[co-author: Christopher Roeder]
With the pandemic shifting the use of traditional office space, there is much uncertainty as to what the future of development in this sector will look like. The panelists of the latest Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey are confident about the growth in demand for office space between 2020 and 2023, but they are pessimistic about the return on investment in new space today. Across the board, there is a wait-and-see sentiment in the office space market, and that portends a downturn in the rate of new development.
Office market industry leaders, Chris Roeder of JLL and Crystal Lofing of Allen Matkins, discuss what lies ahead for this sector of the California commercial real estate market.
1. Results from the recent Allen Matkins/UCLA Anderson Forecast California CRE Survey indicate office developers are taking a “wait-and-see” approach, despite a slight uptick in optimism from the Summer Survey. What types of office projects, if any, will move forward in the meantime?
Roeder: For the moment, we’ve seen an uptick in projects with entitlements take two tracks: The first is smaller developments (i.e. projects at approximately 50,000 square feet) are pursuing build-to-suit office buildings for mid-sized companies that want to control their own building, common area, etc. Whereas before, these companies would have considered a mid-sized or large block in a larger building. Some like the appeal of controlled access. These projects have lower capital exposure with a larger tenant pool.
The second track we’re seeing is a conversion and consideration of lab space. Our largest new lease was from VIR Biotechnology at The Exchange for 133,896 square feet. Lab space vacancy in San Francisco and the Peninsula stands at less than 3 percent with increasing demand. Of the 44 companies that went public in 2020 (excluding Special Purpose Acquisition Companies that have not completed a reverse merger), 21 were life science or health care companies. These life science and health care companies have a combined market cap of $34 billion. As successful life science companies expand, they will command more space. We know of at least two projects already considering redesigning their entitle office projects to lab space to accommodate this demand.
Note that some of our largest companies in the Bay Area are still moving forward with long-range development plans. It should also be noted that our top 50 companies continue to hire in the Bay Area; venture capital funding and IPOs were both close to, or at, all-time highs; and a tremendous amount of wealth creation is happening in the Bay Area. For example, the top 50 publicly traded companies in the Bay Area had more job postings in Q4 2020 than they did in Q4 2019.
Lofing: Notwithstanding the current “wait-and-see” approach that many office developers continue to take, superbly located, first-class office projects, whose target tenant base consists of large, well-capitalized tenants that are in industries poised for growth post-COVID, have proceeded with entitlement and construction in the meantime. There are also some office projects that may not meet those metrics exactly that had to proceed during the pandemic because construction was underway and it would have been more devastating, if not impossible, to halt construction. As tenants start returning to the office, there will ultimately be demand for new or redeveloped buildings and office space that incorporate updated technology as well as health and wellness standards that have come into tighter focus during the COVID-19 pandemic, such as state-of-the-art HVAC systems, higher standards for indoor air quality and use of fresh air, other infectious disease control measures such as the use of touchless technology, outdoor work spaces, and adjustments to optimal space design and floor layout for interior office spaces. In addition, although some developers may have hit the “pause” button on entitlements for certain office projects during the pandemic, given the lengthy entitlement timelines for commercial projects on the West Coast, a large number of office developers have continued to work on obtaining entitlements for their projects on the assumption that when they obtain their entitlements and thereafter their certificates of occupancy three, four, five years down the line, the office market and larger economy in general will be recovered from the effects of COVID-19.
2. At the beginning of the pandemic, it was clear that the use of office space, and need of square footage, would change for the unforeseeable future. Nearly a year later, how will landlords respond to these ongoing shifts in 2021 and beyond?
Roeder: There are still a lot of unknowns and there is a broad spectrum of how companies are reconsidering their office space needs post-pandemic. We have seen everything from companies with employees back in the office full-time (e.g. Netflix), to companies with employees working remotely and renting space on an as-needed basis (e.g. Dropbox). We do believe there is a lot of hyperbole in the news and that most companies understand the intrinsic value of serendipitous creation, building culture, and retaining intellectual property of the office. However, we do know that flex work environments (i.e. working in the office 2-3 days a week) will be more prevalent post-pandemic. We surveyed office employees and found that approximately 54 percent would like to spend between 1–3 days a week in the office. What people want and what people will do to remain relevant at work are two separate items, but we do know that flex work schedules are likely to increase noticeably post-pandemic. This could mean a more "hot desk" format in the future. Also, we are seeing some tenants consider the health of the buildings in selecting a space. As such, WELL-rated buildings, buildings that have robust HVAC systems that take in outside air, and other features that reduce the risk of exposure in indoor spaces will be worth more.
Lofing: Landlords will have to continue to be flexible and adaptable to public health guidelines, tenant needs with regard to the same, and potential changes in the business models of their tenant base that affect tenant space needs. Among other things, the pandemic has simultaneously accelerated the health and wellness trend and forced both landlords and tenants to re-examine how they were addressing health and wellness in their spaces. It is also forcing tenants to reconsider their business models and the amounts and locations of office space that will be needed to implement those updated business models. It is imperative for landlords to continue collecting as much data as possible, in order to understand their tenant base preferences and changing space needs, as well as what their peers are doing in terms of post-pandemic building improvements and amenities. The landlords that continually collect good data and constantly look for new ways to implement appropriate actions or update policies or management based on the same will be the most successful at retaining tenants and attracting new tenants post-COVID.
3. What are the silver linings for office owners, landlords, and developers in the work-from-home era? What are the biggest, perhaps obvious challenges they will face in the years ahead?
Roeder: Similar to other REITs and developer opinions, we are seeing a share of companies trend away from increasing employment densities in offices. This means gross densities at roughly 200 square feet per employee compared to 150 square feet per employee. We don’t forecast that reduction in densities will increase overall office space demand but it will help to counter some of the reduction in demand associated with fewer employees coming into the office. We also believe that companies that commit to office space will be able to innovate and pivot at a faster pace than those companies emphasizing a work-from-home model. We have already seen bi-furcation of demand where larger companies (e.g. Facebook, Amazon, and Netflix) have made more commitments to office space during the pandemic, whereas small and mid-sized companies have shed space or are reconsidering their space demand. If this trend continues, we would expect a larger share of our tenant demand to shift to larger requirements over small ones, with smaller tenants using flex work environments. We anticipate that more owners will include their own flex workspaces either operated by them, by a turnkey provider, or through one of the flex work operators. The successful small business operators provide organic demand that can fill the larger spaces in an owner’s portfolio.
Also, we expect that some businesses will choose a hub-and-spoke model where a share of their workforce will no longer commute to the office but work closer to home. This would result in more suburban office demand over time. While secondary and tertiary markets did not perform as well in the previous decade, these markets may perform better due to larger demographic (i.e. aging millennials) and socio-economic factors driving talent to the suburbs.
In terms of challenges, there are plenty. First, will be wooing workers back to the office and reconnecting them to their employer and their clients. This means highly amenitized spaces that embody the culture of the company. Second, is the perceived risk of public transit that dissuades returning to work, which will especially impact urban center business districts (CBDs). Transit agencies are working on this problem, but it is likely to remain a concern post-pandemic. Third, and most difficult, is to improve the quality of life in cities by reducing homelessness and other social issues facing our major cities. If we achieve this, we will more than regain our ground, as clusters of innovation fuel office demand into the indefinite future.
Lofing: There are several silver linings or potential silver linings for office owners and developers during the work-from-home era. As an initial matter, office owners and office developers were, generally speaking, significantly better capitalized going into the pandemic as compared to the Great Recession, and the debt markets, though paused for a few months, are functioning, albeit more cautiously than 10 months ago. The work-from-home era is still devastating, but office owners are better able to withstand this downturn as compared to the Great Recession because they were financially healthy to start. In addition, the initial government stimulus was passed incredibly quickly and was a huge boost to the economy, including programs enabling tenants to pay rent with government-provided funds, and the second government stimulus is in process of assisting individuals and businesses now, which will hopefully permit a large number of struggling businesses and persons to financially survive the winter surge of COVID-19. Well-capitalized office buyers are also hoping for opportunities to purchase distressed assets as we move further into 2021, which may come in more unusual packages than in the past, such as an opportunity to purchase a shopping mall and redevelop it for office or mixed-use. As far as challenges, office owners will continue to be challenged in implementing public health measures and responding to tenant space needs in the coming years, but both offer opportunities for landlords to digitize their buildings and systems and connect with their tenants, including more efficient communication platforms with their tenants. Also, it remains to be seen how durable and widespread work-from-home will continue to be once the government orders are lifted, and particularly what the effect of work-from-home on space needs will be and whether tenants ultimately de-densify their space, which could result in a net-neutral or even an increase in space needs.