Evolution is not a gradual process, and it is not the strong that necessarily survive. It is the most adaptable that survive. Mankind is the ultimate alpha predator of the earth because he is the most adaptable due mainly to his large brain. The recent Covid pandemic is case in point. Years ago, Covid would have likely killed hundreds of millions rather than the 6,809,882 last reported as of 3/10/23 (worldometers.info). We humans quickly adapted, changed our habits, and invented a vaccine in an incredibly short amount of time. All of which saved many millions of lives.
Covid not only physically affected human health, it also affected human interaction. The way humans live, work, and play and the integration of these have irrevocably changed in many ways. However, the “behavioral experiment” of the Covid pandemic accelerated trends that were already evolving. Aided by relentless innovations in technology, human interfacing, logistics, communications, transportation, entertainment, and living arrangements have been profoundly impacted and now become habit as we come up on the Covid three-year anniversary.
Building shelter is the world’s oldest profession. One challenge with modern real estate is its physical permanence. “Built to last” generally inhibits “built to adapt”. Since we know that being adaptable is the secret to sustainability, towering office buildings built to impress and to last for centuries physically, are not necessarily built to adapt to a new way of work. Peter Drucker, the legendary Harvard Business School business management guru declared in 1989 that commuting to the office was dead. His prescience may have been a few decades premature, but no less accurate. It required many years of technological gestation and became manifested by Covid. So, now it is up to mankind, with its large brain, to adapt to the new paradigm that office is where it needs to be, not where someone wants it to be.
Sitting in traffic to drive to a beehive that is no more productive than a home office or a local co-working location is not empowering, purposeful or productive. The rationalization by employers that socialization promotes innovation and creativity is tenuous at best and in any case is counterintuitive to task performance as time at the kitchen or lunchroom is rarely productive to task performance. The smart employer is rethinking this relationship and coming to the conclusion that the 5 day work week is dead. This means at least a 20%, if not 40% reduction in space needs. In addition, the needed space will need to be experiential, purposeful, and highly functional. It will not be the same old office “factory” space.
Owners and lenders of office must act now to determine if the space where their capital is deployed is still relevant or can be fixed up to be relevant once again. Can it be a destination where employees want to go because it is comfortable (productive), accessible (purposeful), safe and engaging, or does it need to be something else. The empirical study by Cushman Wakefield (read here)suggests that as much as 1.4 Billion Square feet of office space will be functionally obsolete by 2030. Frankly, that prediction could happen much sooner. Smart money aways thinks ahead. One major international office developer based in Dallas who understands the purpose of office space has established an Experience University to help it cultivate the service delivery model of its office space to be a highly relevant hospitality-like experience. If you are a custodian of capital with investments in office space in danger of becoming functionally obsolete, time is your enemy and hope is rarely an effective business strategy. The underlying premise of a cap rate is sustainability of income. If that assumption is proven false, cap rates, as a prognosticator of value, become useless and die as if hit by an Extinction Level Event (ELE). The only semi reliable valuation model becomes repurpose or repositioning cost, which can cost over $200 psf. Repurposing office into multi-family for example will require a 50% to 75% destruction of value in the office building.
Multiply that by 1.4 Billion sf of office at an average value of $300 psf (which is very low) amounts to about $336 Billion. And this does not even count the negative cash flow that many of these buildings are currently experiencing. The longer the capital waits to face the scary truth, the worse the situation gets. So what do you do? Harkening back to our post of almost a year ago, the custodians need to triage immediately:
Q V will thrive: Hold and retain and keep in top shape. Flight to quality will sustain NOI.
Q IV can survive: Hold and improve to best in class economically. Cut costs, cut rents and manage negative cash flow until market recovers.
Q III has a place: Recapitalize or sell. Needs major equity infusion. May need to shutter to minimize costs until market rebounds.
Q II is a zombie: Sell immediately or recapitalize. Economics do not support pouring good money after bad.
Q I are functionally dead: Sell immediately to be transformed into something else; likely multi-family.
We are already seeing many cases where owners have handed keys back to banks or simply stopped paying debt service. Whether they foreclose or not, lenders now own / control all QI-QIII, properties and many QIV properties. It’s already too late to save any equity positions. For these properties to survive, they will have to be sold quickly at valuations that will cause losses to the debt holders. That is inevitable, but necessary. The debt capital will need to act fast to mitigate the losses to 70%-90%. The debt then can be redeployed into more productive assets at recapitalized valuations and stronger business models.
A disease like Covid is part of nature. It promulgates natural selection. Either the body fights it off and survives or you need to create a vaccine to inject into the host to give it a chance to survive. Covid (ELE) has infected all commercial office space. The vaccine to stave off ELE is fresh equity capital. Without it, the strong and adaptable assets may still survive, but the weaker ones will not. The only way to inoculate them with an injection of equity is by selling or recapitalizing them. The longer one waits to deliver this equity vaccine, the more likely that host (office building) will become a zombie building and die an ugly death. The sooner the custodians of capital face the ugly truth and act, the sooner the pain can turn to gain.
ELE is here. Equity is the vaccine. The vaccine is in abundant supply and ready to deploy, but it must be administered quickly to Impact Alpha.