This article was produced by the Moody’s Analytics | CRE. For more commercial real estate insights and analyses, visit the Moody’s Analytics CRE blog.

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Since the onset of the COVID-19 pandemic, U.S. office lease terms have shortened, as tenants sought more flexibility while rejiggering their workforce structures and feeling out their long-term office space needs. If shorter leases are a lasting trend, that could mean more cash flow volatility for office owners, as well as greater concessions and capital costs that come with greater tenant churn.

It is unclear if the trend of shorter leases will endure. Shrinking lease terms was a gradual trend over the nine years preceding the pandemic, but it is not clear that COVID has amplified that trend. Thus far, lease shortening is minor, especially when excluding small tenants and very short, extension-like leases that have helped tenants delay space decisions until after full-remote working broadly ends as a pandemic necessity.

Indeed, office vacancy and subleasing rates approached historic highs during the pandemic, but many large firms are committing to large spaces with typical long lease terms akin to those signed pre-pandemic. One key lingering issue will be the ultimate duration of the pandemic, where eventually remote working as triage will start to become the norm, to the detriment to the office sector writ large.

Shorter Office Lease Terms Driven by Pandemic “Bridge” Leases

Average U.S. office lease terms decreased significantly in 2020, from roughly five years to four years, as exhibit 1 shows. However, that decline is significantly muted when excluding very short-term leases of one year or less. Excluding very short leases, terms only declined from about 65 to 63 months. While that decline is not insignificant, it is in line with the declines seen between 2010 and 2013 and also 2015 and 2017. Therefore, excluding very short leases (one year or less), the 2020-2021 lease term contraction is more a continuation of a decade-long trend, where lease terms have moved slowly from about 67 to 63 months. Also, this trend does appear unique to office sector, as lease terms have not clearly retracted in the retail or industrial sectors.

Historical average U.S. Office Lease Term in Months: We included all lease types (new/renewal/extension/expansion), and lease term lengths declined evenly among all lease types over recent years. (Sources: CompStak, Moody’s Analytics)

Some tenants are taking advantage of depressed office rents and locking down their spaces at below pre-pandemic market, but many tenants are acting more cautiously and are signing very short extension-like leases to bridge COVID. Exhibit 2 shows that the percentage of very short leases increased from 14.8 percent in 2019 to 25.9 percent in 2020 and 32.2 percent in 2021.

This illustrates the major ramp up in tenants avoiding long-term space decisions, given the uncertainty of when COVID-19 will “end” and how various remote working arrangements will interplay with each firms’ space needs. This is not to mention that some firms are still dealing with residual pandemic-related economic challenges. As we mentioned in our 2020 paper, the office sector is seeing an odyssey, not an exodus. Short-term leases give tenants the maximum flexibility as the future of office plays out for them.

Historical distribution of office lease terms. (Sources: CompStak, Moody’s Analytics)

Small Tenants Have Made the Biggest Shift

Small tenants tend to sign shorter leases, and their leases became even shorter during COVID-19. While the average lease term dropped from five to four years, the median term decreased even more, from about five years to three years. Exhibit 3 shows that the lease term reduction was effectively di minimis for mid- and large-sized leases. But, for small tenants, the average lease term fell significantly from three to two years in 2020, and further decreased by about three months in 2021.

Historical average U.S. office lease term by tenant/lease size: Tenant size is based on the size (sq ft) of the space it is leasing. Share of small leases by count has been increasing, putting greater weight on small lease trends in average statistics. (Sources: CompStak, Moody’s Analytics)

Comparatively, this ties out. Small tenants generally have access to fewer resources and are more sensitive to uncertainty and real estate costs than larger tenants.

Capital Markets Want to Know: Is COVID Past, COVID Prologue?

During COVID-19, very short leases might be the optimal solution for office tenants (i.e., “I don’t know what we’re going to do right now so let’s kick the can down the road with a lease that gets us to the other side of COVID”), but they represent threats to the stability of office revenue. There is the top-line, effective gross income risk of greater “natural” vacancy rates that result from greater roll. And there are also the greater costs that come with greater churn, like more concessions to attract (or keep) tenants, tenant improvement work letters, and leasing commissions.

These threats don’t only increase tenant rollover and cash flow risk for landlords, but also create underwriting concerns for both investors and lenders. If this trend is prolonged, we will likely see office cap rates rise, corresponding to less cash flow stability historically offered by long-term office leases. Exhibit 4 shows that the CRE capital markets are anticipating more risk in offices going forward. Following the Great Financial Crisis (GFC), spreads gapped out because office-using employment plummeted, borrowers defaulted on office loans, and the capital markets dried up. During the pandemic, office performance was relatively stable, but given the existential uncertainty of the office sector, cap rate spreads have approached those of the GFC.

Historical average U.S. office lease term and cap rate spreads:  Caption: Cap rate spread based on Moody’s Analytics U.S. office cap rates spread to 10-yr U.S. Treasuries. (Sources: CompStak, Moody’s Analytics)

Tick Tock: As Pandemic-style Working Drags on, Office Sector Is More at Risk

The lasting impact of remote working is going to be dependent on how long pandemic-induced remote working continues. After the pandemic “return to office”, most tenants expect to have centralized workforces with more flexibility for remote working. That does not ubiquitously translate to huge cuts in office space per employee. But, full remote working and less office-using employees does translate much more clearly to less office demand.

Coronavirus variants like Omicron, that prolong widespread full remote working, have the potential to further entrench permanent remote working, despite it being holistically less efficient for firms for many reasons. In the most extreme case, if pandemic-induced remote working were to continue indefinitely, firms will eventually have to abandon the “return to office.”

Exhibit 5 illustrates how the battle of attrition would play out over the long-term. There will likely be a threshold where firms are collectively forced to switch to more full remote working. We may be approaching that transition period soon. If pandemic-style work were to last another year or two, we’d likely see a shift, where firms en masse abandon the idea of flexible-but-centralized working and switch to significantly more fully remote employees.

Hypothetical share of permanent fully remote workforces versus duration of pandemic. (Source: Moody’s Analytics)

For more commercial real estate insights and analyses, visit the Moody’s Analytics CRE blog.

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Xiaodi Li is an economist at Moody’s Analytics, specializing in commercial real estate. She has published papers in leading urban economics journals, and received coverage by top newspaper publishers. She earned her Ph.D. from NYU, Master from Cornell University, and Bachelor’s degree from Tsinghua University.

Kevin Fagan is a senior director and Head of CRE Economic Analysis at Moody’s Analytics, responsible for research, product development and strategic initiatives for the MA CRE group. He was formerly director of research in the Moody’s Investors Service CMBS team for ten years. Prior to joining Moody’s Analytics, Mr Fagan held CRE research roles at ING Clarion and Jones Lang LaSalle. He also practiced as a structural engineer, designing large scale commercial buildings in California. Mr Fagan holds an M.S. in commercial real estate development and finance from the Massachusetts Institute of Technology and a B.S. in architectural engineering from the University of Texas at Austin.

Victor Calanog, Ph.D. CRE® is the head of commercial real estate economics at Moody’s Analytics. He and his team of economists and analysts are responsible for the firm’s market forecasting, valuation, and real estate portfolio analytics services. He holds a PhD in Applied Economics and Management Science, trained by a dissertation committee composed of faculty from the Wharton School of the University of Pennsylvania and Harvard Business School.