1Q 2021 | STATE OF THE MARKET
Home Is Not Where The Office Is
- Thus far, the U.S. office market remains relatively resilient throughout the pandemic, primarily due to the long-term nature of office leases and overall creditworthiness of corporate tenants benefitting from a resilient stock market and government stimulus.
- COVID-19 did not destroy the office sector, but there are challenges ahead.
- The abundance of sublease space will have a chilling effect on near-term rent growth.
- Should physical distancing protocols remain in place, tenants may need to keep their same footprint, even if part of the staff works from home some days.
- The case for returning to the office primarily stems from the desire to foster a company’s creativity, culture, career development, communication and collaboration, which will be difficult to accomplish in a work-from-home environment.
- Landlords and tenants’ management alike will need to adapt quickly to ensure they provide an environment where employees want to collaborate and can maximize efficiency. By providing employees with collaborative, safe environments, companies will be able to recognize the value of office expenditures.
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Before diving into near-term headwinds and long-term trends, it is important to look back at how the office sector has performed up to this point. When the first official COVID-19 case hit the U.S. in January 2020, few would have imagined the U.S. would lose 22 million jobs by April and end the longest economic expansion in U.S. history. More than one-third of jobs lost were in the leisure and hospitality sector (37.9%), whereas just 7.6% of the jobs lost were held by office users (Figure 1). In many areas, eviction moratoriums were put in place and landlords had to wade into untested legal waters, using active asset management, to find common ground with tenants through lease modifications.
Fig. 1 – Employment Change QOQ
In order to support the economy, the Fed lowered rates to 0.00%-0.25% for only the second time in history, which consequently improved corporate balance sheets and boosted the stock market. In fact, the Dow and Nasdaq rose over 60% and 85%, respectively, from March to December ending the year up 4% and 32%, respectively, from the pre-COVID peak in February despite U.S. unemployment reaching a record of 14.8% (Figure 2). In addition to large companies garnering support from the stock market, small businesses were also supported by Payroll Protection Program (PPP) loans. As part of the PPP loan program, tenants could use up to 25% of their loans to pay their rent. When combining tenants’ buoyed balance sheets with the long-term nature of office leases – typically 5-10 years – many landlords have had enough cash flow to get by.
Fig. 2 – Unemployment Rate
Even with the additional stimulus, corporations are not immune to the economic downturn and have put a pause on leasing due to the uncertainty of when they will return to the office and what their space needs will be when they do return. According to CoStar, annual leasing velocity totaled 270 million square feet in 2020. That total was a 40% drop from 2019 and nearly 15% lower than the trough during the GFC in 2009. Office demand posted its worst drop in 20 years, with the vacancy rate rising by 140 bps in 2020, and annual asking rent growth dropping to -1.2%. The avalanche of sublet space on the market contributed to the rent declines as those spaces are often discounted upwards of 20% compared to direct rents. During the GFC, forward-looking firms took advantage of steep rent cuts to either move up to higher quality space that had been unaffordable or lock-in early renewals at highly discounted prices. This time, if tenants are not facing an imminent lease expiration, they are reluctant to lock up their current space by renewing – even at a potential discount. This trend is highlighted by the count of office lease renewals decreasing by 40% from 2019 to 2020.1 Many tenants are still evaluating the cost-savings versus the culture-erosion dynamic brought about by the work-from-home experiment. Few have been willing to spend capital on major redesigns of their office space, as there still is not full clarity as to whether the layouts and designs preferred pre-COVID will be sanctioned and still functional in 12, 24 or 36 months. Tenants across the world seem to want shorter leases, and that trend may be here to stay. In Hong Kong, an average office lease lasts three years. In the U.K., it’s six. In the U.S., it fell 15% in the first five months of 2020 to seven years and it’s likely to fall farther, according to JLL. With less contracted cash flow, large TI buildouts that have been common in recent years may no longer be economical. Landlords will need to rethink concessions in general and rework their business plans to allow for more frequent turnover.
At the forefront of many landlord’s thoughts is what all of these shifts in office demand, lease structure and desired office layout and use will have on asset prices. At this point, the outlook is hazy as the lack of office trades since the start of the pandemic has limited price discovery. The annual investment volume total in the U.S. office sector, at $72.9 billion, was the lowest since the aftermath of the GFC in 2011. The 2020 total was also nearly 34% lower than the annual average over the previous five years. The picture would be even worse if not for the $30 billion worth of assets that traded hands during the first quarter of 2020, which represented 42% of the annual total. As that was the highest first-quarter total since the peak of 2007, an argument could have been made that the U.S. may have approached a record year for office transactions – if not for the arrival of the pandemic at the end of the quarter (Figure 3).2
Fig. 3 – Total U.S. Sales Volume
Temporarily depressed top-line income or cap rate expansion may be offset by the fact that office supply has slowed down. Currently only 150 million square feet of U.S. office space, or less than 2% of total stock, remains under construction with many proposed projects put on pause (Figure 4).
Fig. 4 – U.S. Office Under Construction
Despite this low supply, strong corporate balance sheets, and the long-term nature of office leases, the U.S. office sector faces several near-term challenges.
COVID-19 regulations forced many companies utilizing office space to implement work from home (WFH) policies for their non-essential workers at the beginning of 2020. WFH has been around for years but had been slow to catch on. Employers’ lack of general trust that workers could consistently be productive at home and the lack of widely available high-speed internet at employee homes contributed to the slow adoption of widespread WFH before 2020. Some well-reported attempts to implement widescale WFH programs were reversed when they observed that their company culture and innovation had suffered. For example, IBM started WFH in 2017 (yet it quickly ended), and Yahoo banned WFH in 2013. In 2020, WFH was deemed more successful and productive than in the past, largely due to the fact that most companies were forced to implement and learn to use new teleconferencing tools and advanced information technology systems. Zillow, Twitter, Square, Facebook, Coinbase, Dropbox, Spotify, and Nationwide are just a few companies that have announced plans to have employees work from home indefinitely.
Working from home provides employees with flexibility and reduces rental costs and office supply spend. According to CBRE, people increasingly want to work remotely and competition for talent will likely take place over the battlegrounds of not just flexible work policies, but also flexible work support such as stipends, home office equipment, and technologies. PWC conducted a survey of 1,200 U.S. office workers and over half of employees (55%) say they would like to be remote at least three days a week and almost a third (29%) prefer full-time remote work (Figure 5). In contrast, when asked how they feel about remote work at their company, 43% of executives prefer limited schedules or want to be fully back in the office as soon as feasible. In comparison, only 24% expect many or all office employees to work remotely for a significant amount of time. There is certainly a disconnect between executive and employee WFH expectations that will be ironed out over time. Remote work and flexibility are likely here to stay in some capacity, but so is the office sector. Over the next three years, while some of those executives expect to reduce office space, 56% expect to need more.3
Fig. 5 – How Often Would You Want to Work Remotely After COVID-19 is No Longer a Concern?
This shift to remote work and job losses in general caused a domino effect and created another headwind – a skyrocketing amount of sublet space. The amount of sublease space on the market surpassed 190 million square feet, an increase of nearly 70 million square feet from the start of 2020.7 The flood of sublet space on the market contributed to the rent declines as those spaces are often discounted upwards of 20% compared to direct rents. From a market perspective, gateway markets saw the largest change in available sublet space over the year with Boston and San Francisco seeing the largest increase of 137% and 126%, respectively (Figure 6).8 For example, Pinterest paid $90 million to break their 490,000 square foot lease in San Francisco. But the trend also applies to suburban traditional tenants like State Farm, who put their entire 340,000 square foot regional office in Concordville, Pennsylvania up for sublease as they are planning to move to a permanent work-from-home strategy. The office sector will have difficulty pushing rents with this flood of available space hitting the market at discounted rates in the near-term.
Fig. 6 – Change in Available Sublet Space YoY
The main reasons many tenants will keep an office footprint is because of the “Five Cs”: Creativity, Culture, Career Development, Communication and Collaboration. The “when” will depend on each company’s and industry’s sensitivity to the impact of all or a few of the “Five Cs.”
There is a common saying that COVID-19 accelerated pre-existing trends. If communication was lacking in an office prior to COVID-19, then the pandemic escalated that trend. Colleagues have to overcommunicate in a time where visibility is lacking. While teleconferencing tools have made this unprecedented shift to remote work feasible, “Zoom Fatigue” is wearing on people after a year. Nothing replaces an in-person conversation. If a company chooses a hybrid model, communication will be even more of a necessity. Many conversations will happen organically around the office and if a colleague is remote, they may feel left out of the conversation or even the company. To provide an analogy, it would be very similar to if your entire team were to go into an office and close the door. In their 4Q Earnings Call, Zillow announced they are adopting a hybrid model of work, but its CEO says it’s trying to prevent one major downside: a ‘two-class system’ where those who come into the office are viewed as better employees. Additionally, Sid Sijbrandij, CEO of code-collaboration firm GitLab, described a hybrid model as “the worst of both worlds.” Sijbrandij warned that remote employees won’t feel included and will have a more challenging time communicating than their peers who report to the office. Whether companies choose remote work or a hybrid approach, remote communication will continue to be second rate to in-office conversations.
Creativity, Culture, Career Development, Communication and Collaboration are imperative to the framework of any company. The office sector has the acknowledged headwind of remote work, but office demand will likely return as WFH ultimately cannot replace the in-office “Five Cs.”
When office demand returns, tenants’ space needs may look different. Similar to the speed of business, landlords and tenants alike will need to adapt quickly to ensure they provide an environment where employees want to collaborate and are able to maximize efficiency. Just like the retail sector had to adapt to and embrace e-commerce, the office sector will need to learn to accommodate COVID-19’s disruption of the space.
Most executives (87%) expect to make changes to their real estate strategy over the next 12 months, according to PWC. These plans include consolidating office space in premier locations and/or opening more satellite locations. Over the next three years, while some executives expect to reduce office space, 56% expect to need more. These mixed findings show that some companies are planning to reinvest the remote work dividend in new ways in order to create a special experience in the office (Figure 7).
Fig. 7 – What Changes are Executives Making to Their Real Estate Strategy?
As we look to 2021 and beyond, there will likely be trends toward a flight to quality and de-densification of the office. There will be changes to what we consider personal vs. collaborative space and to which amenities are highly valued. These trends will widely vary based on location, industry, tenant, space use and culture. Offices located in suburban areas not dependent on public transportation or high-rise elevator systems are more likely to reach peak occupancy than dense CBD office buildings. Additionally, more business-friendly markets with less restrictions will likely see a quicker return. To illustrate this point, Kastle Systems’ “Back to Work Barometer,” based on entry card swipes in major cities, found Dallas, Houston, and Austin top the list as the most open cities, with occupancy rates of 36.9%, 36.7%, and 35.8%, respectively. Four cities — Philadelphia, Washington, D.C., San Jose and New York — are still experiencing slight declines in occupancy rates as of early March and the least open city is San Francisco, at 13.7% (Figure 8). Besides location, the pace and scale of returning to the office will also vary within business sectors based on the individual company culture. For instance, Goldman Sachs CEO David Solomon says “I do think for a business like ours, which is an innovative, collaborative apprenticeship culture, this is not ideal for us. And it’s not a new normal. It’s an aberration that we’re going to correct as soon as possible.” Whereas Deutsche Bank is weighing a new policy that would allow most employees to permanently work from home two days a week. Even within companies, there may be roles that can be remote and others that require being in the office. All of these changes to space needs will lead to new lease agreements upon renewal and require experienced asset management.
Fig. 8 – Physical Occupancy by Market
The “Flight to Quality” trend was occurring long before the pandemic. In order to create an environment where employees will be enticed to return to the office, tenants will want LEED and WELL certifications, newer HVAC systems, and the locations closest to where their talent wants to live. Low-quality, outdated, high-rise office buildings will likely struggle to attract and retain tenants. However, this creates a value-add opportunity for owners to renovate and even qualify for ESG certifications, which has been an increased initiative for many investors.
Space needs will vary by industries, individual companies and their remote work policies. A tenant may need more space if they plan to de-densify their employee’s space or potentially less space if they have a portion of their employees work from home. When looking at CoStar’s occupied office square feet and dividing it by Oxford Economics’ office-using employment, the space per employee has been steadily shrinking since the GFC (Figure 9). Companies have been squeezing more and more people onto floorplans, getting as low as 240 SF/employee on a national scale, although 50-100/SF per employee is more common in sectors like Wall Street in Manhattan. COVID-19 will immediately push companies in the other direction, needing more space per employee. “Bullpens” and “Amoebas” style offices will likely start reverting to more personal space for employees. We have already started seeing this jump in recent quarters due to job layoffs but also due to space need changes. The emphasis on health and well-being in the workplace has accelerated during the pandemic and is engrained in the employee consciousness. As an example, the way people carry around hand sanitizer is habitual now. Beyond requirements for personal new cleanliness norms, workstations and conference rooms will likely continue to be reconfigured to allow for greater separation between employees. To attract and retain the best talent, some firms will have to change their previous ways of packing employees in and instead give them more elbow room to make the office experience more comfortable. The modern office needs to be relevant as the next best alternative is an employees’ home.
Fig. 9 – SF per Employee
CBRE defines this trend as “Me vs. We Space” (Figure 10). In order to influence employees to use the office as their destination of choice, tenants will rethink what their offices can deliver that is unique compared to the experience of working remote. The office’s purpose will be to provide a venue for community, culture and collaboration. Employers will look more closely at the type of work being done in the space and the composition of the office will adjust to reflect this.
Fig. 10 – “Me” vs. “We” Space
Coworking could be a solution to gain more flexibility of future office space needs. While recent headlines surrounding WeWork and Knotel are not overly positive, the concept has existed for decades and has recently grown to account for ~2% of U.S. office space. Green Street estimates 10% of total U.S. office space will be in some form of flex office by 2030, with the majority of that coming from enterprise tenants, a single tenant on flexible lease. Firms like CBRE are bullish on coworking outlook demonstrated by the 40% stake in Industrious and the creation of Hana, an in-house flexible space provider. According to their website, CBRE believes “that flexible space can be a compelling option within a corporate real estate strategy. The flexible space market is established and growing rapidly, and property owners are looking for flex solutions from a knowledgeable, investment-grade service provider.”19 There are many drivers that could influence flex office growth in the long term, with a wide range of outcomes on office demand (Figure 11). The potential net impact boils down to whether the continued aggregation of independent workers and remote workers spur more demand than what gets cannibalized by corporate users switching to more densely formatted flexible space. In the near-term, coworking providers are expected to be under pressure. This model was built on open-plan design with the intention of socialization and interaction, which is not productive with current social distancing protocols.
Fig. 11 – Weighted Average Number of Days in Office
Although the news is filled with announcements of permanent work from home strategies, what many of these companies are saying is contradictory to their actions.
Europe’s return to the office presented a hopeful outlook for the office sector, before the second lockdown. In Morgan Stanley’s AlphaWise analysis, almost three-quarters of E.U. white-collar employees were commuting again (68%) in July 2020. French companies have led the charge to bring their teams back to the workplace, as 83% of French office staff returned, followed by Spain, Italy and Germany, with about three-quarters (around 75%) heading back in.20
Additionally, the rollout of vaccines is raising confidence in returning to the office. Uncertainties remain about how to bring employees back safely, whether it will be safe for them to travel for work, as well as how to align workforce scheduling with schools reopening. Tenants and landlords should develop a strategy that helps meet their goals while also addressing employee safety expectations and the need for increased flexibility. Employees are likely to expect to work in less densely configured spaces and to seek assurances that health checks are being made.21
Active asset management will be imperative to work through these uncertain times. The challenge is to get tenants back in the office safely and asset management is needed to be agile as tenants will have rapidly changing needs. In the words of Michael Baracco, a Bellwether Asset Management Principal, “now, more than ever, we need to be focused on tenant relationships and attuned to market intel. Landlords will need to be somewhat reactive in the near-term. However, as employees return and trends are solidified, proactive asset management to best position buildings to meet the differing needs of tenants will lead to long-term success.”
Many questions around the office sector will not be answered immediately and demand will likely come back gradually with space needs varying widely by individual companies. While there are certainly headwinds for the office sector in the near-term, the need for office continues to evolve and will not disappear. History indicates humans typically have short-term memories for overlookable challenges. Office demand will come back but may evolve and look different as we head into 2021 and beyond. No Zoom meeting can replace the in-person office experience with regards to creativity, culture, career development, communication and collaboration.
1 CoStar, Lease Comps, March 2021
2 CoStar, Analytics, March 2021
3 PWC, Remote Work Survey, January 2021
4 Wall Street Journal, Netflix’s Reed Hastings Deems Remote Work ‘a Pure Negative’, September 2020
5 Society for Human Resource Management, Study Finds Productivity Not Deterred by Shift to Remote Work, September 2020
6 Cushman and Wakefield, The Edge Volume 5, February 2021
7 CoStar, Analytics, March 2021
8 CoStar, Analytics, December 2020
9 Bloomberg, Dimon Sees ‘Carrots and Sticks’ Approach to COVID Vaccines, March 2021
10 Stealing Fire by Jamie Wheal and Steven Kotler, published February 2017
11 Harvard Business Review, Create a Work Environment That Fosters Flow, October 2019
12 Lucidspark, How collaboration and creativity are suffering in the wake of COVID-19, September 2020
13 Business Insider, Google is allowing employees back on campus for outdoor-only meetings because remote isn’t always enough, December 2020
14 Harvard Business Review, When to Fire a Top Performer Who Hurts Your Company Culture, October 2012
15 Gallup, Remote Work: Is It a Virtual Threat to Your Culture, August 2020
16 PWC, Remote Work Survey, January 2021
17 Harvard Business Review, Remote Managers Are Having Trust Issues, July 2020
18 Lucidspark, How collaboration and creativity are suffering in the wake of COVID-19, September 2020
19 CBRE, Flexible Space Solutions, March 2021
20 The Guardian, UK office workers slower to return to their desk after COVID, August 2020
21 PWC, U.S. Remote Work Survey, March 2021