prices would need to decline to bring those potential buyers off the sidelines and return deal volume to normal levels. This measure works by estimating the dynamics around the revealed preferences of buyers and sellers over time. This measure shows that the challenges for office assets in central business districts (CBDs) are more severe than for assets in suburban areas.
Prices of offices in central business districts have suffered more
The RCA CPPI for CBD office assets peaked at a record-high level in Q1 2022 and prices have fallen a cumulative 40% since then. The RCA CPPI is not tied to a particular price level, but if we peg the index level for Q1 2022 to the simple average of USD 408 per square foot (PSF) for all buildings sold in that period, it implies that these same assets would have sold for USD 245 PSF in Q4 2023.
But not all assets would be able to close at that price level of USD 245 PSF. The MSCI Price Expectations Gap for CBD offices stood at -19.7% for the fourth quarter of last year. That percentage means there was a -19.7% gap between the expectations of asset values for buyers and sellers. If buyers and sellers meet halfway on that gap, it implies a market-clearing price of USD 221 PSF.
Different losses everywhere
So where are prices for that average CBD office asset that sold for USD 408 PSF in Q1 2022? Realistically, the price is somewhere between USD 245 and USD 221 PSF. The owner of that CBD office asset in Q1 2022 would likely have realized a loss of between 40% and 46% if they went to market with an eye to immediate liquidity in Q4 2023, according to the analysis.
For suburban assets, the decline was not as severe. The MSCI Price Expectations Gap stood at -9.5% in Q4 2023. Given the cumulative 17% decline in the RCA CPPI for suburban assets seen between the peak in Q3 2022 and the end of 2023, that gap implies investors would realize a loss of between 17% and 21%.
Deal volume has fallen sharply for the office market, with the biggest challenges seen for CBD offices. This element of the market is mostly concentrated in the large hubs like Manhattan, Chicago, San Francisco and Boston. How firms use space is changing, but the price implications vary by market and asset type. Stakeholders in office assets should not make the mistake of assuming that the worst headlines apply everywhere.