The machinery of the commercial real estate industry has a long history of quickly producing product when there is great demand for it, maybe too good. It’s not so good about correcting an imbalance when there is too much supply. The strong demand headwinds whipped up by pandemic induced changes in user behavior and exacerbated by rampant inflation and rapidly rising interest rates, have made it extremely challenging to underwrite future operating performance for several types of properties.
Perhaps the most profoundly impacted in the post Covid era are older Class B & C office, particularly those located in the CBD in gateway cities. Office space use and office building design has evolved considerably over the past 100 years. We could label those built from 1920’s to 1930 (before air conditioning) as “Office 1.0.” Those built post WWII in the 1940’s and 1950’s (with air conditioning) would be “Office 2.0.” Those built in the 1960’s and 1970’s (with fast elevators and cool lobbies) would be “Office 3.0.” And, finally, those built in the 1980’s and 1990’s (with advanced curtainwall designs and innovative operating systems) would be “Office 4.0.” Virtually all of Office 1.0 & Office 2.0, with a few notable exceptions, are no longer used as office, if they still exist. Only about 30%-40% of Office 3.0 is still utilized as office. Now Office 4.0 is facing the same fate as its predecessors, only this time, the transformation to the "next generation" WFH hybrid workplace model ("Office "NextGen”) will be faster and more dramatic than ever before.
WFH has been around for a long time, but it was never the base case. Covid accelerated WFH Office NextGen as the workplace model of the future. It forced a change in behavior of the office user and that change has become a habit. Office space utilization has stagnated at less than 50% in all but a few submarkets and only 35% in some submarkets. Technology and the mobile workplace make many workers more productive by not coming to the office. The intrinsic value of avoiding a lengthy commute a few days a week and avoiding the increased crime and homelessness of the CBD make for a very compelling case for the Office NextGen model.
On top of this, real effective office rents (after TI’s, free rent, and other concessions) have not changed much in the past 30 years. It is not a far stretch to conclude that the net result will be a 20% to 40% drop in space demand. With many CBD office markets already at vacancy rates over 20% and utilization of the leased space at 30% to 40%, tenants are reducing their footprints everywhere upon renewal, making it almost impossible to qualify sustainable net operating income for a property. This contraction in demand may result in an oversupply of 40%-50% in many submarkets.
When you add on the combined impacts of inflation, increasing operating costs, and interest rates, dramatically increasing the costs of debt, the pressure on Office 4.0 values intensifies. This phenomenon is emperically documented the attached white paper and the in the WSJ article: Rising Interest Rates Threaten to Expose Office Buildings’ Inflated Values. While directionally accurate, it is likely that the estimation of a value correction of 20% in this article is far too low. It fails to consider the extensive capital costs to lease and release Office 4.0. It also fails to consider the pending SEC regulations that will mandate ESG modifications that could significantly drive-up ownership costs. The NBER white paper appears to be more accurate and in line with our thinking of a 40%-50% decline in the value of Office 4.0. Some may be reduced to land value or be transformed into other uses as happened to Office 1.0, 2.0 and 3.0. Such a precipitous drop is already happening in some markets like Los Angeles, Dallas, and NYC. If history is a guide, this trend will accelerate. We believe the office space sector is on the precipice of a massive destruction of value. This office apocalypse will be much worse than that after the GFC, which was a liquidity problem, because it is caused by a destruction in demand and a fundamental redirection of utility. In anticipation of getting out in front of this value calamity, many institutional owners are looking to exit Office 4.0 to preserve equity, while some lenders are offloading debt to mitigate writeoffs.
Simply put, like its predessessors, Office 4.0 is rapidly becoming obsolete.
So, what will the next generation of office need to be? Office NextGen will be a place where you want to go – not have to go. Says, the CEO of one major architectural firm: “A destination, not an obligation”. To become a destination, Office NextGen must deliver a comfortable, accessible, safe and engaging (“C.A.S.E.”) experience. What goes into making the CASE for Office NextGen?
Comfortable: Office NextGen tenants will need to feel that they can be highly purposeful and productive. This includes providing a variety of work environments that enhance collaboration and communication while achieving the highest standards of ESG and EDI best practices.
Accessible: Long uncomfortable commutes, poor parking, barriers to utilization are deterrents. Office NextGen will be mobile, flexible and locationally adaptable to tasks and user needs on demand. Technology will play a major role in connecting, communicating, engaging and tracking utility and performance.
Safe: People hate the CBDs because of crime and homelessness and the sheer hassle of parking and taking care of daily needs. Office NextGen will be very safe and secure. Surveillance and security will be omnipresent, with privacy a caualty to the monitoring and tracking of every movement.
Engaging: Office NextGen will provide what you cannot get from home. Energy, collaboration, human engagement, fun, purpose, fulfillment and more. It will be a place where you want to be, not have to be.
The path is clear and the reset is coming. Making a CASE for transforming Office 4.0 into Office NextGen will become critically important to Impact Alpha. The successful implementation of this reboot will require a reliable valuation model for multiple transformational strategies that will enable new equity to make a strong CASE for the new or repositioned Office NextGen use. Corion has developed its own, very successful proprietary property market pricing model (“PMPM”). It is fast, highly accurate, scalable, and applicable to almost all asset classes and particularly to Office 4.0. Our team has performed hundreds of them for investors and lenders. If you are wondering what your Office 4.0 property (or any property) is worth to help you sell, finance or implement an operational strategy to make a CASE that will attract capital, please reach out to us to see how we can help.
Corion can help you make a C.A.S.E. to Impact Alpha for your property”