Will Downtown Office Towers Continue to Command Top Rents?

By Paul Leonard CoStar Advisory Services

For those living in one of America’s largest cities and working downtown, the daily commute not too long ago probably involved crowding onto trains that were over capacity during peak hours and often operated with outdated ventilation systems. Commuters then flowed into enclosed transit stations before exiting and facing the last gauntlet of the commute, riding a crowded elevator up to the final floor.

This typical journey to work for millions of Americans was mildly unpleasant before the pandemic, but is now shaping up to be borderline unbearable when commuting to the office eventually resumes. The logistical nightmare of getting workers safely from their homes to the office is keeping a lot of mayors, governors, CEOs and office landlords and managers up at night. Fear of crowding in subways, office lobbies and other public gathering spots threatens to upend the three-decade trend towards the reurbanization of America’s cities.

When we eventually resume life as we knew it, larger cities with longer commutes and a dependency on public transit will face unique challenges that smaller, more car-dependent cities will largely avoid. Compounding this threat is the fact that the metropolitan areas that are most reliant on transit and that have the longest commutes also have the highest office rents in the U.S. This raises an important question of whether these larger cities will continue to see such disparity in rent premiums after the pandemic.

Top-tier markets such as New York, D.C., Boston, Chicago, Los Angeles, San Francisco and Seattle are the most challenged by this trend. Companies located in these markets are likely to face the most pressure from employees to continue to work from home or have more flexible schedules in the future.

But while top-tier markets collectively face enormous challenges, New York City stands out as being far and away the most acutely impacted by transit concerns associated with virus transmission risks. According to the U.S. Census Bureau, 31% of New York's metropolitan workers commute via mass transit to work, and this number is far higher for commuters whose destination is Manhattan. San Francisco is in a distant second place at 17%, and only four other markets are above 10% — all of them top-tier markets.

This past April, when New York City was the epicenter of the COVID-19 pandemic, ridership on New York’s subways dropped an unprecedented 92% compared to April 2019. But in the months since, ridership has only recovered to a 77% deficit compared to last year.

In addition to having long, transit-dependent commutes, these top-tier markets also have the greatest share of office space located in mid- and high-rise buildings necessitating an elevator ride. Nearly half of all office inventory in tier-one markets is above the fourth floor. That compares to a little more than one-third of the office space located in tier-two markets and only about a quarter of the office inventory in tier-three markets. In addition to mass-transit concerns, these high-rise cities face another hurdle in the logistics of getting workers from the ground to their floor without crowding in the lobby and the elevators.

If we focus within these markets, we find that 75% of the four- and five-star office space in central business districts nationally is located above the fourth floor versus just 31% of office inventory outside of the central business districts. New York is not alone in facing challenges presented by elevator queues and crowding. There are 28 cities in the U.S. with central business districts where 70% or more of the four- and five-star office space is located above the fourth floor.

In addition to longer, transit-dependent commutes and the prevalence of high-rise towers, nearly all central business districts command a rent premium compared with their surrounding markets. Once again, this premium is highly correlated to the market tier. Among the tier-one markets, there is a 72% rent premium, led by New York’s 125% rent premium for downtown office space compared to its suburbs.

The average rent premium falls to just 30% in tier-two markets and to just 15% in tier-three markets. The question remains, will office buildings in central business districts be able to maintain the same rent premiums after the pandemic?

Commuting activity may return toward previous levels once a vaccine for the new virus is developed and immunity levels eventually increase. This has historically been the case after other health scares or shocks, such as 9/11, that also prompted employers to reconsider downtown locations. In the past, initial concerns subsided over time once the general public perceived the threat had passed or had been addressed.

But that, of course, will take time. For investors concerned by the short-term implications posed by interrupted commuting patterns, there are a few office markets that have less dependency on mass transit. In addition to suburban markets generally, Sun Belt areas such as Phoenix, Arizona; Austin, Texas; Orlando and Tampa, Florida; and San Diego, California, are the least impacted by this trend, as they are far more dependent on cars with a relatively low share of high-rise office inventory.

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