If you were at ULI last week, you probably felt that the mood was universally gloomy in general about the machinery of transacting commercial real estate grinding to a halt as no one wants to catch a “falling knife”. The knives were falling for every product type as rapidly rising interest rates and stubbornly persistent inflation are making it very difficult, if not impossible, to determine when the knives are going to hit bottom. The disconnect between investors acquisition valuation models and their AUM valuation models is widening. This is common when the economy is buffeted by major headwinds. It seems to be less of an issue when the wind is at their backs, although maybe it should be, as buying at the peak can often be a lot more costly than buying before a bottom.
Most of the doom and gloom today centers around office space, specifically, older Class A CBD office and Class B & C office in general. The same malaise that happened (is happening) to Class B & C malls throughout America is now happening to Class B & C office; especially those in CBDs that have to compete with newer Class A office buildings. The rush to quality by tenants exacerbated by Covid, combined with resizing their footprints due to pressure from the WFH movement is accelerating the decline in value for these assets. This phenomenon is well documented 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 older office properties. With rising costs and interest rates, it now costs at least $150 psf for new tenants and $50 -$75 psf for renewals, exclusive of tenant specific infrastructure. It also fails to consider the pending SEC regulations that will mandate ESG modifications that could significantly drive up ownership costs. Older office is simply functionally obsolete and in vast over supply – not unlike class B & C malls have been for the past decade. Just as with stick & bricks retail, the demise of which has been vastly overblown, office has firmly moved away from the concept of providing office workers with space to providing them with an experience. The good retailers have figured this out and are making significant changes to their assets to entice customers to visit as an experience. This was going on well before Covid. There was (is) way too much retail that is not experiential and purposeful. It is rapidly disappearing. Older CBD office and most Class B & C office faces the same fate. There is way too much office that does not deliver a comfortable, accessible, safe and engaging (“C.A.S.E.”) experience. So, what does the CASE look like for the future of office in the new WFH world?
Comfortable: Tenants need to feel that they can be 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. The office of the future will be mobile, flexible and locationally adaptable.
Safe: People hate the CBDs because of crime. They fear for their safety. The office of the future will be very secure, surveillance and security will be omnipresent. There will be no privacy, but there will be safety and security.
Engaging: The office of the future will be 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 new product being built is making a very strong CASE for the tenant of the future. The problem with fixing / repurposing the older Class A CBD and Class A & B office is market pricing; and hence the recapitalization necessary to transform those properties that can be transformed lies is impeded by the “Lag Effect” in valuing assets held by private capital investors and fund custodians. Unlike the public markets, which value publicly traded companies like REITs on a daily basis, privately held AUM are only valued quarterly and then only based on appraisals, which rely on comps and transactional datapoints. But, when there are strong transactional headwinds due to exigent circumstances inhibiting price discovery, like rapidly rising interest rates, generationally high inflation and evolutionary demand that is still finding its way, there are few, if any, reliable comps and datapoints to complete a meaningful appraisal. This causes valuation “Lag” and “Analysis Paralysis”, which only becomes worse with time as private capital investors, out of the money sponsors, and odyssey fund managers (‘Private Capital”) who get paid fees based on AUM are not particularly wild about marking to market. While marking to market is painful, it is necessary if these assets are to become useful again. Not doing so results in an inefficient use of resources and misallocation of capital.
Over the past 15 – 20 years, office utilization, went from about 250 square feet per person to 75-100 feet pre-covid. That contraction of over 50% had the same impact as doubling the supply of office, notwithstanding all of the construction that took place during that period. Post-Covid, this densification is now reversing back. It is unclear where it will settle, but utilization has forever changed by WFH. Covid has accelerated the evaluation of true office utilization. Pre-Covid it was only about 70%-75%. Post-Covid it is about 35%-40%. Card swipes showing higher utilization are not a substitute for real occupancy. Let’s say you have 100,000 SF leased, of which 40% is being used. Then de-densify by 50% and you feel that 60,000 sf is necessary, but maybe only 3 days a week. Tenants are running their own utilization models and evaluating their employee needs for collaboration and personal growth with productivity benefits of no commute and more efficient use of time. We believe the result will be a 20% to 40% drop in space requirements. With many CBD office markets already at vacancy rates around 20%, there may be an oversupply of 40%-50% of office space in many CBDs (and even suburban office). Accordingly, it is very likely that valuations of older office properties are more likely to drop by 35% to 50%. Such a precipitous drop is already happening in some market like Los Angeles, Dallas and NYC. It will accelerate.
Is reliance on a systematically flawed system of valuing assets based on appraisals to value AUM properly serving the investment community? Just as the lending community has moved away from LIOBOR to SOFR, maybe it’s time to move to a new AUM value model to enable investors to objectively report changes in AUM values and better navigate investment strategies through turbulent times. The public markets seem to have no problem pricing public real estate enterprise quickly and efficiently, although it does promote an emotional “sky is falling!” bias that sometimes unfairly punishes and rewards executives of public companies due to exigent circumstances beyond their control which ultimately have little impact on value. Private Capital has the opposite problem with the “Lag Effect” is that perpetuates the “emperor has no clothes” ruse, which is a disservice to disclosure transparency and inhibits timely decision making to efficiently allocate capital. It hides the truth behind a curtain of protocols and processes that mandate reliance on outdated and ineffective valuation tools. In both cases, the valuation models inhibit market price discovery and lead to an inefficient allocation of capital.
Is there a better way to more efficiently and accurately value properties? What if there was a reliable valuation model for each type of asset with input variables updated daily, or even hourly in some cases? With a disciplined approach that could be tested and refined regularly, a property market price model for each product type and submarket could be developed to produce highly accurate and timely market valuation results. If the SEC is about to establish ESG reporting guidelines for companies, tenants and buildings, why can’t it do the same for property valuations? Corion has developed a proprietary property market pricing model (“PMPM”). Our team has performed hundreds of them for investors and lenders for all types of properties. Our PMPM is fast, highly accurate, scalable, and applicable to different property types, classes and submarkets. It can be used for single asset and portfolio valuation to help with sales transactions and financing. If you are wondering what your property is worth to help you sell, purchase, financing or want to implement an operational strategy to make CASE for your office (retail or industrial) property, please reach out to us to see how we can help.
Don’t let the Lag Effect keep you from making a CASE to Impact Alpha for your office property.