A Changing Landscape in Commercial Real Estate
Before the Pandemic
Early 2020, the focus was on interest rates as it often is in commercial real estate. In our industry, capital structure plays no small part in investment decisions. The Federal Reserve had once again softened its posture on the tightening cycle that begun in December of 2015 which marked the first increase in nine years. Three years later, and we reached a local maximum of 2.5% in December 2018; a pivot reminiscent of the taper tantrum occurring in 2013 when the Fed began a period of balance sheet reductions only to reverse course after a turbulent period in the financial markets.
While interest rates were rising the three years prior, there was a pause in the market to see if asset yields would adjust. Yield adjustments in real estate can be stubborn. A key tenet you're taught early in economics: prices trade inversely to rates. As such, when interest rates rise, we expect a fall in asset prices and thus a rise in yield. In practice, this process can be very slow. Try telling your counterparty to an acquisition we should re-trade lower because of a recent rate decision. I've found sellers, apart from those most motivated to sell, tend to delay or reconsider selling altogether rather than take a haircut.
Now that interest rates were falling, it was clear prices weren't going to adjust lower. Transactions increased in volume and velocity. This period between rates cresting and the start of the lockdown was an interesting time. Many of my peers, as well as myself, felt the exuberance. While politicians were speaking about persistent low inflation, the rest of us knew an explosive cocktail of rates too low for too long, a massively expanded money supply, and a dovish Fed would eventually bring problems. But what happened next was a bit more challenging to anticipate.
During the Pandemic
In March of 2020, the World Health Organization declared Covid-19 a global emergency and governments around the world sent their workers home. I would be shocked to find a single office investor who wasn't a bit nervous during this time. We follow access control data (such as key card swipes) and parking lot traffic to indicate utilization of our properties. Suddenly, these metrics fell to near zero. Would workers return following the pandemic? Would rent be paid in the meantime?
For our portfolio, rent was generally paid. Delinquencies rose, but not dramatically. The tenants who weren't paying were often attempting to take advantage of the situation. This was a revealing situation and notes were taken and continue to be used in renewal probability assessments and in lease renewal discussions. The ones who couldn’t pay due to the circumstances surrounding the economy appeared to be a minority from what we could tell. Of those taking advantage, what I found particularly interesting is they were corporates with strong balance sheet positions as often as they were small operators. Think your lease with a large corporate carries better credit and warrants the lower yield? Any tenant is capable of non-performance. And unless you're very large yourself, good luck suing Starbucks to perform on their lease. Hopefully your reserves are deep enough to pay debt service, maintain solvency, and continue operations all the while the corporates enjoy their improved liquidity position at your expense.
While our existing lease book wasn’t hit as hard as we first feared during the onset of the pandemic, re-leasing was dead. I don't recall looking at any fresh deals during the first year of the pandemic. Duration fell dramatically. We encountered tenants looking to move within the market due to their existing landlord not willing to sign one-year deals. However, we're a spec operator. Our space for lease is fresh space. I'm not going to drop a new one-year deal on a spec suite where I don't stand to break even after the cost of the buildout. I'll take my risks with vacancy and wait for a recovery as opposed to taking the guaranteed loss. No reason to count on a renewal if the tenant is already shopping the market looking for a deal. These are highly mobile types that can harm your re-leasing assumptions if you allow too many through the door.
While we weren’t signing new deals with a single year of term, we did however sign short-term deals with existing tenants who had expirations during the pandemic. As much as I dislike one-year deals, I understood and appreciated their perspective that signing long-term deals in the face of so much uncertainty wasn't something many of our tenants could do. Because of this, our portfolio lease duration declined by more than a year. Meanwhile, our liabilities remained fixed. Poor duration matching can be a big problem in our industry. Fortunately, we have both high-quality debt and high-quality lenders in our corner. What affected us most was the elevated re-leasing costs when we emerged from the lockdowns.
Because our lease duration had shortened considerably, we had to work through a lot of renewals in a short span. Mostly, this meant leasing commissions. But concessions and downtime where also a drag on returns. Midway through 2023 and we're still rebuilding reserves for re-leasing costs. While this must have been a phenomenal period for the leasing broker, the expense hurt. In the long run, I think this may have done more harm than good to the leasing brokerage business. Leasing costs escalated from being a necessary evil to an unbearable cost. Leasing commissions were entering into nearly every conversation I had with peer operators.
After the Pandemic
We emerged from the pandemic, and we were told that the real estate market has been irrevocably altered. Was it? My assessment is yes, it's a different industry post-pandemic. But not because of the reasons that seem to be the dominant narrative. I don't see a world of office obsolescence. It's a provocative headline for a business news segment or article but it’s not what I'm seeing in my portfolio. Then how has the industry changed?
Spec Suites Lease
Leasing preferences changed in a big way post-pandemic. If you have shell space or tired buildouts from a previous tenant and you're waiting for a deal prior to completing a buildout, be prepared for serious downtime. I understand the fear a landlord may have of not wanting to spend money on a buildout that a prospective tenant may want to change. However, the tenants we're encountering aren't as interested in having a voice in the design. They want move-in ready space and they're expecting the landlord to put quality product into inventory.
Why the switch in preference to ready to lease space? I'm not convinced this is anything structural about the industry. I think the more likely contributor is a broader decline in attention spans. In the social media age where content is being served 30 seconds (or less) at a time, short-termism is become pervasive in all aspects of our society and culture. I see the change to spec suites as a reflection of this change within our broader society. I also see this benefit accruing disproportionately to landlord. Rather than having to manage the expectations of tenant improvements, the landlord is now able to build more efficient space and the leasing discussion is becoming a take it or leave it structure.
Big Space is a Waste
My portfolio isn't the largest the world has seen. My average suite size before the pandemic was around or below five thousand square feet, with the largest suites not exceeding the low tens-of-thousands of feet. We're seeing this continue to fall. Our inventory in highest demand consists of suites around two thousand feet. Generally, these spaces consist of a reception, an open area beyond for workspace, a kitchenette, all bordered by a handful of perimeter offices. When our larger suites come back to us, we break them up to conform to this trend.
Bad Narratives
Office isn't dead. For the sake of our economy, it can't be. In the globalized world, our goods and services are in competition with the rest of the world. With back-to-office rates in Asia soaring relative to the West, we can't afford the disadvantage of operating inefficiently. There's no doubt that working from home is more pleasant than commuting to an office. But production in a competitive world isn't about pleasure, it's about output.
This isn’t to say that employee satisfaction isn’t important. I believe it’s critical for all stakeholders, including employees, to be happy with their lot. But you won’t have employees to keep satisfied if global competition has driven you out of business.
Second, if I can hire a worker on a remote basis, why would I pay the premium high cost of living areas carry? If you can work anywhere in the country, the wages would fall to match the lowest cost living area. If you assume that the potential of an employee is indistinguishable between one located in San Francisco California or Jacksonville Florida, the employer should prefer the lower wage reflective of lower living costs.
On the bright side, perhaps this narrative will help with the incredibly high cost of living in California and New York. But the field of play isn't confined to the United States. If I'm indifferent amongst labor within United States by hiring remote, why wouldn't I be indifferent amongst global labor? The quality of digital connections these days is incredible. I routinely video chat with friends in Colombia and the quality is as if they're across town, rather than across the world. If remote is the standard, and corporations are not location dependent, the United States would bleed jobs, or the cost of labor would adjust downward towards lower cost areas globally.
What I find particularly interesting about the argument for or against work from home is that the advocates for both appear to be switched. Corporates, who should prefer, all things being equal, lower cost labor to higher cost labor are advocating for a return to office. Corporates should prefer to forgo the overhead cost of placing employees in office space. All the while, labor in high-cost areas should advocate for maintaining their in-office jobs, or their wages will decline. Is it possible that corporates believe their workforce is capable of greater efficiency in an in-office setting than at home? Otherwise, the presumption would be employers are so pleased by burdening their employees with in-office work that they’re willing to bear greater overhead. I doubt a profit motivated enterprise would take that position, even the most malicious among the group.
Next, the example that's often used to demonstrate office obsolescence is the vacancy rate in metro high rise. For these investments, I would be concerned to a degree. The willingness of the public to enter elevators seems to have declined following the pandemic. I increasingly encounter tenant conversations showing preference to walk-up and stairs to high-floor views. I get it. I don’t like elevators either. Especially waiting in the morning line to board the elevators up to your office.
That said, I see the problems with high rise also to do with the social issues of urban metros. Properties in the suburbs are easier to access, cleaner, and safer. People don't seem to want to lease office in downtown Los Angeles? People don't seem to want to visit cities with drug and homeless issues that pose a safety threat in general. Of course office properties in urban metros are going to show vacancy. Until local governments in the metros decide to do something about their substantial problems, I see the tower market deteriorating further.
Last, tenants of towers tend to be corporates who lease larger blocks of space. As I mentioned earlier, we see the average size of suites declining. It's not surprising to see vacancy in towers given their exposure to this. Our ten-thousand foot and larger suites are coming back to us, also. Towers have greater exposure, so the impact is going to be particularly acute.
Final Thoughts
The world has changed following the pandemic, and so has commercial real estate. No doubt about it. That said, I'm wary of popularized narratives that seem to have the purpose more to capture attention than communicate real developments. The changes that have appeared within my portfolio's sample seems to be more on type of space, not the obsolescence of office real estate altogether. Office will continue to be needed or we have bigger problems to deal with. People not in offices translates to people without jobs. The notion that you'll be able to work from the comfort of your own home is lunacy. There's nothing special about being an American or someone who lives in any other of the high-cost areas of the world. You're in competition with everyone else.