To appreciate how significant an impact COVID-19 has had on office properties, including the pivot by companies to remote work, it’s important to first go back more than three decades to the 1986 Tax Reform Act. The TRA reintroduced many of the 1981 tax incentives meant to encourage commercial real estate investment — these incentives would later be identified as contributing factors to the overbuilding of office CRE during the first half of the 1980s. CRE professionals with gray hair and career scars from the savings and loan crisis will likely recall how that single event rippled through the economy and culminated with the Resolution Trust Corp. (RTC), a real estate finance acronym that will forever live in infamy considering its role in cleaning up after the collapse of the savings and loan industry.

As was the case then, the premise for investing in office space was turned upside down. Losses in, say, historic office rehabilitations could no longer be used to offset gains in other assets, such as stocks. As a result, partnerships defaulted on loans aggressively made by savings and loans in a deregulated environment. The net impact wiped out S&Ls, a key real estate capital source. A total of 1,043 S&Ls closed between 1986 and 1995, according to the FDIC, which is double the bank failures that occurred during the Great Recession. It took nearly a decade until a capital funding replacement emerged to backfill the loss of S&Ls in the form of commercial mortgage–backed securities (CMBS). Ironically, CMBS was the financial instrument that enabled the final cleanup and dissolution of the RTC.

Fast forward to 2020, when a pandemic caused the next great office disruption. Like the 1986 Tax Reform Act, this disruption will take years to understand and write the “rest of the story,” as the late radio legend Paul Harvey stated. But before hypothesizing about the office sector’s future, let’s reflect back on 2018 and 2019 to gain the necessary perspective on office properties before COVID-19.

OFFICE BY THE NUMBERS

Office assets, especially those in large cities with growing technology and financial services industries, were experiencing positive space absorption, declining vacancy rates, rising rents, and stable or declining cap rates prior to the onset of COVID-19 in early 2020. The burgeoning tech workforce was in search of the experiential “live, work, and play” lifestyle in the city. Do you remember the hype and office specification list during Amazon’s frenzied search for a second headquarters in 2018? Office space density ratios compressed from 300 square feet of office space per worker in the 2000s to 150 square feet per person by 2019, and the design of that space was more open in layout to facilitate creative collaboration. Gone were formal offices with walls and cubicles that segregated the workforce. The predominant theme in office in the years prior to COVID-19 was, “If workspace isn’t cool, then it isn’t working.” And this mindset gave rise to WeWork and other shared office space concepts. The metrics in both 2018 and 2019 were favorable to investment in office properties; in contrast, 2020 and 2021 have posted negative metrics at levels that surpass the contraction experienced during the 2009 Great Recession.

ABSORPTION

Net absorption for class A office space has been hit hard due to COVID-19, according to Colliers. From mid-2018 through year-end 2019, class A office absorption in the United States exceeded 10 million square feet every quarter, with an average of 13.5 million square feet for the six quarters preceding first quarter 2020, with first quarter 2019 leading the way with 22 million square feet of net absorption. Then came COVID-19 in first quarter 2020, and class A office absorption went negative for the first time since 2010. Each successive quarter during this period posted worse absorption than the prior quarter, reaching negative 45 million square feet in first quarter 2021, nearly double the Great Recession’s rock bottom of negative 25 million square feet absorption during the second and third quarters of 2009.

OFFICE TRANSACTION ACTIVITY

JLL Research dissected office transaction activity before and after the arrival of COVID-19, and, like absorption, the change in office property sales quantifies the adverse impact. From 2016–2020, quarterly office transaction activity ranged from 47 million square feet in first quarter 2020 to 67 million square feet in second quarter 2018. The investment interest in office acquisitions, though, plummeted to just 26 million square feet in second quarter 2020 and has yet to recover with anything close to the 50 million square feet quarterly level from first quarter 2016 through fourth quarter 2019. While transaction activity has remained net positive thus far, much of this activity is in suburban and secondary MSA class A assets where workforces are currently relocating, such as South Florida; Nashville; Charlotte and Raleigh, N.C.; Boise; Salt Lake City; and Phoenix. These population and workforce migration patterns can be seen in the U-Haul 2020 Migration Trends report and United Van Lines National Migration Study and became more evident in the 2020 census data. The noteworthy observation here is that investors have hit a cautionary pause button on office investments until they can sort out the temporary or permanent nature of remote work accelerated by the pandemic and understand the change in workforce migration.

Something that has been underreported about the increasingly sticky situation with remote work is that the trend toward less time in the office was well under way before COVID-19, as the workforce wrestled with affordability issues in the largest and most dense office markets in the United States. According to JLL, the five MSAs with the most office inventory are also among the most expensive to live in. These five MSAs are New York City with 464 million square feet, Washington, D.C., with 336 million square feet, Chicago with 256 million square feet, Dallas with 194 million square feet, and Los Angeles with 190 million square feet. The question, therefore, regarding remote work is: Which driver came into play first, a lack of affordability in the largest office MSAs or COVID-19? The answer is important to investors because if they ignore the affordability element and assume office CRE will return to 2018–2019 levels in the foreseeable future, they may be surprised at the why and where behind key office metrics such as absorption, vacancy and transaction activity. My view is that COVID-19 merely accelerated and added to the stickiness of the situation occurring with remote work due to affordability issues, as shown by the 2020 U-Haul Migration Trends report and the 2020 U.S. Census. Is workforce migration foretelling where office demand is shifting after COVID-19?

TIMES ARE A-CHANGIN’

In 1964, Bob Dylan recorded a song about change that became one of the greatest tunes in rock history. Three messages embedded in The Times They Are A-Changin’ underscore the investment attitude of many office property asset managers almost two years into the pandemic: 1) Change is constant, 2) You can’t expect anything to remain the same, 3) Anything that appears one way today may appear differently in the future.

Office property has been through disruptions before (like the 1986 Tax Reform Act and the Great Recession), and changes that followed returned the office sector to a desired asset type fueling more investment and new construction activity (like the creation of CMBS).

What will change the utilization and investment profile of office that will transform this property type’s out-of-favor perception in 2021 to something more desirable in 2022 and beyond? Office investors may not be thinking through many qualitative workforce, social, generational, and even ESG (environmental, social and governance) influences because they are distracted by headlines dominated by the rise in cases of the delta variant of the coronavirus in the second half of 2021, the emergence of new COVID variants, and a potential return to some sort of shelter-in-place orders again this winter — or at least the continuation of remote work policies by traditional office space-using industries such as financial services and technology. While all these influences cannot be covered in this article, a few are worth consideration heading into 2022.

For one, traditional measures of employment as a proxy for office demand will become less predictive, especially the longer COVID-19 stays in the picture.

Office property demand models have been designed around the assumption there is a direct correlation to job growth. As long as the U.S. Bureau of Labor Statistics Employment Situation Summary indicates 200,000 to 400,000 net new jobs per month, office property demand will expand in the 2 percent range per year. The problem now is that not as many of those jobs will need office space. Take logistics and ecommerce, for example, where office work will be part of a large ecommerce fulfillment warehouse. The question then becomes, “What is the new correlation of job growth to office space demand?” Nobody knows, and every major commercial brokerage and property investment firm is scrambling to develop a new model. Kevin Thorpe, chief economist for Cushman & Wakefield, stated it best with the following two observations associated with the company’s midyear office report:

• “The longer COVID-19 is present, the more transformative it is going to be.”
• “The bigger question regarding remote work is its ripple effect to the service economy — think about business travel-oriented hospitality and transportation companies (such as airlines and Uber) with fewer office workers traveling, commuting and gathering to meet colleagues and clients in person.”

All these service companies also have in-office workers who occupy office real estate to manage corporate and logistics operations. Do these ripple-effect office jobs from the service economy in dense urban office markets function more efficiently working remotely? And how do office demand models adjust for these office-related jobs that are also going remote in part or in full?

Consider the recent announcements by Google, Apple, Microsoft, Salesforce, and the like, all indicating an expansion and extension of remote work into 2022.

GENERATIONAL WORKFORCE

Workforce composition is going to answer all the aforementioned questions. Older workers are leaving the workforce at the fastest pace ever, and millennials and Gen Zers are going to have a lot to say about office space needs and remote work. In September, the New York Federal Reserve released its latest Survey of Consumer Expectations. The labor component revealed workers 50 and older plan on exiting the workforce sooner. According to the report, “the average expected likelihood of working beyond age 62 ticked down to 50.1 percent, from 51.9 percent in July 2020. This 50.1 percent level was the lowest reading since the start of the series in March 2014. The average expected likelihood of working beyond age 67 also declined to 32.4 percent, from 34.1 percent in July 2020.”

NEW OFFICE PERFORMANCE MEASURES

Where should office property investors and their advisers look for more predictive office demand data? Two suggestions are Kastle Systems and sublet office reports by major brokerages such as Colliers.

Kastle Systems Back-to-Work Barometer: Kastle Systems is the technology company that handles electronic keycard systems allowing access to office buildings for many companies and property managers. Measuring this activity is a great proxy for whether the workforce is returning to physical office space. Kastle’s data shows that less than 25 percent of office workers were returning to the office in first quarter 2021 at the onset of vaccinations. Despite more than half of all adult/working-age Americans being vaccinated, just over one-third have returned to the office as of Oct. 18.

Office Sublet Vacancy: CRE brokerage companies such as Colliers have led the charge on this data during COVID-19. In November 2020, Colliers again began tracking sublet vacancies in their quarterly Office Market Outlook reports. The second quarter 2021 edition showed the United States had more sublet office vacancy than at any point since data began being tracked in 1990, and a shocking 30 million square feet more than at the peak of the Great Recession.

THE OUTLOOK FOR 2022 AND BEYOND

In my experience, there is no chance of finding light at the end of a dark tunnel unless one looks up and forward. Looking down or backward only confirms what we already know — office property is not where CRE investors want to place capital due to the uncertainties around COVID-19, the extension and more permanent adoption of remote work, and a changing workforce. The future for and opportunities in office properties will only be found by focusing on forward-looking data and metrics. What are those sources and metrics to pivot to in 2022?

In addition to monitoring quarterly earnings for major office tenants and their announcements regarding remote work and the previously discussed Kastle Systems Back-to-Work Barometer and sublet office vacancy data by national CRE brokerage firms, three others are recommended:

• CPPI Measures (Commercial Property Price Index)
• Nareit Office Property Returns
• CompStak Data

CPPI measures: Two organizations provide credible data on commercial property price increases, Green Street and Real Capital Analytics (recently acquired by Moody’s Analytics). Both CPPI sources show that office property price increases have declined substantially and are currently negative (–6 percent from pre-COVID-19) or have the second-worst change behind malls (–13 percent from pre-COVID-19). Capital is being lured to industrial (+41 percent CPPI), self-storage (+40 percent), and manufactured housing (+31 percent). Not too long ago, office was experiencing double-digit price increases. Keep in mind the message from Bob Dylan’s The Times They Are a Changin’: You can’t expect anything to remain the same. Monitoring CPPI provides office investors the opportunity to see the change as market conditions turn.

The RCA CPPI is different from the Green Street CPPI in that it tracks a broader array of office properties across many MSAs (Green Street’s CPPI is primarily based on institutionally owned assets). At mid-2021, RCA’s CPPI showed the differentiation between the performance of central business district office (–4.6 percent) compared to suburban office (+11.7 percent) year-over-year. This CPPI data lends support to the hypothesis that workforce migration is benefiting suburban office property due to affordability issues and the impacts of COVID-19.

Nareit office property returns: National Association of Real Estate Investment Trusts’ Midyear 2021 Economic Outlook on REIT performance noted similar findings to the aforementioned CPPI data — namely, that office property lagged most commercial property types in overall performance. The Nareit data goes further than the CPPI data by analyzing the total return for each property sector. In other words, it goes beyond just transaction prices and quarterly valuation estimates, and incorporates the effect of rents and operating expenses on net operating income. In essence, Nareit’s total return measure incorporates the impact from items like sublet space on rents and higher operating expenses for other services, like janitorial and cleaning due to COVID-19. At mid-2021, the year-over-year total return for office was –11.7 percent, the second worst behind retail and diversified REITs at –12 percent and –12.8 percent, respectively. What REIT property sectors were producing total returns to attract investment capital in first-half 2021? Like the CPPI data, the answer is self-storage (+32.1 percent), single-family residential (+21.2 percent), and industrial (+18.2 percent).

CompStak Data Leasing activity is the bellwether indicator for when total return and price metrics will change. By the time you analyze transaction data, you are typically too late to be ahead of a changing investment pattern. CompStak, a leading crowdsourced CRE platform, is to leasing comps what many regard CoStar is to property transaction data. By mid-2021, Comp-Stak was tracking leasing activity on 1.5 million properties. Approximately 30,000 appraisal, brokerage and investment companies use and contribute to its database of more than 4 million leases. It is reliable because there is an extensive validation process for primary sources, and it is affordable because access is based on a point system for the lease comps users provide.

THE REST OF THE STORY

The pandemic’s impact on office properties and remote work has yet to be fully written. The longer the pandemic persists and new variants emerge, resulting in the extension of remote work, the stickier a situation is going to be. To more accurately foretell the future price and total return metrics post-COVID, office property investors and participants need to adopt a whole new set of data sources and metrics to monitor and re-create a more sustainable and balanced remote work model. Office demand models need to be recalibrated and dynamic, moving away from the models that assume X number of new jobs equates to Y percentage growth in office demand.

Kastle Systems Back-to-Work Barometer, sublet space data by brokerage companies such as Colliers, CPPI from Green Street and RCA/Moody’s, and real-time leasing activity intelligence from CompStak are just a few of the forward-looking resources office property investors should put on their radar. And there are other resources and metrics I discover every quarter. For example, I recently came across the Service Employees International Union that reports on the utilization of office building janitorial workers. It currently reports that 15 percent of its serviced office buildings have yet to reopen, and more than 3,000 U.S. cleaning crews are idled due to remote work.

To close out this report, I’d like to leave you with a quote from Christine Putur, REI’s executive vice president of technology and operations, following the outdoor retailer’s announcement to sell its new HQ building rather than move into it: “We felt there are moments when being physically together makes a difference, but it doesn’t have to be all the time. We want to move forward with more habits, new norms — let the outcomes drive when and how we get together.”

K.C. Conway is chief economist at the CCIM Institute. Read the full CCIM Institute report here.