Leasing in CRE is Changing

Will Office Space Really Change That Much?

‍

The prognostications on the re-imagining and even death of the office as we know it are a popular, dare we say it, “trending” topic these days. The concept of working from home coupled with social distancing has pushed a bevy of opinions on the way businesses will occupy space (or not) and employ people in the future. Some good opinions on the subject are

‍

WSJ’s Offices of the Future

NYT’s Office Predictions 

And...TechCrunch took a crack at it too..

‍

So, we thought it might be nice to toss our hat in the ring of what may happen. Of course, two years from now we fully expect to come back to this blog and laugh about how wrong we were...but hey, somebody has to be right...right?

‍

It seems many of the opinions and predictions on the future of office are fairly short-sighted. So we wanted to take a more comprehensive view of the industry. While Covid-19 has certainly had a major impact on the way companies are occupying space now, that doesn’t mean the future is necessarily written in stone.

‍

What’s Happening Right Now?

‍

For the offices that are opening, we’re seeing roughly 50% of a given space being used. Most offices offer a combination of private and open areas (every company is different with their layout needs of course) and it’s these open areas that are causes for the most concern. Cubicle sections, open-desks, “drop-in” areas and common meetings rooms are likely to go unused in the short term. 

‍

Some companies have adopted a one week in/one week out schedule (with deep cleaning every night) to allow folks to access their common desks/cubicles without fear of contamination. Companies are doing what they can to follow guidance and limit the amount of people in an enclosed space.

‍

This creates several issues for the company who is paying for the space. If they are NOT using the space at all, they almost certainly want relief from their Landlord. Those types of discussions are very likely to end in court. If they ARE using their space, it’s frustrating to be paying 100% for something you can only get half-usage from.  Right or wrong, companies fear liability from bringing workers back to an office too soon. We need regulatory clarity on this issue, soon.

‍

Now, does this dictate the company immediately subleasing or trying to give-back portions of their space? It’s not clear yet. As treatments and reduction in cases continue we can only hope that people (and by virtue of their organizations) start to feel comfortable enough to occupy. We DO believe that the distancing and cleaning/hygiene standards are here to stay though. 

‍

What about working from home? Is there some grand change afoot? Perhaps, but unlikely. Companies prefer to lease or own their spaces because productivity, security and culture can be managed best on-site. Some companies who are uniquely suited to working from home will certainly do so, but we expect the majority of occupiers to continue occupying.

‍

We’re breaking down the future (and current state) of office into time frames to make the subject easier to digest.  Without any further adieu, here’s what we think the future looks like for office leasing.

‍

In the Short Term (Next 12 months)

‍

The next 3 months look pretty ghastly for office space. We fully expect vacancy rates to balloon significantly as a glut of business closures drive both direct and sublease occupancy down significantly.  Right now, businesses are concerned with being sued over opening their offices and the potential for someone getting sick. This liability (founded or not) is keeping some doors closed.

‍

So what happens short term? We expect companies to reduce their footprints but NOT due to health regulations or spacing, rather, due to the economic effects of the current environment. Layoffs have affected 36M people in this country and we don’t expect all of those jobs to come back.  It will take time for those jobs to be needed, filled and subsequently drive space demand. 

‍

Deal volumes will continue to be weak in the short term, pricing will fall and Landlords will need to get competitive to capture any deals that are floating around the market. Tenants will rule the roost short-term especially if they are in a position to lease space.

‍

To Summarize:

‍

• Businesses will need less space because they have let go of so many people
• “Phased” openings and limited occupancy even in existing leases are likely
• Subleases will grow exponentially in most markets as will vacancy rates
• Relief requests, force majeure and condemnation claims will head to court.
• Pricing should fall and Landlords will need to get competitive, especially in the class B and below assets (bulk of the market)
• If you’re a tenant you’re going to make a smoking deal.
• Working from home will likely dominate in the short-term but start to phase out eventually
• Spec-suites and management of offices via app (like a hotel) will begin to be used 

‍

Which brings us to the Mid-term Outlook (13-36 months)

‍

After we get past the “panic” phases of the virus and hopefully have some solid health solutions we do expect companies to start returning to their spaces and occupy more normally, using 75%-100% of their existing footprints. Commercial real estate isn’t rocket science. Buildings literally are built to serve one purpose, to provide space to lease to users. We will need the economic environment to improve significantly for companies to start feeling comfortable signing leases. Within 1-2 years this should happen.

‍

When businesses start to hire, economic demands pick up and space is needed. We actually believe that due to the hygiene and distancing needs companies will potentially need more space than they did before (assuming hiring equals out) due to needing to space people out. Common areas, cubicles area and “drop-in” desks will go away in the mid-term. Private offices and meeting areas will likely be amplified by hospitality-style “booking” apps where occupiers will allow employees to book/schedule areas needed on-demand. The goal here will be to limit the amount of people occupying a single area.

‍

Even with improvements in both treatments and the economy we do not expect a “quick” recovery for the office markets. It will take years to unwind the damage caused by the shutdown and change in demand-relationships for occupiers and owners. However, some new trends should start to take hold.

‍

• “Co-working” with individual desk leasing (WeWork style space) will likely face severe headwinds. We cannot see companies mindfully going into denser spaces with people (from all types of companies) packed in seat-by-seat.
• “Regus”-style shared suites (individual offices) are actually positioned quite well. We believe both the economies of scale, private-footprint and flexibility of a shorter-lease is a premium many companies will be willing to pay to reduce long-term lease obligations in a rapidly changing environment.
• Consolidation in the brokerage industry is likely. We expect there to 25-35% less professionals working in the leasing space by the end of 24 months.
• Property defaults will begin. This is a domino-like sequence of events that start with businesses (due to no fault of their own) being crippled by the shutdown. Eventually this will trickle to the owners not receiving rents and lenders not receiving mortgage payments. In fact, it may already be starting according to TREPP data on bonds.
• Properties owned with CMBS debt are most at risk.
• Lastly, tenants who are signing longer-term leases are going to command excellent deal terms and require significant build-outs to ensure proper health and hygiene standards are taken into account. We expect health/distance to become as ubiquitous a concern as the fire-marshall and permitting process.

‍

That brings us to the foo-fah land of LONG term predictions!

‍

Honestly anyone who says they know what is going to happen 3+ years out is either Nostradamus or #fakenews. We’ll do our best, but no one really knows. There’s a ton of variables in play here from health to economic conditions but we’re going to bullet point what we believe will be the long-term “new normal” for offices.

‍

• Companies will offer work from home but require a portion of time to still be spent in the office.  As a result, space footprints won’t reduce as much as everyone thinks after this crisis.
• As equilibrium returns to office leasing, landlords will push back on flexible leases and shoot for longer-term deals again. Flex-space is a means to an end but income/term/credit is the mix that makes CRE assets valuable. Landlords won’t lightly abandon that nor will lenders.
• The design of space will certainly change, but we don’t expect plexiglass and bubble-wrap everywhere. We do expect amenities like hospitality space-usage/booking apps to become popular for occupiers to manage their internal space more effectively.
• Parking will continue to be a problem and we’ll need more of it. Mass transit and car-sharing will likely reduce in the future. Perhaps dedicated uber/ride-sharing amenities will become the standard in buildings.
• Buying opportunities for assets distressed in the mid-term will be plentiful and fantastic for those with cash on hand. It’s an excellent time to have dry powder for CRE investment.
• As an investment class, commercial real estate is poised to do very well as the economy recovers.
• Internet and tech-enabled connectivity will be an absolute necessity going forward. Companies will need top-tier speeds, data management and access to their files remotely (and securely) to be prepared for any additional pandemics/shutdowns.

‍