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Tumultuous times for office: If office properties do not address changes in workplace patterns, they will fail
- May 1, 2022: Vol. 9, Number 5

Tumultuous times for office: If office properties do not address changes in workplace patterns, they will fail

by Alex Frew McMillan

The office sector has arguably seen the greatest shift produced by the pandemic. Once the go-to investment for real estate investors, office assets suddenly became a pariah, thanks to COVID-19. No one wanted to share four walls, sealed windows and an HVAC system with a bunch of loosely connected colleagues at the height of a mysterious and scary disease.

True, retail property and hotels have also been hit hard, but it is a tectonic shift to see office property fall down the list of priorities for investors. Many investors coming into 2022 and looking at 2023 say they’re excited about logistics, life sciences, data centers. Office? Well, yes, they guess they need to hold that, too.

“COVID has created a lot of confusion in the office market, particularly within the investment community,” says Simon Martin, chief investment strategist and head of research at Tristan Capital Partners. The pandemic accelerated two themes “we all knew about, but not everybody was completely prepared for,” he notes.

One of the chief concerns, of course, is the increased prevalence of work-from-home strategies and the virtual office. The pandemic also played into concerns about climate change and overall wellness, thrusting environmental, social and governance (ESG) themes to the top of the list of priorities.

Kenneth Tsang, head of research and strategy for the Asia Pacific region at J.P. Morgan Asset Management, agrees increased awareness of safety and wellness, together with broader environmental themes, are having a “profound” impact on the office market. Hybrid and flexible working models will also be a “major change” in the region. Both cloud the picture for investors.

“Office space is here to stay, but the supply/demand equation for the sector will get more complicated than before,” observes Tsang. “Growth drivers for aggregate office demand will be more diversified. The way of working is changing, and the spatial design of office space is evolving.”

QUICK SHIFT OUT OF THE OFFICE

Workers adapted quickly to the “agile” working practices forced by the strictures of the pandemic. And they have shown a distinct preference to continue with some of the newfound flexibility.

Only 14 percent of 14,000 Europeans polled say they want to return to the office for a 9-to-5 day, according to a survey by Samsung Electronics Co. and consultancy The Future Laboratory. More than half the respondents say they’ve become more productive while working at home.

Similarly, only 15 percent of employees in Southeast Asia say they would prefer to work from the office full-time, when surveyed by EY. On average, they would want to work between two and three days remotely, with 35 percent favoring a shorter workweek. Companies take heed — 60 percent of those polled say they’ll consider leaving their jobs if there is no flexibility in when and where they work.

“We’ve had perfectly good remote-working capabilities for some time, and even pre-COVID no one needed to attend the office just to sit at a computer connected to the network,” points out Mike Bessell, head of global strategic analytics at Invesco Real Estate. They simply weren’t being used until necessity called. “COVID simply forced a massive remote-working experiment.”

New patterns of hybrid work started to form in 2021. Employees have reported, anecdotally, they can feel isolated working full-time at home, and they value the social elements of the workplace. Meanwhile, companies and the people working for them now see more clearly how the office serves a role in fostering collaboration, learning, creativity and culture.

“It is too early to say what the post-COVID world looks like,” says Bessell. “But we’re definitely looking for a return closer to the pre-pandemic normal.”

On Wall Street, U.S. banks have been particularly keen to get staff back in the office — some would say hidebound. The sudden explosion of the Omicron variant held off plans for bankers to be at their desks this January. By early February, though, staff at Goldman Sachs Group and Jefferies had returned to downtown Manhattan, with Morgan Stanley and JPMorgan Chase & Co. set to let their suits follow suit.

It is far from obvious where most companies will settle. The confusion may clear the way for employers to redesign existing office space, and for companies to seek efficiency gains in what they occupy. Martin says evidence from existing leasing patterns suggests tenants will keep “the vast majority” of their space, but changing behavior and usage patterns indicate a 15 percent to 20 percent reduction in net space absorption over the next few years.

CALMING THE HEADWINDS

How to fit together each office is a challenge. Still, office space has inherent attractiveness as a holding, though perhaps slightly dimmed. For investors with surplus capital to deploy, there is a need to uncover yield that can be found in office ownership. That may drive renewed interest in the sector.

Entering 2022, “we are seeing the headwinds that had been facing the office market begin to lessen,” says Brian Klinksiek, head of European research and global portfolio strategies at LaSalle Investment Management. “The chasm that opened up between ‘favored’ and ‘unfavored’ property types, with offices falling into the latter category, is, therefore, also beginning to narrow.”

Investors say they rate industrial and distribution space above all in terms of prospects this year, PwC and the Urban Land Institute’s Emerging Trends in Real Estate Asia Pacific 2022 report shows, narrowly ahead of multifamily and rental residential property. Newly developed residential also rises above office in terms of priority, meaning only the sectors that suffered most directly in the pandemic — hotels and retail, with assets often forced to close — have worse prospects in the eyes of those institutions surveyed.

That’s a far cry from pre-pandemic levels, when office space dominated investor mindshare. Promising demographics and the need for diversification are also encouraging investors to explore alternative sectors, such as data centers, life sciences, senior housing and self-storage, the Emerging Trends report shows.

The pandemic has also encouraged a shift in mentality, with investors prizing cash flow rather than their normal holy grail of yield. High vacancy rates and increased tenant churn are still making life difficult for landlords, so investors want to see them retain their existing tenant base and recruit stable newcomers, even at discounted rents.

“We’ve taken a bit of speed off the fastball,” an office landlord in Tokyo says in the Emerging Trends report. “If we had a tenant far below market and they wouldn’t pay up, we’d take the space back and lease it up to market, with a year or two of transition to get it up to full-face rent. But we don’t want to do that now because tenants aren’t making very dramatic decisions, so once you have a relatively large vacancy in your building, it becomes kind of hard to fill it up.”

Landlords and investors have some careful calculations to make, believes Tsang, when rental contracts come due. He says it is important to “assess prudently” how passing rents and the expiry of the current lease term match with anticipated rent reversions and upcoming rental cycles that ensure future rental growth. All the figures involved were scrambled by the pandemic.

Similar patterns are occurring in Europe, ensuring office markets are not reverting to any kind of pre-pandemic status quo. “Competition for tenants remains fierce, and demands from occupiers for increasingly curated and customized services embedded within their office buildings continue to grow,” notes Klinksiek.

PROPERTIES STRANDED IN TIME

Investors must beware office assets that risk becoming “stranded,” cautions LaSalle. That can happen geographically if they are not in metro districts with access to a strong pool of human capital. But it can also occur in time, if buildings are not well positioned for the future through strong environmental and operational capabilities, high-quality amenities, and solid wellness credentials. With workers looking to blend work with play, buildings that offer facilities and venues for lifestyle improvement should rate high on the priority list for employers and, therefore, asset owners, as well.

Nuveen Real Estate has been eyeing the shifting profile of the “perfect office” for some time, but the pandemic has forced it into full focus. The need for outdoor space, fresh-air ventilation, natural light and welcoming indoor spaces must meld with the need for collaborative “managed-flex” space that fosters collaboration. Landlords and tenants, alike, want much more than “just a place for employees to get online and work on a computer,” explains Chad Phillips, global head of office at Nuveen Real Estate.

Companies must also manage how and when offices are in use. Phillips expects 3.5 days in the office to be “fairly typical,” presenting a challenge as to when those days fall for each team. “The responsibility will be on managers to make sure the right teams are in the office at the right time to ignite the right office culture.”

If all employees attempt to work from home on Monday and Friday, spending Tuesday, Wednesday and Thursday in the office, there’s no reduction in the amount of space needed on those heavy days. So effective scheduling will become a significant test, to smooth out capacity at any given time, make the booking of shared “hoteling” facilities effective and easy, develop concierge-style services, and ensure mentor-junior and work teams are present at the same time.

Bessell noted anecdotal evidence of companies reducing the amount of space sought, but holding their budgets steady. “They’re willing to pay up for better quality, even if the total space is less,” he says. “They want greater flexibility,” both in usage and the types of leases they sign.

PLACES TO TARGET

The LaSalle European Cities Growth Index rates London highest in Europe for commercial real estate demand. Paris comes in second and is closing the gap on the British capital. Madrid, Stockholm, Luxembourg City and Munich also score high.

“These cities were able to demonstrate strength and resilience during the pandemic, with the strong return to offices we saw in 2021 playing a key part in this,” says Klinksiek.

In the United States, Nuveen Real Estate suggests investors will be rewarded by focusing on “smile states” — picture a broad smile across the country from north on the West Coast through the Sun Belt, and across to the southern and central East Coast. Add to the considerations a preference for business environments with less “friction” in the form of taxes and regulation, and for places that combine innovation with culture. Through that prism, cities such as Miami; Raleigh, N.C.; Atlanta; and Dallas are poised for sustained strong growth, says Phillips.

For the United States as a whole, office use in January 2022 was still running low, at 30 percent of normal, according to Invesco Real Estate, citing market data. But significant variability exists. San Francisco and New York City had particularly low usage in January, with less than 20 percent of leased space currently being used. In Austin and Dallas, occupancy was running above 40 percent.

Residents in those coastal cities are more reliant on public transport and hesitant to use it, whereas other cities have more of a car culture. Add to that the “blue state” bias versus the Libertarian stance championed in Texas, where the governor has fought to ban mask mandates, and it is clear investors need to consider numerous location-specific factors.

FUTURE-PROOF PURCHASES

Nuveen Real Estate believes investors should prioritize city centers with strong connectivity and a wide range of leisure options, over towns and suburban markets. Besides environmental operational efficiency, occupiers may target offices with higher ceilings, greater flexibility of use, and space they feel is conducive both to employee well-being and productivity.

Boutique buildings in city districts with strong cultural elements should favor a “stock-picking” approach, says Phillips, because this is not an office investment environment where all assets will rise across the board. “We’re being picky for new acquisitions, to make sure we’re on the winning side of the demand equation,” he adds.

One interesting consideration coming to the fore in Europe, and gradually elsewhere in the world, is the question of how to rate existing office stock against gleaming new-build structures in terms of carbon expenditure. There has always been an emphasis on the newest and latest buildings and technology, and it is certainly easier to ensure they have the best environmental considerations. But owners and investors are starting to weigh the carbon and materials costs of demolition and reconstruction against retrofitting an older building; it may not make it to “net zero,” but could be a better environmental and carbon-offsetting strategy.

“The future of a grade B or C office building will depend very much on its location,” explains Klinksiek. “Increasing awareness of embodied carbon has focused minds on the trade-off between operational carbon and the carbon expended in constructing a new building. If the building has interesting historical architectural features, the value potential from refurbishment is even greater. But in less-compelling locations, the only options may be change of use, such as conversion to residential.”

A sophisticated approach to office ownership, coupled with escalating interest in “net-zero” strategies, must consider the entire lifecycle of a building. That starts with planning, moving through development, acquisition, operations, refurbishment and, ultimately, disposal. A building is an asset but also a product, with a lifespan, possibilities for reuse and recycling.

COMMUNICATING CHANGE

Phillips encourages owners considering an overhaul of their assets to communicate extensively with tenants, both to find out what they want and to explain the kind of retrofitting and high-efficiency equipment and fixtures that can be installed. The steps taken to reduce water and energy use, and to handle or repurpose waste, should be stressed and demonstrated publicly. Tenants may welcome electric-vehicle charging stations; rooftop and parking-canopy solar arrays; indoor air-quality sensors; biophilic designs, with “green walls” and plenty of plant life; and facilities, such as lactation rooms or meditation space, that promote inclusivity. An older building is anything but a static space.

Corporate occupiers and investors, alike, are increasingly beholden to scientific targets on energy efficiency and carbon generation for the properties they use or own. On the staffing side, prospective employees want to further their careers while ensuring their values are shared by their employers, particularly on issues such as sustainability, diversity, wellness and inclusion. “Tenant engagement” may become a motto for landlords looking to cater to such companies, while features in buildings and districts that promote physical activity — gyms, shower facilities for active commuters, stair access, the ease of getting outside — should pay off.

Where there has been a “green premium” on properties with strong ESG credentials, office space that does not adapt will face a “brown discount” instead.

Tristan Capital Partner’s Martin says the decline in office-space demand due to work-from-home flexibility is “insignificant” compared with the effects on supply that stem from the heightened scrutiny of ESG credentials.

“Post-pandemic and COP26, the bar that tenants set for their space has been raised significantly,” explains Martin. They limit their search to high-quality buildings in good locations with strong energy-efficiency credentials and a range of amenities. “This is channeling demand into a relatively limited stock of highly certified buildings.”

Less than 20 percent of the total office stock has an energy-efficiency certification, Martin notes, “and almost all of it is fully occupied.” European class A office vacancies run at about 2 percent, and the situation is unlikely to ease soon, with little space due to be delivered in the next three to four years, based on a variety of factors.

The pandemic has disrupted supply chains and construction, causing delays and higher pricing. Development plans were also shelved over doubts about the direction of future office demand. Would-be occupiers have responded by committing early on space, meaning buildings due to be delivered in 2022 and 2023 are essentially already full.

“The market is going to be very tight for an extended period,” says Martin. “As leases burn off, it will become clear that the effect on rents of marginal demand changes associated with agility are insignificant relative to the supply bottlenecks.”

What’s more, 80 percent of occupiers are trying to squeeze into 20 percent of the space. Rents for premium properties with the right social and environmental credentials could climb faster than expected now. Meanwhile, poor-quality assets will suffer as tenants vacate, and owners look to “upcycle,” redevelop or repurpose.

The world is well into the third year of an unprecedented challenge. Office property, once boring but reliable, finds itself in the maelstrom of change. It will be fascinating to see how we and the world of work emerge.

 

Alex Frew McMillan is a freelance writer based in Hong Kong.

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