Office Real Estate Crisis Predicted To Worsen By 2030: How Major Cities Can Adapt

Investing in commercial real estate has bottomed out, and according to a new report, office occupancy in large urban centers is not going back to pre-pandemic levels for decades.

The new 88-page report was published Thursday by the McKinsey Global Institute, an international research firm focused on economic and business issues.

Major Urban Centers Never Recovered From The Pandemic

The COVID-19 pandemic was one of the most economically damaging events of the century so far. The total toll of the pandemic has been estimated to reach between $14 trillion and $16 trillion for the U.S. economy by 2023.

Yet, the pandemic also left other marks that are becoming noticeable in specific industries. For real estate, it means that office space in large cities will likely never be what it once was.

The report examined 17 “superstar” cities across six countries, which are typically large urban areas that contribute significantly to the world’s GDP and its growth. The pandemic-induced shifts in work behavior, coupled with advancements in technology, have drastically changed how employees engage with their workspaces.

"Hybrid work is here to stay," said McKinsey. 

Today, employees visit the office, on average, 3.5 times a week. That's down 30% from 2019 levels.

Large companies in the service sector accounted for the lowest levels of office attendance. In firms with more than 25,000 employees offering professional services, workers now come into the office about 3 times a week.

These numbers are in line with peoples' wishes. Most of the subjects surveyed by McKinsey said their preferred number of days to go to the office was 3.2 a week, and 10% of them even said they'd quit their job if required to attend the office every day.

The consequences of this cultural shift around work is affecting more than just office space. Urban cores lost inhabitants in a trend that's disproportionately affecting big cities in the U.S. New York and San Francisco are among the cities to lose the most urban dwellers between 2020 to 2022, with a 5% and 6% drop respectively.

This has led to reduced walking traffic for store fronts in urban centers, lending to a rise in online shopping. Foot traffic near stores in metropolitan areas is still 10% to 20% lower than in 2019.

The drop in demand is also affecting rent prices. From 2019 to 2022, asking retail rents declined an average of 5.4% in the cities analyzed.

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Office Real Estate Only Got The First Taste Of The Decline

"In the scenarios we modeled, the amount of office space demanded in most cities does not return to pre-pandemic levels for decades," said the firm.

According to McKinsey, the behavioral changes caused by the pandemic will continue to push down demand for real estate in most big urban centers due to lower office attendance, accelerated out-migration from cities, and less shopping in office-heavy neighborhoods.

The firm modeled two scenarios for 2030: one moderate and one severe. The more severe scenario assumes that by 2030, all office workers will follow the ongoing trend in large companies offering professional services in the knowledge economy, which present the highest levels of hybrid work and reduced office attendance.

In the moderate scenario, the median city will have 13% less demand for office space by 2030. The drop in demand climbs to as much as 38% in the severe scenario for some cities. This can lead to a drop in the total value of office space in large cities of between 26% from 2019 to 2030 in the moderate scenario, to a 42% drop in value in the severe one. 

How Will Urban Centers Adapt?

One trend that could save urban cores from decline can be to adopt a strategy of mixed-use development.

"Turning empty spaces into hybrid places could be a way to transform superstar cities and prepare them for a dynamic, prosperous future," said McKinsey.

This can be done by either adapting existing office buildings into office/residential hybrids or by developing new projects with this approach in mind. According to McKinsey, mixed-use neighborhoods have proven to be more resilient during the pandemic than office-dominated ones.

From the developer's side, building new buildings with a flexible floor plan can allow the properties to maintain their value through shifts in demand.

Regardless of the challenges facing office demand in the coming decade, ETFs following the commercial real estate space are having a week on the green side.

• Invesco S&P 500 Equal Weight Real Estate ETF EWRE is up 0.2% on Thursday at the time of this writing and 2.6% in the past five days.
• iShares Core U.S. REIT ETF USRT is up 0.17% on Thursday and 2.2% in the last five days.
• First Trust S&P REIT Index Fund FRI is down 0.6% on Thursday but up 2.4% in the last five days.
• iShares U.S. Real Estate ETF IYR is up 0.14% on Thursday and 2.6% in the last five days.

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Picture made with artificial intelligence using Midjourney AI.