The Office - Will we ever get back to the water cooler?
Office property has been the biggest real estate casualty of the recent Covid pandemic. Hospitality and Retail took a heavy initial blow but they have both come roaring back as consumers unleashed their pent-up demand for leisure and shopping once restrictions were lifted. Office on the other hand has been struggling to regain anything close to pre-pandemic occupancy.
There are a number of factors working against an office comeback. The prolonged pandemic shutdown and work from home orders demonstrated that much of what could be done from the office can be done from home just as easily. With so much office infrastructure already set up in the cloud, it was an almost seamless transition. Most offices no longer host their own on-site mainframe computer servers or phone exchange systems, making remote work easy.
Now that workers are used to the convenience of working from home and the saved time from commuting, it will be a struggle to convince them to return to the office 5-days per week. Due to the current difficulty employers have in recruiting new staff, they are in a tough position if they try to make employees return to the office fulltime. Such a requirement will keep new recruits at bay, and also make existing employees look elsewhere. You will be hard pressed to find a job vacancy today that stipulates that a new recruit must be in-office fulltime.
Not helping matters was the report of a new study released recently on 4-day work weeks. The study was conducted in the UK and the results found that both employers and employees were happier and were as productive with a 4-day week compared to 5-days. 61 companies and 3,000 employees took part in the study, with 56 companies stating they would maintain the 4-day work week going forward.
There are plenty of advantages to working from home, time saving being the biggest. However there are huge advantages to working from the office. Working with your colleagues helps foster new ideas, it provides training, mentorship and accountability. All these things are much more difficult to achieve remotely. Having a presence in the office around senior management, where they can see you in action, is also your best possible route to promotion.
The compromise so far has been a hybrid of work from home, most typically seen as a 3-day in-office work week, with 2-days working at home. This is very visible if you take a walk around any city downtown office area as it will be more busy Tuesday through Thursday, and very quiet Monday & Friday. Even with 3-days in the office becoming more typical, the actual occupancy in office buildings even on those busier days is much lower than pre-pandemic.
Kastle Systems is a security company in the commercial real estate sector. They monitor building access among other security services and they track individual keycard/fob access to office buildings. Their data is used to determine weekly office tenant occupancy rates for 10 top U.S. metropolitan areas. For the week of March 1, 2023 the 10-metro average occupancy rate was 50.1%, compared to 99.1% pre-pandemic. These figures refer to the physical occupancy of leased space, not the vacancy level or unleased space. If only 50% of leased space is being occupied, it is a very telling indicator of what a tenant will likely need to lease in the future when their lease comes to renewal.
This should all translate into businesses requiring less office space. Even if their headcount remains the same, and all headcount were to return to the office 3-days per week, a business will likely stagger teams on alternate days. Even on days where everyone is in-house on the same day, it is more likely that some form of office sharing (office hoteling) will be used, and the need for large private offices will no longer be there.
As office leases tend to be 5 and 10 year terms, we may not see the full brunt of this massive work behavior shift for some time. As leases expire, businesses will be looking for smaller spaces than before. We should see the effect of this kick in this year and continue for the next 6 years.
There is some evidence of properties taking a hit to their income due to falling rental incomes from vacating tenants, or lower renewal rates and lower square feet requirements. This coupled with rising interest rates is a perfect storm for office owners. Recently Brookfield Asset Management defaulted on their $750mil debt secured against two 52-storey office buildings in Los Angeles.
In 2021, taking a bet that a full return to office would happen, Pimco (Pacific Investment Management Co.) acquired Columbia Property Trust Inc. for $3.9 billion. Columbia owns 19 office buildings in cities across the US and has $1.7 billion of debt that has now gone into default. Meanwhile Vornado Realty Trust has stalled on proceeding with their redevelopment of New York’s Penn Station. The project is an 18 million-square-foot development to include 10 towers of mostly office space.
Office space does not repurpose easily to multifamily or hotel, and when it does it is often inferior to purpose built product. Unless the recent change in work habits revert back to a more traditional in-office environment fulltime it is hard to picture office property performing well for many years. The glut of vacant space will push down rent rates, and the absorption of the available space could take many years to fill.
We should expect to see lenders with lots of loan losses associated with offices over the next few years. Unlike the serious loan deterioration that we saw during the Global Financial Crisis (GFC) in 2008 that brought down many banks, the projected office loan losses are unlikely to have the same impact this time. Banks have much better reserves compared to the GFC, and so far losses seem confined to the office sector. The recent high profile bank failures are more to do with those banks treasury mismanagement of interest rate risk and duration risk, and the resulting loss of confidence of their deposit holders.
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