Even as the Coronavirus pandemic begins to dissipate slowly in major market CBD’s, the concern of a “third wave” has now captured the attention of mainstream media stoking more fear and concern into the already inflamed passions of anyone who was working inside an office building Pre-Covid. How will the “new normal” look for working in an office building post Covid? Is your commercial building able to meet the evolving needs of workers and demands of tenants? To make matters worse, office buildings now have a new competitor called work from home (“WFH”). By some estimates this phenomenon reduced office space demand by as much as 20%. It remains to be seen how sustainable the new WFH culture is, but what is certain is that the demands of office workers for a healthy, purposeful, safe and comfortable work environment that is seamlessly accommodating to the mobile worker is not negotiable. So, office property owners must ask themselves, “Does my office building satisfy these new demands? Does it enhance performance, promote collaboration and cultivate the culture of the company? Or, is it functionally obsolete?”
I recently read the article, “The Hybrid Office: Merging the Physical and Digital Worlds” where CBRE presents a clear challenge to office property owners, “perfect or perish” the integration of the physical world with the digital world. Office as a Service (“OaaS”) is rapidly becoming the new post Covid model. The challenge for owners of commercial office will be how to achieve the objective of “perfecting property performance” as a service efficiently and economically. Sadly, over 90% of office properties in the country are more than 30 years old and likely, functionally obsolete to meet the demands of the post Covid tenant. Even many of the office buildings constructed in the last 5-10 years are going to need significant modernization to be competitive.
Modernizing older obsolete office buildings is a very challenging and expensive proposition, made worse by the nature of the capital structures. Unfortunately, unless the equity and debt are in alignment on what steps to take and the tenants cooperate, many buildings are in danger of becoming “zombie” buildings, where the equity has evaporated and the lender is unwilling or even incapable of infusing the capital needed to modernize the property. This was frequently the case after the GFC, but the difference in that environment was that most of the buildings needed modest infrastructure work. Their components were not significantly compromised. Most of the costs to resuscitate the properties were for tenant improvements to accelerate leasing and create a sustainable net operating income to refinance the asset.
Covid has created a much different challenge. The physical plant has been significantly compromised by the new demand requirements and protocols of tenants. The business models supporting the capital structures of most non-institutionally owned commercial properties were not designed to accommodate a large infusion of new capital to modernize them after that have already been repositioned and upgraded. Faced with the prospect of the need for a large capital infusion, the equity (ownership) must determine whether it can or has the desire to potentially “throw good money after bad” or walk away. Lenders have neither the money, personnel, nor desire to execute extreme makeovers. Unfortunately, in many cases, the economic model will not be supportive, and the only solution will be foreclosure or a deed in lieu so the lender can salvage what they can by selling the property. Those ownership structures that are well capitalized (most REITs and institutional owners) should weather the Covid pandemic reasonably well. The outlook for the smaller, privately held properties with tight capital structures is far less sanguine.
In general, the recapitalization process works fine when the impacted property is an outlier and prospective buyers can readily determine market demand. When the problem is endemic and tenant demand (rent, occupancy, term) is undiscernible, there is no clear visibility to value. This creates paralysis with lenders (and prospective buyers) as they neither know what the value of the collateral is nor what their liabilities may be. Commercial real estate is an ecosystem dependent on a transparent valuation algorithm that is fundamentally based upon user demand. A property is only worth what a user is willing to pay to rent or use it. When value discovery is compromised, it is very hard to develop a reliable repositioning strategy without starting from a very low basis. Hence, we are seeing the “Covid discount” of 20%-25% popping up everywhere. This is currently playing out in most CBD’s across the country. A recent example is a 200,000 square foot office building in a tier two CBD witnessing substantial growth where pre Covid it was worth x (barely the level of the debt) and post Covid now x-20%. The effective occupancy is 60% to 65%. It is running at a loss after debt. The property needs a $17,000,000 (25% to 35% of value) capital infusion to upgrade HVAC systems, lobbies, elevators and provide a robust tenant improvement package to drive post Covid occupancy. There is no equity in the building and the debt is looking at a significant loss of 20%. The building has become a zombie building. The lender is paralyzed by the stunning and sudden loss in value. Failing to act quickly is causing the building value (and debt) to decline daily.
As the Covid wildfire blazes through commercial real estate, wreaking havoc and destruction upon the ecosystem, tenants will run for cover using every means possible to reduce their rent. Owners and lenders, paralyzed by disbelief sit patiently, hoping demand returns and brings fresh growth to the market. The problem with this strategy is that it ignores the problem. If the building is functionally obsolete, and most are, you have to fix the problem to reestablish a value proposition. Neither ownership, nor the lender have any incentive to infuse the capital required to fix the problem. The building must be recapitalized. The only way to do this is to recapitalize with new equity at a different price point. As shown above, waiting will only exacerbate the problem as current tenants roll and downsize or look for ways to terminate their leases. In an office property that is not performing its operational responsibilities, most leases allow for termination by the tenant.
“Perfecting property performance” in the post Covid world requires thoughtful analysis of the property and functionality of the user experience overlaid against the practical application of building modifications and operational changes and protocols that can elevate said experience. Whether through direct investment or advising our clients, the mission of Corion Enterprises is to modernize the built world by providing a healthy, comfortable and purposeful lifestyle environment.
We learned a lot from helping lenders and owners workout property challenges after the GFC. In every single case, allowing the building to become a zombie asset only exacerbated the problem. Fix the property level issues and fix them fast. Cycle the capital stack and cycle it fast so the property solutions can be implemented quickly. Only then will the custodians of the capital structures (owners, investors and lenders) have visibility to property value and be able to begin the process of rebirth.
Until then, your office building may be obsolete.