Nearly overnight, the COVID-19 pandemic changed how companies do business. Millions of employees were sent home to work remotely. As of early this past September, it was still unclear when the majority of these workers would be recalled to their offices.
This change could have a significant long-term impact on office-space demand, as well as ultimately affecting the incomes, values and financing potential of office buildings. All of this makes it well worth the time of commercial mortgage brokers to consider the future of the office.
The COVID-19 pandemic has brought a deluge of commentary about the death of the office. Every day seems to bring another story about a large corporate tenant giving up space.
At the end of August 2020, the social media tech company Pinterest, which was booming pre-pandemic, backed away from half a million square feet of Class A space in San Francisco. Near the start of the pandemic, Facebook announced that half of its employees may work from home over the next several years, while Twitter said that its employees could work from home indefinitely.
On the other hand, numerous real estate executives predict there will be a sharp rebound in demand for office space once the pandemic wanes. In a number of interviews, legendary real estate investor Sam Zell remained optimistic about the future demand for offices. He noted that the coronavirus health crisis has created great uncertainty for all commercial-property sectors, and likely will change office layoffs and add to the time that employees work from home.
But he also believes that the majority of people will report to an office at least four days a week once the health crisis fades. In a June 2020 article in The Economic Times, Zell pointed out that employees are “social beings” who want to interact.
It seems safe to say that the best buildings in the best locations will benefit at the expense of lower-quality products.
Extreme predictions on either side of the argument are unlikely to be accurate. Instead, there is bound to be a transformation in the way office space is used and an evolution in the market. The sector may well shrink and will certainly change, but the office will remain.
Anyone with tenure in the industry remembers the confident prophecies that no one would want to work in a skyscraper after 9/11. That was obviously wrong, but companies began to think more about dispersing their personnel and about the vulnerability of depending on infrastructure, such as subways and electrical-power substations. Morgan Stanley, for example, chose to sell rather than occupy the new headquarters building it completed in 2001 on Seventh Avenue in midtown Manhattan. Instead, it bought the former Texaco headquarters in Westchester County, New York, to decentralize its operations outside the city.
Similarly, the impact of the COVID-19 pandemic on office space also will be strategic. It will vary by type of tenant and place a premium on certain kinds of buildings. Mortgage brokers will have to be more careful as lenders are likely to become more selective about office assets and their rent rolls.
In estimating demand, the type of tenant is a crucial factor. Technology companies, almost by definition, have a younger and more technologically savvy workforce, along with a business model that lends itself more easily to remote working.
Lenders might worry that any asset dependent on these tenants may have trouble when leases come up for renewal. Financial-services companies, especially banks and trading firms, have speed, regulatory and security requirements that make working from home more difficult. Lenders may well assume that such tenants are more likely to renew.
In the middle are professional services — the accounting, law, engineering, advertising and consulting companies that are the most important tenants for filling millions of square feet of urban and suburban office space across the country. These companies still need office space for meeting and receiving clients, and few of them will become fully virtual organizations. But for nearly all of these companies, their office leases by far account for their largest fixed cost. Therefore, they are highly incentivized to follow the lead of the big four accounting firms and move toward smaller footprints with fewer assigned spaces. Every dollar a company takes out of its lease commitments falls into the personal bottom line of each partner.
These factors seem to point unescapably to one direction in aggregate office demand: down. If the office isn’t going away, however, how will it change? It seems safe to say that the best buildings in the best locations will benefit at the expense of lower-quality products. But what will that mean in practice?
To the suburbs
Downtown areas, which have benefited from rejuvenation efforts in recent years, may well struggle. Major cities that depend heavily on mass transit, such as New York and Washington, D.C., may be hurt the most as no one can predict when ridership will recover to previous levels. Cities with many tall downtown office towers, such as New York, San Francisco, Chicago and Los Angeles, face the question of how to handle elevator capacity while enforcing social distancing. It will be difficult for lenders to underwrite future occupancy rates for such assets while so much remains unclear.
Many downtowns also experienced looting, arson and vandalism this past summer. It is sometimes forgotten that the reason downtowns began to suffer a generation ago was in large part due to safety concerns. By the same token, the resurgence in downtowns across the country has been predicated on safety. With safety being uncertain in these neighborhoods, they may take a long time to recover.
In parts of downtown Washington, D.C., streets remain blocked off with buildings inaccessible by car. But it is not just a big-city problem: Foot traffic in downtown Raleigh, North Carolina, fell this past summer to the point where the streets felt like “a ghost town,” according to The News & Observer. The urban live-work-play environment so sought after by millennials — and the real estate developers and lenders chasing them — may not be the future.
Landlords leasing office space in downtown Bethesda, Maryland, a suburb roughly seven miles from D.C., have seen an interesting phenomenon. Tenants that may have otherwise decided to stay in downtown Washington now see Bethesda as a way to get out of a central business district with closed streets, dependence on mass transit, higher rents and exorbitant parking costs. And tenants that might have moved to downtown Bethesda from their suburban corporate-campus settings in North Bethesda or Rockville to take advantage of more walkable amenities could be rethinking their desire to leave.
As these trends play out across the country, a desirable location may be the one that is less dense and has better parking than its competition. In some ways, this is a return to the 1970s and ‘80s. Yet the most desirable buildings are generally the most modern. These buildings have the best air-handling systems, the most flexible floor plans, well-designed common areas, and low-touch elevators and bathrooms.
Making predictions amid so much uncertainty is risky. But it seems likely that overall office demand will shrink as more companies, especially professional-services firms, realize they can get by with less space. This will place a premium on locations that don’t require mass transit, and that are seen as safe and easy to access.
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The most-desirable office buildings will be the newest ones, as usual, but especially the lower-rise buildings that don’t require a long stretch in a packed elevator. Downtowns, whose rebirth has been won through hard-fought trial and error in cities across the U.S., may struggle for some time. ●