Office: Finding Good Bones in the Toughest Neighborhoods

We’ve previously flagged notable stresses in the commercial real estate (CRE) market which could lead to attractive investment opportunities over the next year or two. Yet, as far as real estate sectors go, one has us particularly cautious these days—office.

Just as retail properties underwent a physical-to-digital shift over the past two decades, offices are now experiencing their own version of this transformation. This is creating a market that is divided into three categories: best-in-class, transformable, and obsolete properties, much like what was seen in the recent retail experience.

Office Isn't All of CRE and Not All of CRE Is Office

Before delving into the office real estate market, let’s recall one key (and oft-neglected) fact. When people hear “CRE,” they commonly think of office space and nothing more. But the office sector comprises just a small portion of all CRE. In fact, office accounts for only around 15% of the broad US CRE market (Display). That small weight partially explains why, despite our concerns, we still expect attractive opportunities to emerge in CRE overall.

How Strained Is Strained?

What makes the office real estate market notably weaker than other property sectors? In 1Q2023, foreclosures on offices vastly outnumbered other property types—accounting for more foreclosures than all other types combined, based on RCA/MSCI data.

What’s more, office revenues remain ~10% below where employment levels suggest they should be, according to Moody’s. And yet even the most optimistic forecast from major real estate company CBRE expects vacancies to rise through 2024.

The culprit? Work-from-home (“WFH”) is expected to reduce office demand by around 14% over time (Display). And only half of that contraction has been realized thus far.

One final difference between office and other real estate sectors bears mentioning. Although growth in net operating income (NOI), the primary earnings metric for real estate, is expected to land in the middle of the pack compared to other sectors, office spaces require nearly 30% of NOI to be spent on capital expenditures for maintenance and improvements. In contrast, industrial or apartment spaces require only low-teens levels of expenditure, while retail properties require low-20s levels. Naturally, this makes office spaces less appealing to investors.

Not a Monolith

Before the pandemic, the office sector was already starting to split into two categories: the highest-quality properties and everything else. The work-from-home trends that emerged during the pandemic have only intensified this division, and we now see the office real estate market separating into three categories: best-in-class properties, properties that need upgrades or conversion, and properties that will become obsolete.

According to research from CBRE, the hardest-hit buildings account for 10% of properties but 80% of occupancy loss. How can we account for this splintering? Here are a few factors at play:

• Location, location, location—the Northeast and Pacific have been hit harder, while the Southeast and Mid-Atlantic are holding up. Downtown locations have also retreated more than suburban spaces
• The prevailing industry mix of a given area, along with the level of hybrid work. Of late, technology companies have experienced the greatest workforce impact
• Local crime rates and availability of nearby amenities such as restaurants, etc.
• Commuting difficulties, with more arduous commutes incentivizing a higher degree of WFH

Interestingly, while a building’s age receives a lot of attention, the hardest-hit buildings have the same age distribution as the office real estate market overall. This suggests age is less of a factor than commonly thought.

The combination of all these factors can make for some tough choices for an investment manager—would you rather own a Class A property in a city with headwinds such as New York or a Class B property in a city with tailwinds such as Nashville?

Solving the Puzzle

What does the future hold for the office real estate market? As discussed, high-quality properties remain on track to perform well over time.

The remaining properties’ issues are harder to resolve. Some can be repurposed. For instance, in many areas where the office real estate market is floundering, converting properties to other uses—such as multi-family housing—could be attractive. Yet there are some critical obstacles to such conversions. The ideal square footage (“floorplate”) for each level in an apartment building is less than 15,000 square feet. Yet fewer than 23% of the hardest-hit office buildings have floorplates that size. With a larger floorplate, conversions become harder and more expensive, potentially rendering them uneconomical. In addition, areas zoned for commercial use may need to be rezoned for residential—if you want an area to have apartments, residents will need schools and other resources as well.

What about office properties with strained cash flows that can’t be easily converted? Here, the solution is more likely to be found in valuation resets and refinancings. Despite having lower fundamentals compared to their historical levels, these properties can still generate cash flows and provide attractive returns for lenders and owners, as long as the deals are made on favorable terms. In some cases, it may be more beneficial to demolish these properties and replace them with new buildings, which would help remove obsolete stock from the market. As the market adjusts to these new fundamentals, we anticipate that prices and terms will change, creating opportunities for experienced developers, buyers, and lenders.

A Small Corner of a Much Larger Picture

Because of the strains emerging in the real estate market, we believe we’ll see increasingly attractive investment opportunities in the next year or so.

While many people may immediately think of office space when they hear “commercial real estate,” the office market comprises only a small piece of the broad CRE market. That’s partly why—despite the unique issues in the office sector—we remain positive on CRE overall. Plus, the office sector itself is trifurcating into prime properties, transformable properties, and obsolete properties. That allows our investment managers to add value through their knowledge, experience, and discretion.