Office tenants struggling to contend with wave after wave of rising COVID-19 cases have increasingly turned to short-term leases – but if the trend continues, it could portend more cash flow volatility for owners, as well as more concessions and increased capital costs.
A new analysis from Kevin Fagan, Xiaodi Li and Victor Calanog of Moody's Analytics REIS acknowledges that while it's unclear if the trend of shorter leases will continue, a "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."
Average office lease terms decreased from five to four years in 2020, but was primarily driven by very short-term leases of one year or less.
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"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 decline seen between 2010-2013 and 2015-2017," the trio write. "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."
The percentage of very short leases increased from 14.8% in 2019 to 25.9% in 2020 and 32.2% in 2021, according to Moody's data. The economists there say those figures illustrate a "major ramp up" in tenants avoiding long-term space decisions against the shadow of COVID-19 and the future of remote work.
Small tenants have made the biggest shift, they say, with the average lease duration falling from three to two years in 2020 and decreasing by three months in 2021
Overall, "the office sector is seeing an odyssey, not an exodus," they write. "Short-term leases give tenants the maximum flexibility as the future of office plays out for them."
In the long term, very short leases pose a great solution for tenants but threaten revenue stability for owners. "There is the top-line, effective gross income risk of greater "natural" vacancy rates that result from greater roll," according to Moody's. "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 the trend continues, cap rates will rise, and the sector will see less cash flow stability. The Moody's team predicts "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," they say. "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."