Investing in Office Real Estate
This learning series on Modern Commercial Real Estate Investing first appeared on the EquityMultiple blog. Please check in there for updates and additions to this series.
The office building asset class is one of the four major commercial real estate asset classes, alongside multifamily, retail, and industrial. Office buildings can range from high-rise multi-tenant structures in urban cores to suburban office parks to exurban single-tenant buildings that might be built to suit a specific lessee.
This article addresses some unique facets of the office real estate asset class. Like other major commercial real estate asset classes, office is being rapidly transformed by technology and shifting tenant preferences.
Current Trends Shaping Demand for Office Space
Co-Working & Remote Work
The last several years has seen the “co-working” model enter the mainstream. WeWork — the household name in the space — manages over 10 million square feet of office space as of this writing. Meanwhile, copycat startups have sprung up in cities across the country, offering curated, open floor plan office space, ultra-flexible leases; and built-in community and events. Rather than dying off entirely, it now seems likely that traditional offices and office leases will yield part of the floor to remote work, co-working spaces, and more flexible leasing models. A growing set of companies (even tech behemoths like Amazon and Microsoft) now supplement corporate campuses with co-working leases, allowing for penetration of new labor markets and the provision of premium workplace amenities and in-person collaboration for employees that would otherwise be full-time remote.
Not long ago, the ascent of communication and collaboration technology had some pundits calling for the end of the office as we know it. The “digital nomad” revolution has only partly come to fruition — the share of knowledge workers who work remotely 4 or 5 days a week rose from 24% in 2012 to 31% in 2016. While the remote workforce is likely to continue growing, it is unlikely that remote work arrangements will render the physical office obsolete. Though video conferencing technology has improved dramatically, teams report greater feelings of engagement with their work and colleagues when they work together in person at least some of the time. Humans are social creatures and will continue to require some degree of face-to-face collaboration.
Many institutional investors are prioritizing investment in new office space models such as co-working space, seeking to diversify away from the traditional office model and invest in spaces that appeal to today’s knowledge workers and offer more flexible leasing arrangements. Co-working is also prompting some confluence of CRE asset classes, as some multifamily and hotel operators are using co-working space as an amenity to attract and retain new residents or guests, and to further their brand.
Suburban vs. CBD
Investors often divide office markets into suburban vs. “central business district”. Traditionally, the viability of urban office locations has depended heavily on access to public transit, whereas parking ratios are critical for suburban locations. This dynamic has been complicated somewhat by recent trends in office employee preference and lifestyle. The “urbanization of the suburbs” that is affecting multifamily and retail sectors has also impacted office. While parking ratios still matter, access to public transit, dining options, and a walkable retail core have become more important for suburban office investors and developers.
Particularly in an economy at full employment, the location preferences of employees (the “sellers” in the labor market) must be heeded by employers, and thus must also be considered by office investors.
Office Space as Reflection of a Tenant’s Brand
Gone are the days when employers could reliably fill cubicles with talented employees without regard for the aesthetic and ambiance of the space. Fictional works like Dilbert, Office Space, and The Office formed a lasting cultural zeitgeist in which knowledge workers are leery of sterile, stifling office space. Social media and employer review platforms like Glassdoor make it much easier for employees to scrutinize or laud the physical space that employers provide, and companies are increasingly viewing their physical space as a tool to recruit and retain talent. Many companies — particularly in creative sectors — now view their office space as a component of their corporate brand.
Hence, forward-looking office investors and developers will seek to provide a higher degree of customization to tenants, allowing occupants to mold the physical space to appeal to today’s creative workforce.
How are Office Rents Determined?
Per-square-foot rents typically vary across units within a single office property, with owners charging premium rents for corner offices, higher floors, access to elevators, showers, or other amenities.
Tenants often demand special features in the leases, including signage rights, rights of first refusal to rent contiguous space (especially for fast-growing startups), parking space entitlement, or even building purchase options.
Office property leases are typically longer-dated than multifamily leases, and rents may lag prevailing market lease rates in the latter stages of any given lease. Hence, “step-ups” of rental rates are common when leases expire.
Skilled office building operators will offer a suite of amenities to align with the preferences of their target tenant(s), thereby facilitating a rapid lease-up period, while keeping cost in line with pro forma targets.
The Risks of Investing in Office Buildings
Office leases tend to be longer-dated than multifamily leases, and even retail leases. This helps to mitigate vacancy risk for investors. Nevertheless, the office asset class does carry a set of unique risks.
Economic downturns can impact the office sector more rapidly and more severely than multifamily. While residents will continue to need housing in an economic crisis, a downturn can stanch the expansion plans of businesses, prompt layoffs, or cause businesses to close altogether — thereby adversely impacting demand for office space.
The credit-worthiness of tenants is also a key consideration for office investors. Office operators therefore examine the solvency and overall health of the businesses seeking to rent their available space. Well-capitalized national or multinational firms are most desirable as office investors consider their lease-up strategy.
Small office buildings, with just one or two tenants, are more prone to vacancy risk, as one broken lease can leave a high proportion of the rentable square footage empty. Investing in well-located, diversely tenanted buildings can help to mitigate vacancy risk.
Demand Drivers for Office Real Estate
While multifamily investors can look first and foremost at demographic trends, office investors must also take a close look at trends in job growth and employment. Historically, positive absorption in the office sector closely aligns with employment growth.
In a growing economy, office investors can look to particular sectors of the economy that are expanding and will hence require additional office space. For example, the tech sector has been responsible for 20% of major office leasing activity in the past few years, and the sector is still expanding at roughly twice the rate of the overall economy.
Successful investors will also take into account shifting preferences among potential tenants and their employees (see the section above on trends in the office sector). Forward-thinking investors and developers will seek to add amenities that will resonate with millennial and Gen Z knowledge workers, such as bike lockers; hip, modern common areas; ground-floor mixed-use space; and proximity to transit and recreational opportunities.
While the U.S. economy has exhibited broad strength in recent years, specific sectors are likely to drive office markets in the coming years. The technology sector, for example, is now a key driver of office demand; CBRE reports that the technology sector has been responsible for nearly 20% of major office leasing activity in recent years.
This particularly benefits markets like the San Francisco Bay Area and Seattle, but the trend also aids emerging, lower-cost tech hubs like Salt Lake City-Orem-Provo, Charlotte, and Phoenix. The tech sector is expanding at about twice the rate of overall economy, despite having slowed during the past few years.
Predictions for the Office Sector in 2019 and Beyond
The U.S. economy continues its record streak of positive job growth. With historically low unemployment and a generally healthy economy, office developers continue to build speculatively in many markets. According to CBRE, office net absorption is expected to reach 37M square feet in 2019, the sector’s 10th consecutive year of positive absorption. Many pundits expect job growth to moderate. Combined with new supply coming online, this could dampen demand for office space in certain markets.
However, with a broadly strong economy, low unemployment, new aesthetic considerations to drive design innovation, and robust in-migration of younger knowledge workers to secondary and tertiary markets across the U.S., office investors should be able to find plenty of opportunities for yield in the foreseeable future.
The Bottom Line: Takeaways for Individual Investors
Seek investments alongside sponsors that are both experienced and forward-thinking: as with other major CRE asset classes, technology is impacting office in profound and lasting ways. Class A operators must offer amenities and floor plans to best align with the brand considerations of potential tenants. In certain markets, office investors and operators must consider the demands of a growing remote workforce, and consider co-working and flexible lease considerations alongside traditional leasing models.
Examine leasing structure and plan: Particularly at or near the top of the cycle (where we may be, as of this writing), the credit-worthiness of tenants and the length of leases are key considerations when assessing potential risk. Co-working and flexible lease models may help mitigate risk going forward.
The Suburbs Aren’t Dead, Just Different: Suburban office markets across the country may benefit from lower levels of construction activity (and competition), and benefit from a growing crop of employers and knowledge workers seeking a better deal outside urban cores. Suburbs are not uniform, however; while transit access is still key to suburban office investing, many prospective suburban office tenants now require an experience that goes beyond the “cubicle farms” of yore.
