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Weekly Market Report - July 10, 2023

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Losses in property class outpaces other assets, pre-pandemic levels


Office tenants in Manhattan are living partially rent-free in the hands of their Class A property landlords, with landlords losing up to 24% of rent on concessions. All asset classes are losing a combined 21.3% of rent on concessions. Class A offices are more likely to earn stronger rents than their lesser counterparts but are also more likely to concede monetary benefits to tenants, such as free rent, furniture, or improvement allowances at the owner's expense. The situation is not getting better for landlords as distance from the pandemic grows. Across all asset classes, the average rent lost due to concessions was 16.7% prior to the pandemic. For trophy offices, the average rent lost due to concessions is up to 20% today, lower than that of Class A properties. However, the need to provide concessions across office classes doesn't appear to be on the verge of easing in the near future. Tenant improvement allowances are near record highs, and the average office tenant in Manhattan landed 16 months of free rent in the first quarter, only a month off the peak amount. Before the pandemic, the average amount of free rent given to tenants was 13 months.


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New York's return-to-office rate is now close to the national average, having increased to 50% of pre-pandemic levels in June. This puts it in line with the RTO rates of other major U.S. cities, including Los Angeles, Chicago, and Dallas. Kastle Systems data shows that hybrid work schedules are common, with Tuesday being the most popular day for in-office work. The upcoming Fourth of July holiday is expected to lead to a drop in office swipes, as it did last year. This data only reflects commercial office buildings equipped with Kastle Systems security technology in 10 major U.S. cities and does not represent the entire workforce.


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Rent resets complicated by slow office sales


The negotiation of rent resets for ground leases has become more difficult for office building owners as they look for rent discounts from landowners. Due to a lack of sales and instability in the sector, agreeing on a land valuation for rent adjustments has become a challenge. Investors spent less than $500 million on Manhattan office properties in the first quarter, down from $5 billion in the same period last year. Ground leases allow investors to divide a property's worth by treating the land and building independently. Vornado Realty Trust and the Korein family are having disagreements over the rent payment for the next 25 years for the land under Penn 1. In case the ground lease becomes too expensive, building owners sometimes walk away, and the ground owner takes over the building. In 2020, Vornado handed 608 Fifth Avenue back to the Korein family, and Aby Rosen’s RFR relinquished Lever House to Tod Waterman and Brookfield that same year.


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Deal comes through despite challenges in funding environment

Tishman Speyer and Silverstein Properties have secured a $330 million refinancing deal for a Midtown office tower, with Bank of America as the primary lender and Taconic Capital taking the mezzanine debt. The five-year, fixed rate loan will replace existing debt and partially fund the building's leasing program. The Class A office tower is 99 percent leased and has secured 321,000 square feet of new leases and expansions over the last two years. The deal is notable given the challenges faced by New York offices and their financing efforts, partly due to high interest rates.


The office space in Manhattan reached a new all-time high in the second quarter of 2023, with 70.3 million square feet empty, representing 19.7% of all Manhattan office space. Leasing activity is slow, with new leases falling by 11.1% in the first half of this year compared to the same time period last year. Midtown offices are faring better than other parts of Manhattan, particularly the Financial District.


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Greg Kraut opts for upgrades over conversions in beleaguered market

KPG Funds, founded by Michael Kraut, has been focusing on buying, renovating, and selling workplace properties that other investors and mainstream lenders won't touch. The company has turned to alternative "hard money" lenders such as Thorofare Capital, GDS Brightstar, Maxim Capital Group, and Sabal Investment Holdings to fund its business model, leaving less room for error on KPG's part. The company launched its first fund in January 2018, and the pandemic ushered in work-from-home policies that turned many office buildings into debt bombs.


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Nonprofit organizations are benefiting from the dismal market for New York office landlords, as they can break into nicer office buildings and secure concessions more frequently. ABS Partners recently landed the New York Public Library in its building at 270 Madison Ave., providing the library with an opportunity to essentially own the space outright. The deal was structured as a leasehold condo, providing the library with an opportunity to essentially own the space outright. In a healthier office market, landlords tend to focus on making a splash with a high-profile tenant and can afford to be picky about what types of companies they want in their buildings. However, in a market like today's, simply finding a tenant who will occupy the space and pay their rent is often enough.


Charitable giving declined in 2022, but Giving USA Foundation chair Josh Birkholz pointed out that donations did not drop by very much and were falling from record highs. The decline in giving is unlikely to have a particularly strong impact on nonprofits' ability to afford new office space, especially as rents remain lower than pre-pandemic levels. Nonprofit experts point to landlords covering more moving costs and nonprofits downsizing as playing more significant roles.


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Manhattan's office availability rate reached nearly 20% in the second quarter of the year, according to a CBRE report. Midtown's availability rate remained at 18.5%, while Midtown South's was 21.2%, and downtown's was 22.6%. Both Midtown South and downtown experienced a 2.3% increase in availability from a year ago. The recovery in the real estate market was attributed to new leasing volume, strong momentum in the rebounding U.S. economy, and increasing New York City office-using employment. However, the record high number of vacancies in the current market can be attributed to discussions of a looming recession. The industry has faced challenges due to a surplus of sublease space available after the pandemic. Tenants are increasingly searching for new construction and buildings with amenities, with areas like Park Avenue benefiting from strong transit options and buildings. Manhattan fell behind with nearly 4.4 million square feet, while Midtown and Midtown South experienced a 22% decrease. Downtown reported better figures, with 1.1 million square feet in leasing activity, a 14% increase from the five-year quarterly average.


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Often contentious process is especially tricky now as property sales slow


New York's office market is facing a downturn, with ground-lease arrangements where building operators pay rent to land owners. This practice has been escalating due to slowing property sales and turmoil in the office sector. Office-building operators are hoping to avoid dramatic jumps in ground rent due to the declining value of land. Ground rents have historically been based on the appraised value of the land as if it were vacant, but the value of land under office buildings is based partly on surrounding office-market values. In the first quarter of 2023, investors purchased only $489.5 million in Manhattan office properties, compared to $5 billion in the first quarter of 2022. A battle over land values and ground rents is currently underway between Vornado Realty Trust and the family that owns the land under Penn 1, Vornado's marquee office tower. The company is wrangling over how much rent the company will pay for the next 25 years. The average acre of land in Manhattan sold for about $67.7 million this year, down 57% from the same period last year. About 11% of securitized office properties in New York operate under ground leases, which are long-term agreements with rent resets scheduled every 20 or 30 years.


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A study found that employees with high wellbeing are 3.6 times more likely to claim they can do their best work, 86% of employees with high wellbeing state they can do their best work, and 3.4 times more likely to express their ability to be innovative. Additionally, employees with more time to focus on their work report a strong work-life balance, with employees who have the proper amount of space to focus on their work reporting 4.2 times more work-life balance. The report emphasizes the importance of employers helping staff find work-life balance in the workplace.



A new report from Yardi Matrix underscores the damage of work-from-home on office


Office job growth is decelerating, with the average national sales price for office buildings plummeting. Remote work is increasing across geographies, and those markets with the largest share of remote workers have the highest office vacancies. Los Angeles saw the nation's steepest decline in office prices. Commercial Edge's report revealed that work-from-home patterns have accelerated over the last three years, driving up office vacancies and creating distress in the asset class.


The COVID-19 pandemic has led to a tripled increase in work-from-home employment between 2019 and 2021. Metropolitan regions with the largest number of remote workers, such as Denver/Boulder, San Francisco/Oakland, and Austin/Round Rock, have also experienced the highest spike in office vacancies. The national office vacancy average has increased from 14.9 percent to 17.1% in the last year, but some cities as of June are experiencing vacancies well above the national average. Houston's office vacancy rate stands at 23.2 percent, Denver's at 20.7 percent, Seattle at 19.5 percent, Atlanta at 19.4%, and Chicago at 18.8%. Office vacancies in San Francisco, Orlando, Boston, and Philadelphia have all increased between 5.9% and 8.5 percent over the last 12 months.


The increase in vacancies has corresponded with slower job growth in office-using sectors such as finance and law. The Bureau of Labor Statistics found that office-using sectors grew only 1.9 percent year-over-year, and that office-using sectors have grown slower for six consecutive months in 2023. The deceleration in office job growth has been widespread geographically, with standout markets in Texas and Florida slowed considerably.

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