June 16, 2020 – As published in Chief Investment Officer.
If the health hazards are resolved, look for a reverse exodus. That’ll benefit battered office REITs.
The silence in America’s office buildings is eerie. Empty or near-empty since March, these habitats of the vast white-collar workforce may shrink drastically as employees continue to do their jobs from home. Such a baleful scenario would be a disaster for the real estate industry. At least, that’s the worst case view.
But the odds are strong that, once employers sound the all-clear and impose stringent health and safety protocols, a decent amount of employees will return, although a significant fraction will continue to toil from home. Reasons for the reverse exodus to the offices: The human yen for community and the sense that collaboration works better in person.
And the upshot is that office real estate, after some body blows, should recover fine. Changed, but fine.
Current estimates, such as one by the Massachusetts Institute of Technology (MIT), find that as many as one-third of office workers want to keep working remotely. But will it stay that high? Once COVID-19 is a distant and unloved artifact of the past, “memories will fade,” predicted Chad Phillips, Nuveen’s head real estate manager for the office sector.
Major shocks to the social fabric tend to alter daily life. After 9/11, security became a standard feature in airports and other public places. By the same token, working in an office will change from the pre-epidemic environment of densely packed desks. These so-called open plans were aimed at promoting cooperation and creativity.
The coronavirus has brought the world a double whammy: In addition to severe illness and death, COVID-19 has slammed the US and world economies with a wicked recession.
For the office sector, recessions have always produced landlord bankruptcies, higher vacancies, and shrunken demand for space. “With negative job growth, office rents will drop,” said Alec Overby, senior analyst at investment manager Cohen & Steers.
US office leasing contracted by 34% in the recent first quarter, to 45 million square feet, compared to 2019’s comparable period, according to JLL, the global commercial property broker and manager.
New leases, which hit a record of 271 million square feet in 2018, had already started to soften last year, amid forecasts of an economic slowdown. Note that the virus panic really only took hold in March, the final month of the last quarter. That means that 2020’s second quarter lease activity, recording a full three months, probably will look a lot worse.
A lot of the damage to the office sector won’t occur overnight. “Office leases are long, lasting five, 10, 15 years” in major metro areas, said Dick Schiller, real estate investment trust (REIT) analyst at Duff & Phelps Investment Management. Of course, office REITs, which are landlords that own large numbers of buildings, have taken a drubbing in the stock market. They are down 27% this year, trade association Nareit’s numbers show. Make no mistake: There will be plenty more blood.
Home, Sweet Home
The sociology of packing people into an office is based on the belief that they will be more efficient there than, say, at home. In recent years, the concept of private offices and walled-off cubicles got the bum’s rush. The new notion was the open plan, with people sitting next to each other at long tables, making conversations easy. “It’s meant to spark creativity and collaboration,” Schiller observed.
Also called “densification,” this arrangement ran into a quagmire with the onset of the pandemic. Suddenly, the idea of sharing air with office mates within reach seemed insane. These days, “density is a bad word,” said Stuart Katz, CEO and CIO of Robertson Stephens Wealth Management.
Amid widespread government-ordered shutdowns, office workers found themselves doing their jobs at home, using keyboards and screens. Imagine if the pandemic had occurred in 1980 instead of 2020: White-collar work would have simply ceased. But now, with Zoom and other teleconferencing technologies, with almost universal broadband, remote work is very do-able.
A big question exists about whether people are more productive at home these days. If you have children, taking care of them plus handling home schooling can eat into work. For others, though, remote working removes distractions. Further, the time and stress of commuting vanishes. After the US Patent and Trademark Office allowed patent examiners to work from home in 2012, their productivity rose 4.4%, a Harvard Business School study found.
Whether that successful experiment can be copied elsewhere or not, a largescale return of workers to offices—provided that they’re safe—has logic to it.
Many people love the camaraderie of an office, and also the chance to get away from the house. Face-to-face interactions, often impromptu, are indeed the crucibles of creativity. “An informal, unscheduled meeting is hard to replicate in the virtual world,” Katz said. Hiring and mentoring also function better in person, pro-office folks say.
At the moment, with more than 118,000 US deaths from the virus, crowding into an office has zero appeal, and infection fear seems to be a hard-wired response for many employees. But this reaction sounds like “a case of recency bias,” said Nuveen’s Phillips. In other words, you believe that today’s reality will always persist. An effective vaccine or a severe retreat of the disease and stringent safety regimens might make things look different in a few months.
Staggered arrival times at work, touchless elevators and restroom faucets, partitions between employees, face masks, marked walking patterns on floors to avoid congestion, first-rate HVAC systems that filter out microbes. All these could ease anxieties and speed a return to something like normal.
Then, said Jeff Doerfler, senior equity analyst at Huntington Private Bank, “hiring and collaboration will pick up” in office settings. And that will help demand for office space.
A key unknown: Would a health-reconfigured office require less space, especially if a portion of workers are at home? Maybe, maybe not. Despite the open plans’ cheek-by-jowl seating arrangements, a lot of space is given over to sizable conference rooms and community areas.
When offices are revamped to become safer, they may end up with “the same size footprint, just used more efficiently,” said Ed Shugrue, portfolio manager of the RiverPark Floating Rate CMBS fund. If that’s the case, the reprieve would boost office real estate’s future.
For the past four years or so, the office sector has been bracing for a mild downturn. That behavior was based on the assumption that the nation’s longest economic expansion was bound to wither, owing to a trade war with China and ebbing growth overseas.
Result: Projections for this year were only modestly negative. In 2020, downtown office vacancies were expected to nudge up from around 10% by a percentage point, and rent growth to slow to 2% from 5%, CBRE Research estimated, in a report late last year. (Suburban numbers were projected to be slightly worse.)
Office REITs’ stock performance in the recent past reflected that relatively optimistic caution, meaning the shares lagged behind others. They had an average annual total return, for 2016 through 2019, of 9%. All equity REITs (that is, those that deal in mortgages aren’t included) were up 10.5% on average, and the S&P 500 clocked 15%.
The virus spoiled that tidy and benign calculation. During March and April, an apocalyptic mindset prevailed, even regarding the strongest of the office REIT players. Take Boston Properties, one of the largest office REITs. With holdings on both coasts, this trust is down 30% in 2020. Another top landlord, Vornado Realty Trust, focused in New York City, has fallen 38%. And West Coast-oriented Hudson Pacific Properties has slid 32%.
For the year’s first quarter, Boston Properties announced that funds from operations (FFO, the REIT version of earnings) rose a healthy 7%, with 95% of the rent collected, a good figure. The company has an ample buffer against bad times: $812 million in cash and cash equivalents and a $1.25 billion revolving line of credit available.
As heartening as all that was, however, Boston Properties in late April withdrew its guidance for 2020, always a sign of possible trouble. Management cited the unknown extent of the epidemic and the “uncertain economic climate.”
The virus-propelled lockdowns scuttled all goodwill that the office segment enjoyed. Just as a rotting carcass attracts carrion, distressed investors are mobilizing to nab failed commercial properties for a pittance. While a lot of the estimated $300 billion in vulture investor ready cash is targeted at the devastated retail market, some will go toward office buildings.
A big negative for offices is that too many are being built, and that spells burgeoning vacancies. In New York City, the nation’s largest office market, a huge complex called Hudson Yards (10 million square feet) is opening, almost 2% of Manhattan’s 568 million square feet total office inventory. Overall, office towers covering 16.4 million square feet are under construction in the city.
Making matters worse, the co-working craze is drowning in deep water. WeWork is New York’s largest office tenant, with 100 locations and too few space renters using them. The company reportedly has fallen behind on payments to some its landlords, and major shareholder SoftBank has balked at a $3 billion rescue plan. “They rented at the top of the market,” RiverPark’s Shugrue said of WeWork. “This is their death knell.” The company didn’t return a request for comment.
Still, things could be worse in office land. Some cold consolation: Offices are better off than retail and hotel real estate. With office REITs shares down 27% this year, lodging is off 45% and retail, 44%. Among REIT categories, that puts offices in the middle. The champs of this field are industrial (aka, warehouses, as in where Amazon and all the other booming online merchandisers stock their wares), down a mere 1%, and data centers, up 19%.
The future for offices, while downbeat, likely won’t be a wipeout. To see what their fate may be in this recession, look at how offices fared in 2009, when the financial crisis had its worst impact.
Back then, rent income plunged 13%. But vacancies, while painful, were not as bad, rising by four percentage points from the year before (the crisis came in fall 2008). This time, the anti-densification trend and the work-from-home impulse may make those numbers worse. But due to long-term leases and the corporate guarantees behind them, such woes will be incremental.
For offices, the brunt of the nation’s economic suffering won’t be felt uniformly. The Class A buildings—with their marble lobbies, acres of glass, and state-of-the-art online capabilities—usually manage to pull through with minimal damage in the end.
After the overbuilding spree of the 1980s, what was then called the World Financial Center foundered in the following decade. Now known as Brookfield Place, the swanky complex in New York City is a desirable office locale with steady demand. Less-popular Class B and C building will get the worst of the downturn. “The fringe buildings were barely making it in the bull market,” RiverPark’s Shugrue said.
Meanwhile, a larger issue is how well big cities will hold up as office employment meccas. The appeal of suburban offices likely will increase. JPMorgan Chase is talking about leasing space outside of New York to make life easier for suburban employees.
And some urban locations have built-in advantages that should help them. West Coast cities, in particular San Francisco, benefit from crackdowns on new development, which have kept occupancy rates high.
Compared with New York’s construction mania, San Francisco “has the opposite problem,” as the center of the flourishing tech industry, said Duff & Phelps’ Schiller. “San Francisco is a good place to be a landlord.” Although the city by the bay’s average rent is a lofty $93 per square foot, versus $85 for New York, San Francisco office landlords have managed to keep rental income stable, for now.
One corner of the office world is doing exceptionally well: doctors’ offices, medical labs, and other health care centers. After all, aside from teleconferencing check-ups, practicing medicine is tough to do remotely. Lab experiments are impossible at home. A good example of a thriving life sciences office REIT is Alexandria Real Estate Equities, whose stock is up 3% this year. Alexandria’s FFO rose 17% in the first quarter, and the REIT just hiked the dividend 3%.
Should job migration continue to the Sunbelt, places like Atlanta have ample inventory. Thanks to some overbuilding, vacancies are around 16%. Just the same, rents are very affordable, at an average of $30, and nobody has to worry about commuting on disease-ridden mass transit. “Atlanta is a driving town and it has a lot of parking available,” Schiller said.
Once the health scare and the recession are over, people who want to work mainly from home can likely do so, yet the office culture will endure. Even now, offices retain a cachet for corporate managements. TikTok, the video-sharing company, announced in late May that it is leasing 232,000 square feet in New York’s Times Square.
Yes, tomorrow’s office culture will be different, to a degree. Cohen & Steers’ Overby said, “The workforce will want flexibility.” That is, some at home, a lot at work. Overall, that’s hopeful news for offices in the future.