[co-author: Kevin Shannon]
Given the continuing pandemic, there is much uncertainty about how the experience of working from home will affect today’s office space market. The panelists' of the latest Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey shared sentiment is about as gloomy as it was in December 2008, during the height of an implosion of economic activity. They see rising vacancy rates and downward pressure on rents over the next three years. This is consistent with the UCLA Anderson Forecast’s projection that a rapid return to pre-recession, office-using employment is not likely.
The implication of the drop in sentiment is, as in 2008, a continued decrease in new office construction over the ensuing three years. Although, half of the Bay Area and Southern California panelists said their plans for the coming 12 months were unaffected by the pandemic, one third are ramping back development by more than 15 percent from their previous plans. For the third that will engage in some new development, the panelists in each market believed that land, building materials, and labor costs would be more favorable. Given the uncertainty about office space demand, these responses seem reasonable and indicate growth in development beginning in late 2021 and a slow return to pre-recession levels.
Office market industry leaders, Kevin Shannon of Newmark Knight Frank and Julie Hoffman of Allen Matkins, discuss what lies ahead for this sector of the California commercial real estate market.
1. WILL THE DEMAND FOR OFFICE SPACE CHANGE, SHORT TERM AND/OR LONG TERM, NOW THAT MORE PEOPLE ARE WORKING FROM HOME DUE TO THE PANDEMIC? HOW WILL LANDLORDS AND DEVELOPERS ADJUST TO THESE CHANGES?
Shannon: There is clearly tension between the need for greater social distancing in the office which could require approximately 5 to 20 percent more office space depending on the existing layout and the increase in remote work-from-home strategies which could decrease the need for office space. The actual net result of this space utilization tension will take time to play out later this year and in 2021 as we fully return to work. Very early feedback from our leasing teams show a net neutral effect although it’s way too early to say this is the trend.
This great work-from-home experiment was forced on us so it’s not surprising that several corporations have said it was going well. What else would they say? The reality is most people miss the office environment and collaborating with their colleagues and will continue to feel more disconnected the longer this full-time work-from-home situation goes on. A recent Gensler survey indicated only 12 percent of workers wanted to work remotely full time. There will be more remote works days and flexible scheduling offered by organizations but the vast majority of employees will return to the office.
Mentorship and culture development are critical to every organization’s success and very difficult to do remotely. Landlords have spent billions of dollars amenitizing office campuses to attract the best tenants who in turn pay much higher rents to attract and retain the best available talent. In the coastal gateway office markets especially, creative and revenue-producing talent will have a competitive advantage over firms working remotely. Competitive advantage will trump cost-savings every time, just like pricier Class A office product in the best office nodes trumps much cheaper commodity office product for the most talented corporations.
Hoffman: There seems little doubt that in the short term the market will soften, and there will be a decrease in demand. Most tenants will not want to make any leasing decisions right this moment, so anyone who is looking to transact will probably have a fair amount of leverage. But it is not clear over the long term that businesses will really lease less space. A company may adopt policies to have a percentage of employees work from home each day, but will need square footage to space out the ones who come in. It's also important to remember that most institutional landlords and developers learned from the "dot-com" bust and other past cycles, and are well-prepared to meet this moment. Yes, the pandemic circumstances are unprecedented, but sophisticated real estate companies have been preparing for a downturn for eight years. Nobody is throwing their entire business model into the garbage.
2. THIS LATEST SURVEY SHOWS OFFICE SPACE DEVELOPMENT SENTIMENT DOWN SIGNIFICANTLY, REACHING LOWS SEEN IN THE 2008 DOWNTURN. HOW LONG UNTIL WE SEE OFFICE VACANCY AND RENTAL RATES BACK TO THE PEAK WE SAW OVER THE PAST 2-3 YEARS?
Shannon: The good news is that the West Coast gateway office markets in Seattle, the Bay Area and Los Angeles went into this downturn in great shape with all markets experiencing strong rent growth and a need for more contiguous big block space. The bad news is about 8.7 percent of all office using jobs have been lost nationally in this pandemic which although it compares favorably to the 12.8 percent overall loss for all job categories is a major blow.
The answer on the time needed to get back to the pre-COVID-19 rent and vacancy levels will vary by market. San Francisco will take the longest to get back because it’s clearly the most volatile post-COVID-19 relative to increasing vacancy rates, sublease space, and lower rents. The Seattle and West Los Angeles office markets are holding up better comparatively and have generally increased concessions but held their pre-COVID-19 market rental rates. I’d predict that Seattle will recover in mid-2021 since they still have a landlord’s market today with less than a 7 percent vacancy rate. West LA is close to equilibrium with vacancy rates around 12 percent today and should recover by the end of next year. San Francisco will take longer to recover than Silicon Valley and may take until 2022 despite its huge barriers to entry advantage.
It is important to remember that this is a self-inflicted downturn and there is no banking crisis this time. Also, the ultimate timing of a vaccine or therapeutic solution will impact recovery timing. Our West Coast markets including SoCal benefit from having an amazing roster of the fastest-growing technology and media tenants and will recover faster than most national office markets.
Hoffman: As tenants default or let their leases expire, we are likely to see a spike in the amount of finished space coming to market (much of which might also be furnished), allowing for faster moves and fewer deals that require a long tenant-improvement-buildout period. Further, an increasing amount of space is likely to become available for sublease over the next couple of years, as companies downsize and reconsider their office needs. For those reasons, it is possible we will see an uptick in short-term deals (e.g., two-three year lease terms) at lower rental rates, and then see rates start to climb again, as those shorter deals lapse and people increasingly return to the office.
3. PRIOR TO THE PANDEMIC, OFFICE SPACE PLANNING HAD EMPHASIZED COMMON AREAS AND CLOSED-IN, COLLABORATIVE WORKING. HOW HAS THE PANDEMIC IMPACTED THIS TREND TO "CREATIVE OFFICE" SPACE?
Shannon: Billions of dollars were spent by landlords creating terrific office environments with the goal of attracting and retaining the best talent in a very tight and competitive labor market. That goal will not change post-pandemic but how space is utilized post-pandemic will change. You will provide more social distancing, cleaning, and shift away from hot desks, all-access communal areas, and hoteling concepts until there is a vaccine or therapeutic solution. Office densification has increased by approximately 40 percent over the last 10 years and we do think there will be a trend away from densification even after the pandemic is over.
There were many real estate professionals after the 9/11 attack who said that the top floors of high rise office buildings would have a permanently high vacancy rate. Time passed and that changed. The more popular urban and transit-oriented CBD offices that enjoyed the best fundamentals pre-COVID-19 are struggling more right now than less dense suburban product. Time and a vaccine will eventually help urban transit oriented product return to its pre-COVID-19 popularity. It will also allow for widespread use of the collaborative office layouts so popular pre-COVID-19, but not as dense as before.
Hoffman: Landlords seem to be taking a wait-and-see-approach to making significant physical changes to their buildings; it might be too soon to say the wall is BACK. But there is an immediate push to reduce density, reconsider furniture design and layouts, improve air filtration, and implement other changes within existing space, such as installing floor stickers and capacity and directional signage throughout, to facilitate social distancing and one-way traffic around the office. Certainly hand sanitizer and disinfectant stations will become more prominent. Rather than jump straight to costly remodels, landlords and tenants alike must roll up their sleeves to find configurations and adjustments that keep employees safe, healthy, and productive.
4. WHAT ARE THE KEY FACTORS THAT WILL HELP THE OFFICE MARKET REBOUND?
Shannon: The same engines that were driving rent growth and absorption in all the West Coast office markets pre-COVID-19 will lead our rebound. Technology and entertainment, especially content creation, will be assisted by strong growth in the health care and life science industries as well. Many but not all of the big tech companies are on pause right now along with most tenants. We think that these companies will be back absorbing space by 2021. Big tech has enjoyed a strong V-shaped recovery in the public markets already. Many of these corporations are now rethinking space density and will be moving away from 175 to 200 SF per person layouts which will trigger new expansion requirements.
History has clearly taught us to never underestimate the resilience of the US economy. It also has taught us that there is frequently an overreaction when these cyclical downturns occur; one that savvy investors can profit from like we saw in the public market pricing for REITs in March 2020.
Hoffman: In time, there will be a vaccine, kids will go back to school, and this will be in the rearview mirror. When companies began offering employees unlimited vacation time, many were sure productivity would go down the drain and nobody would ever work again. However, it turned out that people actually worked more than when they had structured PTO. I think we will find the same to be true for remote working. People have figured out that flexibility is really nice, and having work-from-home as a viable option is important. But human beings fundamentally want to be around other human beings. We want to receive training and mentorship, make connections with colleagues and clients, rise through the ranks, and build our networks. And human capital is really important for many businesses to grow. If you are an innovative tech company, how much can you really sustain that innovation by videoconference? People are going to want space near the center of the action, once action resumes. The #1 factor in the office market recovery is time.
5. WHAT LOGISTICAL ADAPTIONS FROM THIS WORK-FROM-HOME ERA WILL BECOME PERMANENT IN THE OFFICE SPACE? HOW WILL THESE CHANGES IMPACT FUTURE OFFICE DEVELOPMENT?
Shannon: There are some changes as a result of COVID-19 that will persist post pandemic. There will be more corporate hub-and-spoke strategies that will benefit suburban office product and allow for more worker-commute flexibility. This is especially true for companies in public-transit-dependent urban locations like New York and San Francisco. The leasing activity in Silicon Valley has clearly outpaced San Francisco post-COVID-19 because of this trend.
In addition, many companies will allow work-from-home one or two days a week or some type of more flexible schedule. Some tech companies like Facebook allowed for this pre-COVID-19. A few companies will decrease their space needs and allow certain employees to permanently work from home depending on the their industry and roles. Many companies though will also absorb more space because of the trend away from densification.
The answer to the post-COVID-19 utilization of office space question though is unknown if we are honest and will take well into 2021 to obtain clarity on the answers investors want. Many capital sources naturally will want to see what post-COVID-19 rents are, what the velocity of the recovery is and what post-COVID-19 space utilization is before proceeding on many new development projects. Capital doesn’t like uncertainty so there will be less office development projects consistent with the Survey results. New office product post-COVID-19 though will still be very much in demand by discriminating tenants and will obtain the dominant market share of absorption for the very same reasons they did pre-COVID-19. Speculative office development produced outsized returns coming out of the Great Financial Crisis and we are seeing several best-in-class developers proceeding with projects, even now.
Hoffman: COVID-19 is going to be part of our lives for at least the next 12-24 months, and many of the changes necessitated by this virus are likely permanent. Future office development will be designed with "pandemic compliance" in mind alongside ADA compliance. Touchless elevators and doors, better air filtration, wider corridors, and antimicrobial materials in new construction are just some of the design changes we are likely to see become more prevalent. In the short term, we will likely see physical hard barriers to create distance, but in time, landlords will develop design concepts that make people feel both safe and comfortable. Nobody wants a co-worker breathing right in their face, but nobody wants to feel like they are going to work in a Plexiglass prison either.