America's Office Surplus Began Decades Before the Pandemic

An excess of empty office space threatens to devastate U.S. business districts. Don't blame the pandemic.

America's office surplus has been built up for decades, say real estate investors, brokers and analysts. U.S. developers have built too many office towers lured by federal tax breaks, low interest rates, and inflated demand from loss-making startups. At the same time, landlords have largely failed to demolish or refit old, mostly vacant buildings for other purposes. 

As a result, there are too many offices in the country and too few companies willing to pay for space in them. The rise of remote work during the pandemic has exacerbated a problem that has already arisen, analysts say.

Office surpluses are primarily an American problem. About 19 percent of U.S. office space was vacant in the second quarter, compared with 14 percent in Asia Pacific and 7 percent in Europe, the Middle East and Africa, according to brokerage JLL. Analysts expect that share to grow as leases expire and more companies cut back on their properties.

High office vacancies threaten the finances of building owners and their creditors. They are also hurting the economies of cities like New York and San Francisco, which rely on farms to pay taxes and maintain nearby shops and restaurants.

The surplus of U.S. offices has its roots in a 1981 tax code change, brokers and analysts say. In an attempt to stimulate the economy, the Reagan administration allowed investors to depreciate commercial real estate much faster than before, among other changes, lowering their tax bills. 

Savings and loan associations have showered developers with easy loans, brokers say. This helped fuel the boom in office development in the 1980s, which increased job openings to record levels and contributed to the savings and credit crisis, when many such institutions failed. Vacancy rates fell slowly in the 1990s, but rose again after the bursting of the dot-com bubble and the subprime mortgage crisis.

From desired residences to major commercial transactions.

Within a decade of the collapse of subprime lending in 2008, demand for offices began to weaken. More and more companies are shrinking their office space to cut costs. Firms realized they could save money by abandoning private offices and squeezing more employees into open floors. Some have started allowing remote work. 

Yet the supply of office space continued to grow. Significant tax breaks and other subsidies over the past two decades have gone to projects such as Hudson Yards in New York and the World Trade Center. Converting old, vacant office buildings into warehouses or apartments remained a rarity.

Landlords have become more adept at overcharging rents in exchange for providing tenants with cash gifts and other incentives, creating a mirage of a strong market. Low interest rates and the influx of global capital into the U.S. real estate market kept the value of buildings up, even as demand for offices fell, giving their owners a false sense of security. Those factors masked chronically high job openings and prevented landlords from pursuing more conversions, said David Lipson, president of real estate brokerage Savills North America.

Sam Zell, chairman of Equity Group Investments, said coworking companies such as WeWork Inc. have also contributed to the oversupply of office space. In pursuit of rapid growth, such companies have rented far more space than they could have filled with customers in the years before the pandemic, covering their losses with billions of dollars from venture capitalists. 

"By confusing these numbers, we encouraged developers to come and add office space in markets where there was no demand," Mr. Zell said during New York University's annual REIT symposium earlier this year. Chicago's LaSalle Street, crowded with office towers, is now "nowhere with a whole bunch of outdated buildings," he added.

Vacancy rates are highest in older buildings, which lack modern amenities and are less environmentally efficient. In Milwaukee, 100 East Wisconsin Avenue was the second tallest building in the state when it opened in 1989. Two blocks from the motorway exit and with a 750-car garage, the 35-story tower was ideal for office workers coming from remote suburbs. 

But in the years leading up to the pandemic, developers built a series of glass new office towers nearby that poached East Wisconsin's 100 largest tenants. Today, more than half of the building is empty, and the two largest remaining leases expire next year, according to CoStar Group and a person familiar with the matter. Unable to pay the mortgage, the owner of Hertz Investment Group transferred the property to the recipient in early 2021.

A number of investors have offered to buy 100 East Wisconsin to turn it into apartments, said Jared Friedman, senior managing director of building manager Friedman Real Estate. The building has relatively small floors, making it a good candidate for conversion, he said. 

But many other aging office buildings don't have those attributes, brokers say. High interest rates and rising construction costs also make conversion difficult. "It's not going to be the savior of all that stale office space," said Julie Whelan, global head of tenant research at brokerage CBRE.

Instead, many old office buildings are likely to find themselves under a destructive ball. Brokers say the process will be slow because property owners are often reluctant to admit that their investment is lost. Falling new office construction could help the market recover, but it will also take years to make an impact.

At the same time, vacancy rates are expected to continue to rise. Some analysts estimate that remote work could reduce demand for office space by as much as 20% over many years, although some brokerage firms predict a smaller drop. More buildings are likely to be ransomed. 

"Time solves all problems," Mr. Zell said. "The pain between here and there can be very significant."