Since the onset of the COVID-19 pandemic, 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.

Average office lease terms decreased significantly in 2020, from roughly five years to four years. 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 decline seen between 2010-2013 and 2015-2017.

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. 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 firm’s space needs.

Small tenants tend to sign shorter leases, and their leases became even shorter during COVID-19. Small tenants generally have access to fewer resources and are more sensitive to uncertainty and real estate costs than larger tenants.

During COVID-19, very short leases might be the optimal solution for office tenants, but they represent threats to the stability of office revenue. 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.

The lasting impact of remote working is going to be dependent on how long the pandemic continues. After the pandemic, 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 fewer office-bound employees does translate much more clearly to less office demand.

If pandemic-style work were to last another year or two, we would likely see a shift, where firms en masse abandon the idea of flexible-but-centralized working and switch to significantly more fully remote work with homebound employees.

This story was excerpted from a report authored by Moody’s Analytics executives Xiaodi Li, an economist, Kevin Fagan, a senior director and head of CRE economic analysis, and Victor Calanog, head of commercial real estate economics. Read the complete report at this link: https://bit.ly/3Mw4QBA