Class B office space sees mixed outcomes in Q3 as 'flight-to-quality' trend pervades
By Ashley Fahey
Tampa Bay Business Journal
Published: Oct 13, 2021

There's been no shortage of speculation about the future of the office following the Covid-19 pandemic, but industry executives continue to point to a trend of "flight to quality" for tenants in the market.

While office product across all classes are seeing higher-than-normal vacancy rates, Class B or C space is making up a growing share of what's vacant in many markets. But not all.

In Sacramento, California, the Class B and Class C office vacancy rates at the end of the third quarter were 11.7% and 13.5%, respectively, compared to 8.9% for Class A office space, according to Newmark Group Inc. (NYSE: NMRK). In Denver, Class B space was the only class to experience a loss of occupancy in Q3, with quarterly absorption of -293,169 square feet and year-to-date absorption of -1.1 million square feet.

Conversely, Newmark found Class B office saw the greatest year-over-year leasing activity in Salt Lake City, at 15.5% growth. That's compared to the overall 4.3% growth in number of leases across all classes of properties in that city. Also in Q3, Class B office-rental rates in Cleveland, Ohio, increased ever-so-slightly, by $0.20, to $16.56 per square foot. Class A office space in that market dropped by $0.09 per square foot.

A office-market panel during Urban Land Institute's fall meeting this week tackled so-called commodity office space as part of a wide-ranging discussion about what's next for office space. Commodity space could technically be any class of office space but generally refers to more outdated office buildings with few or no amenities.

For some users in some markets, tenants — usually smaller companies — are still signing leases in older buildings.

"There's different product for different companies," said Michael Covarrubias, chairman and CEO at San Francisco-based TMG Partners GP LLC. He said a landlord he knows owns older midrise office buildings near Union Square in San Francisco and has been "signing leases left and right."

Many of the decision-makers for those kind of buildings don't have to go through a committee or human resources department to approve the deal, Covarrubias said.

Alex Rose, senior vice president of development at El Segundo, California-based Continental Development Corp., which owns suburban office and medical office buildings on the West Coast, said the company is a long-term owner. Some properties in Continental's portfolio have gone through multiple cycles in its ownership, and have been reinvested in accordingly.

"You’ve got to build that into your business model," Rose said. "You gain a reputation for always reinvesting in your product. Those who don’t make those investment are the ones that suffer."

Still, for central business districts with a glut of office space and rising vacancy rates, the picture becomes less clear.

Anthony Chang, managing director at Stream Realty Partners LP's northern Virginia office, said for markets with major supply problems, those commodity or older office buildings will face challenges in being leased up.

"If you have the right basis and you can reinvest and reinvent, then it’ll be fine," Chang said. "But that assumes that you have an overall market that works."

In Washington, D.C., Chang said there's an effort to incentivize converting office buildings into residential space, as there's a lot more office space than other uses today. A recent report from the Downtown D.C. Business Improvement District also predicts a major decrease in property values for the city’s office buildings is coming because of rising vacancy. Large office properties across D.C. could see a 9.7% reduction in assessed value in fiscal year 2022, which the report estimated would result in a loss of $121 million in tax revenue.

But only a certain type of office building can actually be converted into residential units. It also usually requires a lot of capital.

In general, though, Chang said cities are trying to figure out how to make central business districts more mixed-use than they are today. Leveraging unused office space is one way to potentially do that.