Office Sector is Down but Not Out

By now it’s a common trope that people are leaving coastal cities in droves as people seek space and businesses go remote. But does that mean the office real estate sector is dying, dead already, or will see a comeback?

Why are Business and People Leaving the Cities?

It is true that many people and businesses are leaving major cities, but the data shows a more complicated story than what we hear thrown around day-to-day.

The easiest way to determine what’s happening with people is to look at the rents in the major cities, as renters make up the majority of residents in many cases. The data shows that major cities do have rents dropping and vacancies going up, but each major city has a nearby satellite city that has rents jumping as residents leave the big city and move out of town. This is often called the “Brooklyn effect.”

The most notable example is San Francisco which has had an unprecedented 11.8% reduction in rents while nearby Sacramento an Oakland have had unprecedented rent growths of 7.9 and 4.5% which are also unprecedented levels of growth during a recession.

It’s likely that major tech companies are faster to embrace remote work which allows their employees to be more flexible and move on a shorter timeframe than more traditional businesses.

How is Office Space Affected?

It’s important to note that just about every major source or publication has already shown a pullback in the office sector and continues it to accelerate through 2nd and 3rd quarter 2021. It’s noticeable with rent growth expectations in the following graph from CoStar:

Normally in a recession the office sector doesn’t have drastic and sudden changes because long-term leases are often 10+ years. It’s interesting to note that the leases that are coming due are often being extended by 6 or 12 months to allow economic conditions to change enough to give some certainty before businesses end or renew their leases.

But the question is how many businesses are going under and of those that remain, will the rest choose to go remote in some fashion? In the next sections we’ll cover both perspectives, that office sector is going to make a comeback and the other perspective is that it is dead and gone. Then we’ll discuss what you can do as a business owner or as an investor.

Office Real Estate Is Likely Coming Back

The fact that businesses are not ending their leases as quickly as possible points to the likelihood that they don’t want to give up their office space but hope to hold onto it as economic conditions improve. While this is just one data point, it is telling.

UBS, one of the worlds top real estate funds, noticed that office leases in Europe have been renegotiated to reflect current economic conditions, but that office vacancy hasn’t been impacted significantly.

They do acknowledge there will be issues in low price and low-end office space, but they expect to see increased demand in high-quality well-located office assets.

Social Distance Means More Space, Not Less

Brookfield, a major real estate investing firm with over $200bn in real estate under management has a similar but slightly different view.

They believe that Class A office assets will continue to grow as compared to lower end office space. They believe there will be growth in the sector as well as companies are likely to adopt longer term social distancing guidelines which increases their need for space.

Brookfield expects that offices may plan to increase the square footage per employee to 200 square feet, which is about the same density as a decade or more ago. It’s important to note that a decade ago was before trends such as hot-desking and co-working took hold.

In total, they believe office space needs my increase by as much as one third.

Businesses Will Not Give Up Traditional Office Space

Another perspective is that businesses may not be ready or even capable of going to a mostly remote model. For decades or even centuries, the office has been the cornerstone of the business world. Management, team development, comradery, ability to recruit talent, and many other factors come into play when deciding where to locate a major company.

It’s plausible that businesses simply aren’t ready to throw away many of the benefits that offices provide in order to embrace an almost untested new model of remote work.

Office Sector May Be Challenged For Years

On the other hand, many believe that the office sector is in the process of a major pullback as COVID has really changed the landscape of the market. Those who believe this generally cite the fact that many people are working remotely right now, and they expect businesses to keep their employees working remotely instead of bringing them back to the office.

If they keep workers remote, then the need for office space goes down and this impacts the office real estate market.

Social Distancing / Work from Home

Contrary to Brookfield, many believe that companies will choose to forego much of their office space as many tasks can be accomplished by employees who can work from home as efficiently as they work from the office.

Additional Inventory

While Costar does expect a major rebound in the office space, one compounding factor is the fact that office delivers are still slated to come online over the coming years, exacerbating problems with vacancy that are popping up.

The compounding effects of work from home as well as new office deliveries may have a dramatic impact on vacancy and rents in the short and medium term.

Subleasing

Flexible lease options provided by subleasing is another potential factor. Companies may switch to short-term flexible leases available which allows them to quickly expand or contract their office space based on market conditions. This will make the traditional office sector more susceptible to long-term reduction in rents and value.

Breaking it Down Further

The one-two punch of additional inventory coming online in the coming 6-12 months along with the growth in sub leasing has led to net absorptions to decline for the first time in 10 years.

The difficult part is predicting what will happen as business have a difficult time assessing their needs when there is so much uncertainty in the economy. The trend will present itself more fully in the coming months.

Office Sector Isn’t Dying, but It Is Changing

An alternative option is what many are calling the “hub and spoke” model. Essentially, businesses may maintain a corporate presence in a major city, then employ smaller offices in various cities around the metro, state, or even country.

Going back to the first graphic showing major cities residential rents dropping along with neighboring cities rent growth, the story emerges of the hub and spoke model possibly taking place to follow that trend.

Finding Value In “Hub and Spoke” Model

It is far too early to determine that this is going to be the next big thing, it’s important to consider. If you are a business with a lot of employees, you may want to consider downsizing your main office and building out a spoke or two in more suburban areas. Not only is the labor cost less, but the leasing fees and overhead will be less.

If you are an investor, consider looking at the secondary cities within an hour or two drive from primary cities. This is where many “spoke” style businesses get set up as the business still has control over the subsidiary and it is not too difficult to manage and oversee.

During the last recession, suburban multifamily came back much faster than urban multifamily. While office space and multifamily aren’t directly connected, it showed that the suburbs are more resilient to market shocks than urban centers. That knowledge coupled with changing habits and preferences lead us to believe that higher-end and well-positioned suburban office space will outperform the rest of the office space market.

What Will Happen to Prices?

While the future of office space is open to debate, one thing is for certain – rents and prices are declining currently. In an earlier graph we showed rents dropping by around 6% in 2020 and 2021 Costar is estimating a reduction in sales prices by at least 10%, bottoming out by the end of the 2nd quarter 2021.

While it is expected that sales prices should return to pre-virus levels by 2nd or 3rd quarter 2022 there is a lot of debate over which markets and which classes of office space will see the growth and which will lag behind.

The prior recession had 6 consecutive quarters of price declines followed by 8 quarters in order to get back to pre-recession prices. This recession is seen a little differently as it’s caused by man-made factors rather than systemic financial issues which created the prior shock to the market. As such, most analysts are expecting a relatively short recession and quick rebound which should have the office space market back to normal by the middle of 2022.

What Businesses Can Do to Adapt

If you run a business that occupies an office space (or hopes to soon), you can take advantage of the current market uncertainty!

Prior to the economic crash caused by COVID 19, landlords and property owner generally tried to raise rents and squeeze as much profit from their assets as possible. While property owners are still focused on maximizing profits, the method as converted to collecting rents and keeping vacancy low rather than pushing rent as high as possible.

It’s important to look at the trend as something positive for you, as you will have the opportunity to renegotiate leases at renewal and lock in much lower rates with a nice long-term lease. Additionally, landlords may offer some major concessions to keep you as a tenant or lease empty space with the difficulties filling that space currently.

What Investors Can Do to Adapt

Investors that are looking to purchase office space in the last quarter of 2020 or throughout 2021 are really looking toward a friendly environment to snag a good deal. With new inventory coming online and many tenants going remote or downsizing, a lot of opportunity exists.

What you buy will depend on your particular city and what direction you believe the economy and sector will go, but vacated office space in major cities, new construction in secondary cities, or even the reposition of more distressed or old assets into B or even A class office space in desirable areas are all viable options in the current market conditions.

What Are You Going to Do?

Opportunity will be widely available for new investors or lessees. While the opportunity may not be immediate in all asset classes, there are some that have immediate potential while others have potential when being selective and discerning.

There will be increased opportunity with the potential repositioning of assets from one class to another (or from one asset type to another) or in value-add situations.

While real estate is one bright spot in the economy, it is fully expected to see a pullback in most asset classes, but that’s where the similarities end. Some asset classes such as multifamily are expected to see an almost immediate bounce back, while others may not recover for several years.

Given all the uncertainty and variables, it can be a difficult market to navigate. As such, it’s prudent to have an excellent commercial real estate consultant in your corner. Contact the experts at Realty Capital Analytics to discuss your goals and see how we can help.