Office properties have been much maligned in the press - fears of loan defaults, rising vacancy rates, declining rental rates, etc. Much of this reporting is focused on coastal hubs like San Francisco, Los Angeles or New York. So what's going on in flyover country, specifically Metro-Detroit?
Well, there's been at least one high profile demolition (see Regent Court in Dearborn), a successful conversion from office to multifamily (see Forum Flats in Troy), an iconic building brought back online (see Michigan Central in Detroit) and another iconic building potentially coming offline in Detroit (see Renaissance Center in Detroit). Update: As of 11/25/2024 the RenCen will be partially demolished and redeveloped. Link.
While uncertainty still prevails within the office sector, there are glimpses of hope.
Before we get into the facts and figures about the state of the office market, let's recap some major events that have impacted this sector.
The state shutdown in March 2020 caused by the COVID-19 pandemic meant most office workers across Southeast Michigan began working from home
Many companies attempted to implement return to office policies in late 2020, but spikes in COVID cases continually pushed these timelines back
When the state shutdown was officially lifted in June 2021, some large employers mandated a return to office including UWM (five days a week) and Rocket Companies (four days a week)
By early 2024, General Motors and Ford Motor Company mandated employees return to the office for three days a week
Facts and Figures - Small Office
Let's consider small office buildings first, properties ranging in size from 5,000 to 20,000 square feet, across the Metro Detroit market including Oakland, Macomb and Wayne Counties.
2024 Q4 YTD Snapshot
Avg. Sale Price: $94/SF
Market Rent (Gross Terms): $20.48/SF
Vacancy Rate: 7.50%
Avg. Lease Size: ~2,000 SF
Net Absorption (2023 Q4 - 2024 Q4): -85,301 SF
Historical Trends
The following table and chart illustrates changes to small office vacancy rates, market rents, net absorption, average lease size and selling prices since 2010 Q4. It is noted the market asking rent is based on gross terms (landlord paying all operating expenses, i.e. no tenant reimbursements).
Small Office Observations:
Even though vacancy rates have been ticking upward modestly since 2021, current vacancy rates remain much lower than where they were between 2010 and 2015. Vacancy rates are projected to generally remain level through 2029, averaging around 7.50% year-over-year.
The average lease size between 2010 and 2019 was 2,007 SF. Since 2020, however, the average lease size is 1,803 SF. Based on conversations I've had with office leasing brokers across the market, there is a much greater pool of potential users/tenants for smaller office suites.
Market rent continues increasing. Since 2020, rental rates have increased nearly 6%. Landlords and property owners remain firm on rental rates as operating costs continue to escalate. Insurance costs alone have doubled over the last ten years.
The average sales price per SF has been declining, although CoStar projects sale prices have bottomed out. Sale prices are projected to remain flat in 2025 and then begin increasing in 2026.
Aside from positive net absorption in 2023, net absorption has been negative every year since 2018. CoStar projects net absorption will remain negative year-over-year through 2029, although location plays a big role. For example, net absorption is projected to be positive in Birmingham, stable in Rochester and negative in Farmington Hills, Troy and Royal Oak.
It is possible that forward looking projections may change if new supply enters the market. Although it is unlikely a developer would undertake new office construction at this time, unless a proposed development is a build-to-suit deal or almost entirely pre-leased. Construction costs remain too high and demand/rent levels are not high enough to justify new construction. The exception is specialized medical office construction, but for general/professional office buildings, new construction is simply too cost prohibitive.
Facts and Figures - Large Office
Now let's consider large, multi-tenanted office buildings over 20,000 square feet across the Metro Detroit market including Oakland, Macomb and Wayne Counties.
2024 Q4 YTD Snapshot
Avg. Sale Price: $116/SF
Market Rent (Gross Terms): $21.29/SF
Vacancy Rate: 15.10%
Avg. Lease Size: ~3,500 SF
Net Absorption (2023 Q4 through 2024 Q4): -882,760 SF
Historical Trends
The following table and chart illustrates changes to large office vacancy rates, market rents, net absorption, average lease size and selling prices since 2010 Q4. It is noted the market asking rent is based on gross terms (landlord paying all operating expenses, i.e. no tenant reimbursements).
Large Office Observations:
Vacancy rates have been ticking upward since 2019 and are expected to remain around 16.50% through 2029, per CoStar. Reported vacancy rates for the Metro Detroit office market vary by source, as evidenced below.
Newmark - 22.8% Vacancy (2024 Q3)
Colliers - 12.3% Vacancy (2024 Q3)
CBRE - 19.6% Vacancy (2024 Q3)
Cushman Wakefield - 21.8% Vacancy (2024 Q3)
It is possible in the coming years that vacancy rates may continue increasing despite projections they will remain level. Consider the space available for sublet, which is an indicator of declining demand. Between 2010 and 2019, the amount of space available for sublet each year averaged 1,165,858 square feet. Since 2020, the amount of space available for sublet averaged 1,736,114 square feet. In 2024, the amount of space available for sublet is over 2,100,000 square feet. Should this space not be back-filled or re-leased, vacancy rates will increase.
The average lease size between 2010 and 2019 was 4,900 SF. Since 2020, the average lease size is 4,775 SF. As I mentioned earlier, based on conversations I've had with office leasing brokers across the market, there is a much greater pool of potential users/tenants for smaller office suites.
Market rent continues to increase, but this is largely due to increasing operating costs and not entirely reflective of demand/supply dynamics. According to RealtyRates.com, the average operating expense of a Metro Detroit office property in 2020 Q4 was $12.61 per square foot. In 2024 Q3 (most recent date available), the average operating expense was $14.87 per square foot which reflects a nearly 18% increase. (Appraiser Note: I rarely see office operating expenses this high, except for medical office buildings. Nonetheless, the increase is striking.)
While the average sales price per SF has been increasing, this is due to a myriad of factors. Office owners remain reluctant to sell, especially as there remains a price disconnect between buyers and sellers, which has led to lower sales volume/activity. Further, while there there have been some distressed sales in the market, it is possible that the majority of office properties trading hands are stabilized/well-occupied which has contributed to growing sales prices. Buyer motivation may also have impacted the reported sales prices. Buyers using a 1031 exchange may pay a premium for a property to meet strict timing requirements. Alternatively, buyers who are able to assume existing debt at a favorable interest rate are usually willing to pay more for an asset. Suffice to say, the reported average sales price does not provide an entirely clear picture of how office values have changed over the last few years.
Aside from positive net absorption in 2021, net absorption has been negative every year since 2020 with significant negative absorption reported in 2024 Q4 YTD. CoStar projects net absorption will remain negative year-over-year through 2026 and then increase in 2027.
Final Thoughts
Rental rates are rising, but so have operating costs and vacancy rates (albeit the vacancy rate increase for small office properties is relatively nominal in comparison to large office properties). Even though there are some glimpses of hope, such as an increasing prevalence from companies to get employees back to the office to stimulate collaboration, train junior staff and maintain a company culture, there is still plenty of uncertainty. Demand dynamics have shifted, there is persistent negative net absorption and large swaths of space is available for sublet in many Metro Detroit communities.
So what does this all mean from an appraiser's perspective? Firstly, there are many indicators that point to downward pressure being placed on Metro Detroit office values. This can be reflected in the capitalization or discount rate, vacancy rate and/or by applying negative market condition adjustments. However, no two office properties are exactly alike. It is critical when valuing an office property that factors like location, building size, available amenities, typical lease structure, floor plates and layouts, among other things, are considered. This requires the appraiser to have a deep understanding of comparable properties, regular conversations with investors and brokers to validate the reasonableness of their assumptions, and perhaps most importantly, a clear, thoughtful and well-supported analysis.