How We Recover From The Office Real Estate Apocalypse
MyEListings' markets and economics editor and creates content about global macro events and their impact on US commercial real estate.
Recent economic upheaval has impacted US office properties, perhaps more than any other commercial asset class. This trend is largely owing to the remote work genie’s having left the bottle, and whose exit from said bottle was hastened by the Covid-19 pandemic. The base factors were in place already, but their effects were sped up, leaving primarily US suburbs and their class A minus to class C office buildings with unworkable vacancy rates, and numerous impediments to their reclassification. Here, we’ll explore the factors behind this circumstance and the solutions that could help to alleviate this pressure.
The Backdrop
Corporations, in many ways, represent an artifice we humans have constructed to lay over our evolved system of social cues and norms to better extend their functions for specific purposes. They began as formal arrangements to limit the liability of investors, which can be thought of as large nodes in a network. There were relatively few of these nodes, but they were an important fuel for new technology, namely blue water voyages. These voyages brought the luxuries of the east to the western world, namely tea, nutmeg, cinnamon, and pepper, at the time. The cost to finance these voyages had to be borne by a small few, as capital tends to be distributed abnormally in society. To get these few comfortable with investing large sums in the care of a captain and crew that may or may not make it back, these investors arranged with the captains to assign the risks of the voyage itself to the captain, leaving the investors with only the monetary risk.
Corporations Operate For The Benefit Of Shareholders, Not Stakeholders
By the 1600s, this mechanism had morphed into the joint stock corporation, where many investors could pool their resources into a legal entity sponsored by the monarch, and thus achieve the same end. The benefits of investing with limited risk were extended to more people.
These general forms and purposes have been refined, filtered, and codified in law in the ensuing centuries, keeping several vital distinctions, among them the notion that corporations are to be operated for the benefit of shareholders, as it is they who are most acutely at risk in the transaction and process. Not stakeholders, who may have tangential skin in the game arising out of circumstance, but shareholders, who expressly risk their capital to earn a return.
This distinction creates hyper-efficient corporate machines aimed at generating those returns by creating value that they sell to consumers who purchase voluntarily from a marketplace of competitors. Just as in biological systems, however, there appear to be scale limitations to this structural form, and these limits fluctuate with their environment. We are now experiencing a re-calibration of these limits.
The Problem
Corporations tend to function as centralized hierarchies. There’s a chain of command, seniority, rank, etc. This structure is very efficient at maintaining the perception, if not the effect of control by corporate boards, and it tends to repeat itself at smaller scales, down to the office itself.
Offices as centralized places to gather for work are a relatively new concept in human evolution, but one the working public adapted to easily once supported by the relevant enabling technologies, such as the automobile and public transportation. They became entrenched in our culture, and as such, changes to this structure have been resisted, likely out of fear of losing control; but as anyone who understands psychology at any depth will tell you, control is an illusion.
The Covid 19 pandemic managed to force the issue. Companies were compelled to implement existing technology on the fly to allow employees to work from home while remaining in virtual contact with the office. Much to many people’s surprise, employee productivity increased considerably, due in large part to their lack of commute time, office small talk, and other little-recognized time sinks that are endemic to a centralized location. The costs are relatively few, and simpler to navigate. The remote genie has thus rocketed out of the bottle, and if there’s one thing that drives Americans above all else, it is the drive to maintain the high water mark for earned luxuries.
The Problem Of Valuation
Commercial properties are valued primarily as a function of their cash flow, so a property that leases for more will have a higher valuation, all else being equal, and vice-versa. A working paper authored by researchers at Columbia University and NYU that studied New York City commercial properties found that those properties declined in value by about a third; but according to one of the paper’s authors, this could be extrapolated to the rest of the country and augmented if the remote revolution does not reverse. “Imagine thinking about a path where the world remains in this predominantly hybrid or remote work environment that we’re currently in for the next 10 years,” one of the researchers, Stijn Van Nieuwerburgh, said. “Then the decline is larger—it’s 38% instead of 28%.”
Companies looking to re-centralize their work policies in the coming years are often waiting out that possibility by negotiating shorter leases, often one year or less, according to Van Nieuwerburg. In fact, corporate leases of one year or less increased in 2020 to 26% from 15% in 2019, and to 31% in 2021, according to Moody’s Analytics. But these companies could be holding on to a rope that’s about to break. Indeed, there’s a substantial risk these lower-tier office buildings that comprise the bulk of the category in the US could become a stranded asset class in the future.
The Real Problem of Valuation
When office buildings become less valuable, they produce less tax revenue for local and state governments, and this can affect the ability of these governments to adapt and continue to render expected services. There is, therefore, a very poignant and urgent impetus for governments to enable the repurposing of these buildings by investors, in the shortest possible order. But there’s the rub; governments are not structured to be nimble or to shift on the fly. They are layered with many strata of bureaucrats without the organizational, motivational, or hiring talent of private corporations. And this is the bottleneck of the problem.
Institutional investors, moreover, have systematically shifted resources to commercial real estate since 2008, as well. This suggests that pensions in some not-insignificant measures depend on their values, and office properties make up the bulk of US commercial inventory. This points to a certain amount of urgency to act, as both financial markets’ stability and government performance are implicated in any worsening of the situation.
The Solution
The solution to this conundrum likely involves expediting developers’ and investors’ ability to repurpose these aging structures. Many of them lie in popular residential areas, suggesting mixed-use or residential development could be elegant solutions; the problem remains, however, that governments must act to facilitate changes to zoning, land use policies, and ad-hoc legal curbs, and they must do so quickly. “Quickly,” however, isn’t something governments are known to do well. The machinery of government turns slowly.
Conclusion
Top-level office spaces have benefited from a flight to quality during the pandemic, and have not experienced the same levels of demand destruction as their lower-quality competitors. Class A-, B, and C properties have been hit hard with vacancies, and these are not likely to return, therefore these buildings must be repurposed to conform to the principle of highest and best use. Localities with the best solutions to working with investors and developers to create new spaces demanded by their respective communities stand to gain the most from this circumstance. In a future piece, we’ll explore more deeply what governments are doing to streamline these processes and get creative destruction to full swing.
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