Higher-for-longer interest rate horizon complicates office space market

Often hidden beneath discussions about how the era of hybrid work is impacting office real estate is another less talked-about pandemic-induced economic reality: higher for longer interest rates.

"Interest rates are the highest they've been in 20-something years," explains Mike Thornton, a partner at Smith Anderson and co-leader of the law firm’s Commercial Real Estate practice. "I don't spend a lot of time worrying about hybrid work. Interest rates also are having a very real impact," he says.

Thornton and his colleagues provide legal counsel to a broad array of companies across the real estate industry – from construction contracting and project finance to purchase agreements and leasing arrangements. Founded 112 years ago, the award-winning firm enjoys a storied reputation in North Carolina business-law circles.

In response to a stubborn wave of post-COVID price inflation, the Federal Reserve's Open Market Committee hiked interest rates 11 times over the course of 18 months, according to Bankrate. The Fed's key federal funds rate now sits at between 5.25 percent and 5.5 percent, the highest since 2001. Not since the early 1980s has the Fed raised rates so aggressively.

"Interest rates hit directly at the bottom-line of a building," Thornton continues. Developers and lenders are the first to feel it. "Any time that number moves up developers will see less income flow," he says. "Lenders aren't going to take any more risk than Fed bankers say they should."

Like most in the real estate realm, Thornton watches every Fed move closely. He even goes a step further in order to anticipate the nature and timing of interest rate changes, watching regular data on employment. "Since Economics 101 in college, strong job markets historically have been a driver of inflation," says Thornton, who began his legal career 30 years ago. The nation's 3.7 percent January 2024 unemployment rate, in fact, is actually below where it was two years ago, registering 4.0 percent in January 2022, according to the U.S. Bureau of Labor Statistics.

Of course, few would publicly argue that low unemployment is bad for the economy. "We want everybody to have jobs, right?" according to Thornton. But he concedes that the Fed's plans to put interest rates on a downward path likely won't occur so long as the nation's job market remains robust. "As we get stronger and stronger jobs reports, it's going to be hard for them to cut interest rates," he says. Thornton is not among those anticipating aggressive cuts starting this spring, though he does expect at least one cut by the end of 2024. "I don't think rates will fall as quickly as people had hoped," he says.

Smith Anderson's specialized expertise is beneficial to clients regardless of interest rate cycles. Thornton says soft conditions in the office space market have opened up opportunities for tenants to reassess needs and consider changes. "As leases come up for renewal there's always questions of whether an existing tenant wants to shrink their space into something more efficient," he explains.

Some tenants may decide to leave Class B office space in favor of Class A properties, which are typically newer buildings with reserved parking, live security and on-site amenities such as fitness centers, coffee bars and recreation areas. "Certainly, office developers have put more emphasis on that," says Thornton.

He also is seeing shifts in design and space utilization – even changing tastes in decor and furnishings. In offering post-pandemic return-to-office incentives to remote employees, technology companies are pushing the envelope. "Tech is being a lot more adventurous about what they're willing to build," Thornton says, noting a trend toward what he calls "non-traditional" art in spaces inhabited by tech workers.

In contrast, law firms may prefer more familiar design elements. "I don't think you're going to see a lot of ping pong tables at a law firm," Thornton says with a laugh. But like any corporate culture, law offices should offer a physical environment that sparks interaction among veteran players and more recent hires. "Younger professionals realize there are more opportunities for mentorship in the office – that's especially true in the legal profession," he says, noting that his more senior colleagues are often the ones who've grown fondest of their home offices.

Out of about 155 attorneys across the firm, Smith Anderson has a commercial real estate practice of 30 partners and associates who advise developers, investors, lenders, landlords and tenants in office, industrial and retail deals. "We have people under one roof who work all the various components of real estate, from project inception to completion," Thornton says. "It's unusual to find all that expertise in one firm, particularly one located here in the Triangle."