While trophy office assets continue to outperform, Class B office space is showing resilience when compared with commodity Class A properties in some cases.
Before the pandemic, Class A and Class B availability rates were nearly identical. However, a gap between the two has widened considerably as Class A office has underperformed, according to Newmark’s Q3 national office market overview.
New office construction initially had a sharp increase in availability as new supply met reduced demand. Now that new stock has leased up, occupancy rates are outperforming Class A properties and are approaching the Class B rate, said the report.
In central business districts, new construction outperforms Class A, with it outperforming Class B, as availability rates are tightly clustered. In suburban markets, Class B properties have consistently lower availability rates and new construction has faced lease-up challenges, according to the report.
Rents have risen across class segments in both CBD and non-CBD markets since the first quarter of 2020, except for CBD Class A properties. This is despite high availability rates for these properties. Non-CBD rents have generally outpaced rents in CBD markets. Class B asking rents have seen significant rent gains within CBDs since early 2020 while Class A rents have remained relatively flat.
Rent per available foot, which reflects changes in both rents and availability, shows that only new construction and Class B non-CBD properties have improved operating performance since the first quarter of 2020. Non-CBD markets have generally outperformed, except for the new CBD office, which has successfully leased up, albeit with slower asking rent growth, the report said. Class A properties have lagged behind Class B, primarily due to lower occupancy, and owners may benefit from lowering rents to more effectively compete for tenant demand.
In several major gateway markets, true trophy assets have significantly outperformed from a cash flow perspective. For example, New York trophy properties command a 107% premium in rent per available foot, compared with an average of 85.1% across other top-office markets. However, national trophy rent per available foot has declined by 5.9% since the second quarter of 2020, in line with the broader market.
“The outperformance of trophy assets is fairly intuitive, particularly as it remains a small share of the overall building stock,” said the report. “It is harder to explain how Class B offices are retaining tenants in a world with high commodity Class A availability.”
Owners of Class A assets should be able to augment rents to attract tenants and drive cash flows, said Newmark. Debt constraints could be a factor. Lowering rents would trigger lower valuations, accelerating default, and large incentive packages reduce cash flows, which are otherwise captured by owners, the report said.