Navigating office sector distress in 2025

The office sector is facing an uphill battle. Since the outbreak of the COVID-19 pandemic five years ago, it has seen a worldwide shift to hybrid work, a constrained financial market with limited transaction volume, heightened borrowing costs and diminished investor interest. Now, while some investors may avoid the office market completely to minimize risk, others recognize an opportunity to discover untapped value and potential returns as the sector adjusts. Meanwhile, a surge in upcoming loan maturities is driving the need for substantial capital.

Factors shaping the office sector

The real estate debt market, shaped by elevated capitalization rates, has taken a conservative approach in 2024. Overall transaction volume remains low, and lending is concentrated on high-performing asset classes, leaving the office sector in a challenging position.

Monitoring interest rates is essential for the real estate industry. In addition to the Secured Overnight Financing Rate (SOFR), investors and economists focus on the 10-year Treasury yield as a benchmark for mortgage rates and investor sentiment. A rising yield signals a decreased demand for Treasury bonds, driving up borrowing costs and reducing property values, investment returns and the feasibility of projects. Conversely, a declining yield suggests the opposite trend, leading to more favorable financing terms and potentially sparking increased investment activity. Both interest rate indicators fluctuate based on economic conditions, inflation and monetary policy, as shown in the graph below.

Another pressure point for the office sector is record-high insurance costs. As of Oct. 31, 2024, the S&P 500 price of property and casualty insurance index was $1,318.67, up 40% from the prior year and 120% from October 2020, according to Bloomberg. The steep increase is hitting some office markets more extremely than others, New Orleans, for example, saw a rise of 37%; Louisville posted 34.2% and Miami increased 30.6%, according to Trepp. This added expense weighs heavily on office properties already grappling with occupancy and financial challenges.

Meanwhile, office lease trends have shifted since the pandemic. Newmark Research notes a 13.5% decline in average lease sizes and a 6.2% reduction in lease durations. This trend may reflect not only shrinking tenant requirements but also the shift toward tenants requiring smaller footprints and market adjustments driven by remote work. Research from Robert Half’s Demand for Skilled Talent report, published in the third quarter of 2024, found that 37% of U.S. job seekers are interested in a fully remote position, while 60% would like a hybrid role.

Rising delinquencies and special servicing needs

The office sector is also grappling with a growing number of loans requiring special servicing. Trepp reports the volume of commercial mortgage-backed securities (CMBS) loans with special servicers increased at the end of Q3 2024 by more than 26% from the end of last year. Currently, 1,144 loans with a balance of $51.09 billion are with special servicers, which is the greatest volume in special servicing since the start of 2021 when the CMBS industry was still reeling from the results of the COVID-19 lockdowns. Moreover, office property loans in special servicing have increased by 45% since the beginning of 2024, by the end of the third quarter, $20.39 billion of office loans were in special servicing.  According to data from Trepp, over the next five years, approximately $100 billion of office debt is set to mature—nearly $30 billion of it over the next 13 months.

Bank lending constraints

Financial institutions continue to struggle with investment in the office sector, with bank-loan delinquencies climbing as collateral and loan ratios deteriorate. Commercial real estate mortgage delinquencies maintained their upward trend during the second quarter, with the office sector remaining under significant pressure.  According to Trepp, the delinquency rate in the office sector increased by 86 basis points since the first quarter of 2024 to 7.2%. Of the $6 trillion commercial real estate debt sources tracked by Trepp, approximately 51% still sits on the balance sheet of financial institutions.

Compared to pre-pandemic averages, overall bank lending volume in commercial real estate mortgages was down 58% at the end of the second quarter, with office sector bank lending down 65%. However, with the anticipation of interest rate stabilization and market clarity, a modest increase in overall lending activity at the end of the second quarter provides a glimmer of optimism, suggesting potential stabilization.

Have we reached the bottom?

Through the pain, there are certainly indicators that show we have reached the bottom of the market. The Federal Reserve’s rate cuts and indication toward and further loosening, could ease borrowing restrictions and support financial market activity. We are closely monitoring sector transaction volume, which has seemed to stabilize in 2024.  Compared to prior years, this year we have seen the willingness to walk away and sell distressed properties at significant discounts. The consistency in transactions will help guide an understanding of market valuation, promoting increased sector activity.

Also noteworthy are moves by large corporations such as Amazon to require mandatory time in the office by their workforce.  Amazon's decision to enforce a strict return-to-office policy, reinforcing the value of in-person workspaces could positively affect the office sector. Approximately $4.5 billion in CMBS loans are linked to Amazon’s leased properties across major markets. 

With a better understanding of valuation and steady demand for high-quality, amenity-rich smart buildings and well-located spaces, there’s still the opportunity to enhance older office buildings to meet evolving tenant preferences. According to the October 2024 Hines report Diving “Debt-First” Into U.S. Office, the return to work is picking up, and as the supply of the most desirable office spaces remains limited, demand has broadened to lower-tier assets, resulting in positive net absorption across the office sector in 2024.

The outlook

Looking forward, the office sector will remain under pressure. Investment opportunities will be put under the microscope, and we will see more distress and defaults. Many will continue to steer clear of office properties in an effort to mitigate risk, while others will search for hidden value as the sector recalibrates. However, certain indicators are pointing towards brighter days.