As we have noted in previous sector watch reports, no area of commercial real estate has not been deeply affected by the global pandemic. And while we have previously shared our perspective with you on the logistics and the retail sectors, it is now time to unpack one sector that seems to be particularly volatile (with a future that is anything but clear) in this “post-pandemic” world – office.
What we have been trying to explore as a group is where the opportunities may lie among all this uncertainty in the office sector. As with all other downturns or periods of volatility, rather than just dismiss an entire asset class, some investors have been able to refocus their criteria; stick with their methodologies; and leverage their creativity and longstanding relationships to see through this uncertainty to uncover (or create) the opportunities that lie just beneath the surface.
So as we continue to research the sector, we do not believe the pandemic has completely ended the demand for, and the use of, office space – it has only redefined what one would consider positive attributes and potentially hastened obsolescence of others. But to understand the specifics of these rapid shifts is no easy task and it requires constant research and exploration.
It is well established that one of the many changes driven by global pandemic has been those that drive how and where and with whom we work. What may have been viewed as a temporary necessity for public health and safety just months ago, has now evolved into a potentially permanent working model for some companies looking to lower costs and provide its employees with even more flexibility.
Some Current Observations & Research
We came across an interesting article by Commercial Observer’s Greg Cornfield titled “Leases are Getting Shorter and Rents are Dropping with U.S. Office Market in Turmoil (please click here or see the link below). While the headline’s negativity caught our attention, it was this subtitle that prompted us to dive in and share with you: “…leasing activity dropped 53 percent following shelter-in-place orders, and the path to recovery is as uncertain as ever”. The article begins by citing research by JLL that suggests all office leasing activity dropped as a direct result of the pandemic and the subsequent work from home requirements; the inability to conduct in person tours; and, broad economic uncertainty facing nearly every firm, big or small.
None of this is a surprise to you (and us).
This article continues to describe two prevailing schools of thought as to how the pandemic will change the office space landscape:
- The first is quite simple – firms will require less office space because they have made the decision to implement permanent work from home protocols and because economic uncertainty has firms reducing body count and office space expenses as a precautionary measure.
- The second is a bit more nuanced – firms will need more space per capita in order to maintain workplace social distancing protocols. Therefore, while the total body count of office workers might drop, the total space requirement may not decrease drastically.
What do office sector employees think about this all?
When it comes to employee sentiment about the shift to “work from home”, we again refer to the aforementioned article. It presents two sets of statistics that we found noteworthy:
- “…a recent survey of U.S. workers found that Americans who are working remotely during the pandemic have had largely positive experiences. A majority said it has given them more time during the day and improved their health without significantly impacting productivity. Of the workers currently operating remotely, 78 percent said working from home saved them time; 71 percent said they are more comfortable working from home than in an office; and 55 percent said the quality of their work improved.”
- “Additionally, an analysis updated in June by the National Bureau of Economic Research showed 37 percent of jobs in the U.S. can be performed entirely at home.”
What is the market demand for office space telling us?
As it relates to market dynamics, some interesting observations have emerged. Because of the uncertainty facing both tenants and landlords, JLL reported “Renewals jumped to 51 percent of leases, up from 29 percent before the pandemic, “. Yet, all the news is not good for some regions. For example, the same article noted: “The U.S. office market recorded 14.2 million square feet in occupancy losses in the second quarter, bringing year-to-date net absorption to -8.4 million square feet, according to JLL data. New York and San Francisco were responsible for 26.7 percent of all net loss in the second quarter.”
What are some operators telling us?
One observation/theory shared with us by a regional operator of CLass A office buildings was that suburban office market might see an incremental increase for demand for this type of space because of the lower density it provides; proximity to where the employee base lives (bypassing the need for mass transit); and provides employees with the flexibility to work with the team at a nearby hub, when required. And as this operator noted, firms will always need a place for new employees to train and integrate into the corporate culture before being allowed to work from home, exclusively.
Implications & observations
So what does this mean for our investment strategy in the office sector? Here, we would like to share some data points that may influence our approach to office investments in the near- and long-term.
As with all other aspects of our economy, the trends that were in place before the pandemic hit, are simply accelerated. So, whether it was regional imbalances of supply and demand; population shifts from areas with high costs of living and taxes to lower ones; or, the increasing share of flexible work from home policies – everything may look vastly different than it did one year ago, yet in some ways, nothing has changed in terms of our focus on underlying fundamentals of supply, demand, location, and functionality.
It’s simply that the drivers of these fundamentals are accelerated and wider-ranging. In addition to drivers and attributes we have long monitored, here are just a few we think may play a more significant role in our assessment of debt and equity investments in the office sector as a result of COVID-19:
- Divisibility of the floorplates into multiple office suites and the layouts of floor plates relative to social distancing and traffic flows to elevators. (Can the suites be carved up into safely spaced, yet productive suites?)
- Accessibility via modes of transportation other than mass transit. (When employees have to come in, will they prefer arriving by auto or bicycle vs more densely populated trains and busses?)
- Business model and demand elasticity of the tenancy. (In other words, how important is the location to the business and relative to other locations the tenant may have. How much of the business could be “done from home”?)
- Duration of leases and the lease expiration schedule (Firms are renewing now because the market is at a standstill, but eventually expirations will come and lease terms may be shorter and require more flexibility.)
- As it relates to these new leases, one needs to reassess the downtime projected between leases as well as termination options with all the leases executed post COVID.
- Learn if building improvements and capex that prior to the pandemic were not part of the calculus (i.e. specialized air systems, lobby configurations, sanitation requirements, etc.) These could become part of new Tenant Improvement packages and Common Area budgets.
- Understand underlying debt structures of office assets, which will either impair or support the flexibility required to execute updated strategies that factor in all of the points above.
And, this is where we are when it comes to our current evaluation of the office sector in the US.
As always, thank you for your time and we hope this post finds you and your loved ones happy and well. If you are interested in staying connected, please be sure to follow us on social media or visit our website at eastalliace.us
The EastAlliance Family