Deep Dive: The great office delusion


October 11, 2021

By Arshiya Khullar


More than 18 months into the coronavirus crisis, institutional office owners continue to grapple with volatile cashflows amid an uncertain future for the sector. Yet many remain optimistic about a recovery.

Global asset manager State Street became the latest prominent financial services firm to announce, in August, that it was shuttering both its offices in Manhattan in favor of shared workspace for a new hybrid working policy.

Whether to follow State Street by reducing their physical real estate footprint is a question corporations around the world are grappling with. The coronavirus pandemic has changed how white-collar workers want to do their work. That means existential questions about the future of offices keep mounting for occupiers and owners alike. Now, 18 months into the crisis, uncertainty around the timing of a recovery remains as the Delta variant pushes back ‘return to office’ dates. “Just when everyone was roaring back with energy, this is taking the wind out of sails,” says Warren de Haan, founder and co-chief executive at the real estate debt specialist ACORE Capital.

For every State Street fully embracing a hybrid working arrangement there is a firm insisting on reverting to pre-covid working conditions. Investment bank Morgan Stanley is one example. Yet, despite the ambiguity, negativity surrounding office sentiment and weak performance forecasts, there are several managers that remain defiantly optimistic about the sector’s long-term outlook.

During an August earnings call, Canadian asset management giant Brookfield Asset Management’s chief executive Bruce Flatt called his office portfolio “irreplaceable,” adding the firm would not exit holdings in the sector. Certain institutional investors, like Singaporean state wealth fund GIC and Canadian pension manager CPP Investments have also remained bullish on the sector. They hope for deals amid the uncertainty. In July, the two investors teamed up with US developer Boston Properties for a joint venture with a $2 billion initial investment capacity to acquire office assets in hard-hit cities like New York and San Francisco.

With opinion split on the matter, PERE set out to examine the arguments presented by the two sides of the debate surrounding real estate’s most institutional property sector. Are the naysayers failing to recognize the positive attributes of offices for an institutional-grade real estate strategy, even in a post-covid world? Or are the optimists delusional in their extolling of the sector’s virtues?

Earlier this year, The Economist magazine published a damning appraisal of the latter group. In a cover story, it argued: “Office landlords and those who bankroll them will continue to pretend that no storm is coming. With billions of dollars sunk in undesirable buildings, they face a reckoning.”

That reckoning could take a while to arrive because of basic human nature, points out Jeff Jacobson, formerly the chief executive at Chicago-based manager LaSalle Investment Management. Investors, he says, will naturally talk up the prospects for their assets until they cannot.

“When you are committed to your industry, particularly in an uncertain environment, human nature is to assume things will come back and hope for the best. [Office owners’ opinions] are natural and no different to what retail owners did 10-plus years ago when the cracks started to show there,” he says. “But we have been in suspended animation. The chances are that the next decade will be more difficult for offices. Nobody wants to accept a negative reality until that reality is thrust upon them. That’s not necessarily logical. But it is human nature.”


Conflicting data points

Analysts typically assess rent, occupancy and transaction levels – so-called market fundamentals – to determine the health of a sector. But today’s mixed data points do not paint a clear picture. In its US real estate strategic outlook report published in August, Frankfurt-headquartered manager DWS Group gave offices a ‘strong underweight’ recommendation, even worse than for retail, which it assigned as ‘underweight.’ The firm said workplace occupancy was at a lowly 30 percent in Q1 2021. Meanwhile, vacancy rates reached their highest level since 2012 in the same period. Returns deteriorated at 1.4 percent as of the second quarter, versus 0.9 percent for retail, the report noted, citing data from industry association NCREIF.

“It all depends on whose lens you are looking at. The worst I have heard is a very large employer in Manhattan reducing its footprint in the city by 75 percent. The best reaction is of the technology companies taking huge space,” says de Haan. “I often tell people that we just don’t know what we don’t know. If I was to tell you anything other than that I’d be simply making it up.”

Accesso is a US manager investing in multi-tenant office properties with a 15 million-square-foot portfolio of assets under management spanning 23 cities. Ariel Bentata, the firm’s managing partner, says 70 percent of its expiring office tenants have renewed their contracts. Furthermore, he says almost 82 percent of these kept the same square footage.

He is among many executives who feel favorably towards the office sector, pointing to stable current rents and net operating income. Bentata acknowledges that asking rents have stayed flat across the US. However, the net effective rate – rent collected when free periods are taken into account – has dropped “materially” because of longer incentive periods being offered. Pre-covid, landlords typically gave as much as six months free rent. Nowadays, that incentive has increased to nine months, according to Bentata.

“If rents have stayed flat, or slightly increased, but you are giving 50 percent more free rent and the tenant incentive cost is up 25 percent that makes your net effective rate anywhere between 10 and 15 percent lower than it was before the pandemic,” he says. “It is contentious and controversial,” agrees DWS’s White. “There is broad acceptance that the waters are muddied in terms of rents and prices today. But the one thing complicating this is the suspension of activity. Fewer sale transactions are happening and there is less leasing.”

Indeed, the first half of 2021 was the first-time investors spent more money on apartment than office assets. According to property transactions research firm Real Capital Analytics, $117.4 billion of office transactions were completed, an 11 percent year-on-year drop. Apartment investment volumes, on the other hand, rose 35 percent to $128 billion.


Winners and losers

As things stand, the decision of whether to invest in offices is largely contingent on investment strategy, office type and location. The impact of covid-19 has been disproportionate across the world’s key gateway cities and so has the pace of recovery.

London, one of the world’s largest and most liquid office markets, was notably impacted in 2020. The £4.7 billion ($6.4 billion; €5.4 billion) of transactions between January and July represented a 78 percent increase on the same period last year, according to data by property services firm CBRE.

DWS Group’s White says he is optimistic about London because the market saw a correction in values post-Brexit, making them relatively more attractive today. He also pointed at the pivotal role played by the technology sector as occupiers in the city’s office market. In one example, fintech company Thought Machine made July’s largest leasing deal when it took up 65,000 square feet of space at 7 Herbrand Street, according to CBRE.

In countries like Australia, meanwhile, the office sector is seeing deals close at a premium. The country’s biggest office deal of the year was executed in Sydney in July when Australian property company Mirvac and London-headquartered manager M&G teamed up to buy 50 percent of the EY Center at 200 George Street. The two firms are understood to have paid A$575 million ($427 million; €360 million) for the asset, which reflects an 11 percent premium to the building’s June 30 valuation, and a 4.1 percent cap rate.

“Sydney has had a shortage of office stock whilst there have been stock withdrawals for the significant infrastructure improvements, although there are a number of new buildings being built now nearby, for example, Quay and Salesforce Towers,” says Greg Lapham, head of Australia at Savills Investment Management.

“Considering there is a lot of available space in the market, it’s a fantastic outcome for the vendor to achieve a 4.1 percent cap rate, 11 percent over book and A$575 million for 200 George Street, which is a great building. I guess it’s build them, and they will come. I am also sure REITS will receive a share price re-rating on that type of a transaction.”

This faith in Sydney offices holds up for other managers like Nuveen Real Estate too, despite the broader impact of covid-19 and recurring lockdowns.

“Sydney is one of the most diversified economies in Australia and has a lot of underlying strength that will carry a trade recovery cycle,” said Louise Kavanagh, managing director at Nuveen Real Estate, during PERE’s annual Australia roundtable discussion held in August. “Leasing momentum is also coming back. We just finished completion of two office assets in Sydney during the pandemic. I think pricing is tight and may tighten further, but the yield remains attractive. Core offices in Sydney are now close to what industrial is trading at.”

In the US, the future of gateway city offices is more uncertain. Ratings agency Moody’s Analytics forecast the office sector across the US would suffer more in 2021 than 2020. The group singled out Silicon Valley as being particularly hard hit, with effective office rent declines of 15 percent projected in San Francisco and 13.3 percent in San Jose.

Richard Mack, co-founder and chief executive of New York-based alternative lender Mack Real Estate Credit Strategies, believes San Francisco could in fact end up faring worse than his home city.

“When we think about the poster child for gateway city distress, I think it is San Francisco. San Francisco has real challenges in terms of tax issues, homelessness and overall crime. The center of technological innovation resides outside the city limits and tech workers in Silicon Valley are mobile and skilled in working remotely,” he explains. “New York is comparatively better run, cheaper, more interesting, more fun and young people have already come back in droves.”

As such, the firms that are betting on offices today, especially in some gateway cities, are using an opportunistic approach, either from a timing or pricing perspective.

The JV between Boston Properties, GIC and CPP Investments, for example, will target value-add types of investments. Doug Weill, managing partner and founder at global advisory firm Hodes Weill & Associates, which advised on the formation and capitalization of the investment vehicle, says that such a program serves as an indication that “sophisticated capital is still choosing to invest in New York and other primary markets, even when there are some questions as to what a return to work will look like.”

“They are seeing light at the end of the tunnel as it relates to covid-19 and back to work. Many companies are recognizing the need to be back in the office,” says Weill. “There has also been a bit of repricing of some office properties, given there is less competition. There is more of a buying window opening up in the market.”

Read Mortimer, senior vice-president at Rubenstein Partners, says he has heard from brokers that value-add assets undergoing situational distress should come back to market after the Labor Day holiday last month.

“We are starting to see people who are now significantly behind on their projected lease-up for assets bought pre-covid, perhaps because the rents are lower than they anticipated,” he says. “The less well-capitalized owners are running into issues where they don’t have dollars to execute on their business plans. This creates an opportunity to recap those owners with fresh money that comes in senior to the initial dollars.”

Transaction data shows the level of distress in the office sector is increasing. According to Real Capital Analytics, offices accounted for 46 percent of all outstanding distress in Q2 2021, compared with 32 percent in the previous quarter. In addition to distress or discounted buys, office investors are also keenly eyeing long-term triple-net lease office investments. “People are looking to the credit, net-lease market as a source of yield in a world where there is very little yield available to invest in,” Mortimer says.


Obsolescence threat

There are also lingering questions around what type of office buildings and tenant mix would pose the most challenges in a post-covid world. Jonathan Roth, co-founder and managing partner at commercial real estate lending manager 3650 REIT, believes the “losers will be those that are physically constrained and whose assets have been rendered obsolete in the absence of making massive capital improvement changes.”

Tenants in buildings with poor ventilation systems, tiny lobbies and small elevators, for example, could prefer to upgrade to a better-quality office space when their leases expire.

“What does concern me is what will happen to older, Class B Manhattan office buildings that used to charge a rent of $80 per square foot. How far is the rent going to fall and who will occupy these buildings?” wonders ACORE’s de Haan.

With the increasing likelihood of financial services and technology companies opting for permanent hybrid working arrangements, landlords will also need to diversify their traditional office portfolios with other types of workplaces. Life sciences and medical offices are in favor right now, given the covid-fueled demand for life sciences research and development. Real Capital Analytics found in its Q2 2021 report that in Boston, for example, prices may be down year-on-year, but the transaction volume is back to pre-pandemic levels because of the demand for life sciences assets.

ACORE capital has lent credit on eight life sciences transactions in the past six months. De Haan says that while he likes the sector, getting the asset, market and partner selection is important.

“From a tenant perspective, life sciences tenants carry an element of volatility because they typically hold a lot of cash on the balance sheet so there is always a risk of bankruptcy,” he says.


The future office

Even if managers find the right region, tenant mix and investment strategy to make an office investment today, questions about profitability remain. Are office valuations at a level where investors would still be able to generate outperformance, despite adopting a conservative underwriting approach?

Again, there are mixed opinions on the matter. Accesso’s Bentata says that at the beginning of the pandemic, the market was pricing multi-tenant office assets, with a typical four- to seven-year holding period, at an approximately 5-10 percent discount to pre-pandemic levels. “Pricing fell to more than 10 percent in some cities,” he says. “Since then, however, people have got more clarity on rent collections and the pricing has come back for quality assets in certain markets.”

LaSalle’s Gabbay is more critical. He does not believe the volatility is being factored in appropriately in pricing today.

“The pricing of volatility is getting repriced in a way that I’m not sure is reflective of fair value. People are accepting more volatility in the cashflow for a higher asset price, and not necessarily demanding a premium for volatility. By doing this, they’re effectively saying, ‘This is going to work out, I will hold the asset for the long-term and accept the longer hold periods,’” he says. “With tenant improvements, paying leasing commissions, enhancing your on-site amenities to be competitive, the reality is the property cashflow can be volatile [for offices].”

The pressure to make office buildings ‘green’ will be another drag on valuations. Patrick Kanters, managing director, global real assets at Dutch pension fund administrator APG Asset Management, told delegates during a PERE Global Passport interview in August that he thinks “offices are ageing very fast,” as asset owners strive to meet net-zero targets.

He believes more office users would be willing to pay for more sustainable buildings and those higher prices would eventually be reflected in valuations. A failure to make office buildings more sustainable, however, “will eventually hit valuations, if you are not taking care of it properly,” Kanters asserted.

The office sector faced issues of sustainability and de-densification even before the pandemic hit.

The crisis has only accelerated these challenges and added more headwinds. DWS Group’s White says the structural issues facing offices today are akin to what the retail industry went through with the advent of e-commerce. “You could make argument that office is the new retail,” he says.

What both naysayers and loyalists will agree on, however, is that the office – as a sector and as a concept – is on the cusp of a change.

“Office will get incredibly disrupted,” says Mack. “We will need to reset what an acceptable office environment is for people to go to work. The best buildings that can offer that environment will succeed, and the weak buildings will have to turn into something else.”