This article is the first of a two-part series.

The office sector is facing more than its share of tough challenges in a new era of hybrid work that has altered basic supply and demand fundamentals.

The story of surplus office space creating a drag on the office sector appears pretty straightforward. Vacancies have increased as demand has decreased. The national office vacancy rate has climbed into the high teens, which will take years to absorb given the tepid demand and downsizing still under way. However, it’s tough to paint office with the same brush; certain geographic markets have been less affected, and strong assets are outperforming weaker peers.

“On one hand, there are those questioning the role of the office, while on the other hand tenants that are transacting in our markets are paying a premium to elevate the quality of the real estate that they’re delivering to their employees,” says Peter Brindley, executive vice president and head of real estate at the Paramount Group. “We are continuing to see more and more companies that are acknowledging the importance of the office and leadership teams that are requiring their employees to return to the office with greater frequency.”

The Paramount Group is seeing clear evidence of bifurcation occurring in its key investment markets of San Francisco and New York City.

“Tenants that are choosing to transact in these markets are aiming to use real estate as a lever to not only compel their employees to return to the office, but to enhance what these companies fundamentally subscribe to, which is in-person work,” says Brindley.

The result is that activity is benefiting class A buildings, while the more commodity buildings are far less active. Paramount Group is reporting occupancies across its class A office portfolio that are averaging 89.6 percent as of the end of June.

The bifurcation in the market is not necessarily a sharply defined line drawn between newer class A versus older class B and class C buildings but rather a performance gap between modern versus commodity buildings. According to CBRE, buildings constructed since 2010 have consistently recorded positive net absorption leading up to and during the pandemic, while older buildings have accounted for all negative net absorption since 2020. A comparison of vacancy rate by building vintage also highlights the preference for modern space. Based on second quarter data, buildings constructed since 2010 were reporting an average vacancy rate of 14.4 percent, which was 380 basis points below the overall U.S. average vacancy rate of 18.2 percent.

FLIGHT TO QUALITY

Stress is most evident in class B buildings in both CBD and suburban locations, but what are the qualities separating the haves from the have-nots? Age is a factor, with newer properties tending to perform better. However, it is not the only factor. Location, amenities, transit-oriented developments, integration of other mixed-use components, flexible space, health and wellness, energy efficiency, and overall experience are all part of the winning formula for success in the future office. “I don’t think the office is going anywhere, but it is being structurally transformed, and being able to adapt to your tenants is the most important thing,” says Alfonso Munk, CIO for the Americas at Hines.

Tenants are more discerning than they have ever been. They require superior product and well-located properties. They also require amenities both in the building and within the immediate vicinity.

“We are extremely mindful of how we curate the retail in all of our buildings. We’re also mindful of delivering amenities that really do move the needle and make a difference and aren’t just checking the box,” says Brindley.

For example, Paramount has 8.7 million square feet of office space in Manhattan that is all located in relatively close proximity to 1301 Avenue of the Americas, where the firm is in the process of building out a world-class amenity center. The 30,000-square-foot center will be available to all tenants within the Paramount portfolio and will include amenities such as grab-and-go food, training rooms, conference space, informal meeting and workspaces, a wellness space, and game room. The amenity center is scheduled for completion in first quarter 2024.

WARY OF DOWNSIDE RISKS

Investors are understandably cautious about the downside risks of owning office assets that include a negative outlook on demand, discounted values and possible obsolescence.

“Some markets have started to recover, but across the country, we have not yet hit bottom on office,” says Rob Raymond, managing director at FTI Consulting. FTI Consulting is currently working with a handful of large office space users who are still actively trying to reduce the size and scale of their office footprints in the United States. In some cases, those reductions are substantial — by as much as 50 percent. “We have seen the bulk of the drop in demand, but I believe the office market still has a little bit more pain ahead,” he says.

Some market participants see a long road to recovery and return to where supply and demand are more in equilibrium. “In our view, that is more like a seven- to 10-year process with some variation based on whether an individual market is fast growing or has a slower pace of growth,” says Rich Kleinman, head of research and strategy and co-CIO for the Americas at LaSalle Investment Management.

It is difficult to make a business case for buying into a sector where there is considerable pressure on pricing power to raise rents and challenges in accessing debt financing. Although there is a flight to quality occurring with stronger demand for the best buildings, there also are risks associated with how that trend will hold up over time. “We’re a little less positive on that as an investment strategy because when you value a building and look at a real estate investment, you need that building to have tenant demand not just for a few years, but for decades,” he says. Right now, tenants like being in new space and no space remains new forever, he adds.

Given the higher interest rates, capital expenditure requirements and oversupply in the market, the basis for acquiring assets is more important than ever. And some believe that office has made a permanent shift to a higher cap rate asset. Office has always been a capital-intensive asset, and in the current market, investors are taking a hard look at how much they have to spend to maintain occupancy and keep the income flowing. What that means is that a cap rate in office means something very different than a cap rate in industrial or multifamily because so much money is needed to sustain that income in office relative to other property types, notes Kleinman.

INVESTING IN THE FUTURE OFFICE

Although market challenges have pushed some investors to underweight or exit office all together, other investors are leaning in to manage portfolios through the turbulence and take advantage of buying opportunities that arise. For example, Fortress Investment Group recently acquired roughly $1 billion of office loans from Capital One.

“The office sector is in a moment of significant structural change that started even pre-COVID,” says Munk. “There is a bifurcation in the workplace itself and what the workplace means to companies and employees. Obviously, this is a challenge, but for us it represents an opportunity.”

Hines has traditionally focused on high-end, well-located office properties, which works to its advantage in the current market. The company is neutral weight on office with a strategic focus on recalibrating its office assets to focus on strong assets, while reducing exposure to those office properties that are not well positioned to withstand the changing demands of office space users.

Some office properties are clear leaders in the new landscape. For example, One Vanderbilt in New York City is 99 percent leased. Hines co-developed the property and is a minority partner with SL Green Realty Corp. “We will continue to invest in those types of assets, but obviously we are cautious about the sector. We need to make sure that we select those assets that we think are going to win,” says Munk.

Hines is continuing to acquire assets. The company recently purchased 1050 17th St. building in Washington, D.C., within its Hines U.S. Property Recovery Fund. The 154,000-square-foot building is well located very close to the White House and K Street. Hines acquired the asset from the lender at a significant discount and was able to bring in an anchor tenant at closing. “These deals are hard to find, but there are certain opportunities like this that are very interesting from an economic perspective,” says Munk.

The Paramount Group also is sticking with its strategy of investing in best-in-class office properties in San Francisco and New York City. “We have had success over many, many years investing in these two markets, and we continue to believe in the attributes of these markets. There is no question that during the last several years, certainly during the pandemic, both markets have had their fair share of challenges. But as tenants have become increasingly discerning in terms of what they are seeking, we have been able to capture more than our fair share of tenant demand,” says Brindley.

THE EXPERIENTIAL OFFICE

Office owners do have to stay on their toes when it comes to anticipating what tenants want and need in the future workplace. Similar to the transformation in retail driven by ecommerce and changes in shopping patterns, the office is changing from a place where people just go to work to a place where people have an experience.

“It’s no longer acceptable for companies to deliver four walls and a sea of cubes all in beige. They’re looking for unique ways to deliver an elevated experience and support their company’s purpose,” says Brindley. “That is what’s driving the velocity in our two markets.”

Office owners are taking a page from the hospitality playbook to enhance their service and elevate the tenant experience. For example, Paramount is training its property management teams with the Ritz Carlton method to enhance the way it communicates and delivers services to its tenants, which impacts the way it interacts with tenants. The REIT also is rolling out a new tenant experience app at the end of the year that will allow tenants to reserve things such as conference space or in-building catering.

Companies are increasingly looking for destination-worthy office spaces that can help to pull people back to the workplace and enhance productivity. However, it’s not a one-size-fits-all solution. It does depend on the company culture, the people and the type of work being done. For example, Raymond is working with a few clients that are looking to relocate their company headquarters. They’re generally looking at class A buildings that have amenities within the building that are not necessarily part of their contracted leased space, such as casual meeting spaces in the lobby or a café where people can have a meeting outside of the walls of their own office space.

Tenants are gravitating toward the energy and vibrancy in mixed-use lifestyle hubs that can successfully integrate office with residential, retail, entertainment and hospitality in a walkable live/work/play area. For example, while downtown Seattle is still struggling to come back, the Capitol Hill area across I-5 is bustling, notes Raymond. Where there is more energy and recovery is where these different uses are coming together in an organic way, he adds.

Landlords also are paying more attention to details ranging from the type of music they’re playing in lobbies to those that are creating their own unique scent to infuse into common areas.

“Wherever an owner can think outside the box and make their building more welcoming, more appealing and with more amenities is going to help attract tenants over a landlord that does not do those things,” says Raymond.

WHAT’S NEXT

A tale of two office markets part 2 will appear in the upcoming December issue to discuss more about the bifurcation between success and distress and explore in-depth how occupiers are rethinking their office space usage, while some office buildings are facing obsolescence. What will happen to the distressed office properties? Are there any opportunities for adaptive reuse? Or will these assets continue to be a drag in portfolios?

Beth Mattson-Teig is a freelance writer based in Minneapolis.