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Top Office Developers Hit the Pause Button on New Projects

Anemic return-to-office rates cause real estate giants such as Vornado and Kilroy to throttle back on developments

By Peter Grant, WSJ

Nov. 8, 2022 5:30 am ET

U.S. real-estate developers are delaying major office projects already under way or in the planning stages, discouraged by high vacancy rates and the reduction in workspace demand resulting from remote work.

Some property developers view periods of economic uncertainty and weak office demand as good times to launch new projects. Because large-scale developments tend to take three to five years or longer, developers bet that tenants looking to trade up in office quality will be drawn to modern offices with lots of amenities, just as the economy is gaining steam.

But soaring interest rates and the slow pace at which workers are returning to offices have even some risk-taking developers wary about the future. With office use only about half of what it was before the pandemic, some of the most active developers are postponing major projects and are losing their appetite for new developments.

‘There’s increasing uncertainty in the world, and tenants are acting accordingly.’

— Vornado President Michael Franco

That list includes real estate heavyweights Vornado Realty Trust, Houston-based Hines, Kilroy Realty Corp. and Toronto-based Brookfield Asset Management Inc., according to the companies or people familiar with the matter.

“Caution is the word of the day,” Vornado’s president and chief financial officer, Michael Franco, said on Vornado’s earnings call last week. “There’s increasing uncertainty in the world, and tenants are acting accordingly.”

Some analysts took these and other comments by Chief Executive Steven Roth as a sign that Vornado might move slower than expected on its planned new office tower on the site of Manhattan’s Hotel Pennsylvania, which it is demolishing. Mr. Roth declined to address that matter on the call.

Kilroy, which earlier this year delayed a 600,000-square-foot development in San Diego, said last month that it was shelving a 500,000-square-foot project in Austin, Texas, that had already started.

“There are times to buy, times to sell, times to develop and times such as now to be patient,” John Kilroy, chief executive and chairman of Kilroy Realty, said on an earnings call.

About 156 million square feet of office space construction currently is under way in the largest 54 U.S. markets, down from 186 million in the first quarter of 2020 before the pandemic hit, according to data firm CoStar Group Inc. That figure is expected to decline further as developers confront rising vacancies and falling rents in most markets.

The national office vacancy rate stands at 12.5%, up from 9.6% in 2019 and the highest since 2011, CoStar said. Just as worrisome for developers: 37% of the space under development remains available, more than double the rate in 2019 and approaching the record 39% in 2008, CoStar said.

“We’re not quite at 2008 levels, but we certainly could get there in the next year,” said Nancy Muscatello, a CoStar senior analyst.

Many companies have told workers to return to their offices after more than two years of remote work. But businesses also are adopting new workplace strategies that allow employees to work from home a few days during the week.

As a result, tenants need less office space. Most businesses aren’t including expansion space when they sign new leases as they often did in the past, according to brokers. About 212 million square feet of sublease space is currently available, according to CoStar, a record high since 2005 when the company began tracking the metric.

Office landlords had hoped that leasing activity would start to return to prepandemic levels, but there is little sign of that happening, especially now with the threat of a recession looming. New tenant searches in October remained below half of their average prepandemic pace in 2018 and 2019, according to the VTS Office Demand Index.

Not every developer is tapping the brakes. Boston Properties Inc., the office real-estate investment trust, is building a 390,000-square-foot project in San Jose, Calif., near a planned new Google campus. “We would expect an improvement in market conditions” by the time it is completed in late 2024, a spokeswoman said.

Developers forging ahead say that demand remains strong for the highest-quality space with great locations and amenities such as restaurants, good views, fitness centers and daycare. Businesses adopting new workplace strategies feel it is worth paying higher rents for this space partly because they are leasing less and partly to encourage workers to return to the office for more days.

“They want to find the best space with amenities, with restaurants, with locations to bring their people back,” said Steve Center, senior vice president of American Assets Trust Inc., which is developing a 200,000-square-foot office building in San Diego without any preleasing.

This strategy has worked for some developers in past downturns. The Durst Organization in New York famously built a 52-story tower in Times Square during the recession of the early 1990s without preleasing and signed Condé Nast Publications before it was completed.

But high interest rates and rising building costs in the current market have put a new wrinkle in this strategy. Even if developers are able to attract tenants to their new buildings, they might not be able to get the rents they need for their investments to pay off, some analysts say.

“History shows there is likely to be good demand for new and high-quality office space,” said Danny Ismail, a senior analyst at real estate analytics firm Green Street. “But will demand be there at the rents needed to justify those developments?”

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