Sector series: Outlook for US office - changing occupier trends

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1 Real Estate Sector series: Outlook for US office - changing occupier trends February 2019 Executive summary Demand for office space has declined on a per capita basis over the past four cycles Technological advances have reduced the need for workers to commute into traditional offices Office space remains an important element of corporate operations, but it is no longer used as a commodity. Increasingly, employers are investing in space to attract and retain employees Although corporations are using space more efficiently, they are spending more than ever on improving the quality of their space to enhance worker productivity Despite slower occupancy gains over the last cycle, office remains a highly desirable target for investors because of its ability to generate strong income returns and to be an efficient investment vehicle for deploying capital Though office utilization is changing, demand for space will not simply evaporate, but preferences for space will continue to evolve Investors need to be mindful of evolving trends and be keenly aware of how these changes affect underwriting in order to set reasonable return expectations Above all, office demand is likely to stay closely aligned with clearly identifiable drivers of growth, such as technology, demographics, and life sciences Author Arthur Jones Director Real Estate Research Principal Real Estate Investors The future of the office market has been at the subject of much debate and consternation among commercial real estate professionals and investors over the past decade. Advances in information technology, long thought to undermine office demand and, by translation, investment performance, have matured by leaps and bounds. Pundits have long discussed the future of the office market as one in perpetual demise. Technological advances would render the property type obsolete as there would one day be little need for workers to commute into office buildings in busy Central Business Districts (CBDs) or sprawling suburbs. Indeed, technology has hit its critical mass, and most tasks completed by an office worker can be done remotely, including face-to-face meetings that can be attended through video conferences. More recently, the discussion has also focused on the rise of autonomous cars and its impact on office use and locational preferences. Despite the disruptions that technology has brought to the office property type, the market remains both viable and desirable to occupiers and investors. Occupiers have shifted focus from commodity office space toward creating a work environment that will foster efficiency and productivity as well as retain talent in an increasingly competitive environment for highly skilled workers. For its part, investors ability to quickly deploy large blocks of capital in a single office investment and the property type s durability in terms of long-term leases that provide steady income returns, has kept office an attractive and necessary part of any portfolio. There is little debate as to whether the office market will remain a key part of an effective and prudent investment strategy; we believe that it will. The real questions we seek to answer pertain to how occupier preferences will continue to evolve and how they will impact our underwriting to maintain excess returns in a fluid environment. The state of the office market Investor concern with respect to the office sector is focused on the secular moderation in demand over the past decade, as well as sub-par investment returns since the end of the global financial crisis (GFC). Despite nearly a decade of economic recovery and expansion, including the addition of nearly 20 million new jobs a third of which are within office-using industries office demand has struggled to keep pace with prior cycles. The slow pace of demand Real Estate 1

2 growth coming out of the GFC can be explained partially by the depth of the recession, which saw companies let go nearly nine million workers over a two-year period the most severe job losses of any recession on record since World War II. Although observed vacancy reached 17% by 2010, by including shadow vacancy or the space that was leased but not occupied due to job losses combined with longer-term leases the true figure would have been closer to 26% when accounting for underutilization. As severe as the economic downturn was, the recovery has been equally tepid. Though the recession lasted two years, it took four years for the office-using jobs lost during the downturn to be replaced. It is understandable that the first few years of the office recovery would be marked by slow occupancy improvements. Where prior office cycles have typically seen roughly 200 square feet of net absorption per additional worker, between 2009 and 2013 that figure was just 70 square feet. The pace of demand has since improved, but the current demand cycle continues to exhibit more moderate momentum than office has seen historically. Exhibit 1: Office usage per worker is lowest in a decade Occupied office space per worker 230 Occupied SF per office worker Historical average ( ) Source: CBRE EA, Principal Real Estate Investors, Q Occupied SF Per Office Worker Historical Average ( ) Another factor affecting the demand for office space has been the rising pace of technological improvements making it increasingly common for employees to work remotely from home, in satellite offices, in other locations, or even within an office without a permanently assigned location. In fact, technology has evolved to the point that occupiers can forecast day-to-day demand for desk space, so employees can schedule desk space when they need to be in the office in order to maximize space efficiency for the organization and reduce its leasing footprint. Despite the apparent cost savings from reducing the amount of space, the trend is actually toward increased spending on office space as firms look to use modern space to attract and retain top talent in an increasingly competitive market. This is particularly true of larger corporate occupiers with the wherewithal to undertake large redevelopment of existing assets to meet evolving space needs. Smaller companies are also requiring more flexibility in their space by requiring more flexible work space configurations in their buildings and access to common amenities. The most extreme example of this can be seen in the shared workspace industry that opens modern office space up to small firms and individuals as well as to overflow from larger corporate clients. Real Estate 2

3 How are occupiers using space today? Although a key theme in space redesign and occupier research in recent years has been the cost savings associated with open concept design through smaller work spaces and more dense space configurations, occupancy costs for most major corporate occupiers is a relatively small percentage of overall operating expenses the largest being their workforce compensation. While there is some evidence that effective redesign and efficient layouts can save money through smaller leases, more densely occupied space, and greater worker efficiency, relative to what firms spend on talent, those savings could easily evaporate if staff turnover were to increase by just a small amount. In theory at least, most redesigns of office space are focused on employees and enhancing their experience and overall productivity. Exhibit 2: Labor markets are tight and increases in turnover may prove costly Unemployment rates relative to pre-gfc low 8.0 Unemployment below prior low 7.0 Detroit Unemployment rate, pregfc low San Francisco 3.0 Honolulu San Jose Minneapolis Toledo Kansas City St. Louis Portland Cincinnati Louisville Riverside Charlotte Sacramento Columbus Los Angeles Cleveland Memphis Milwaukee New York United States Hartford Oakland Dallas Atlanta Philadelphia Chicago Boston Fort Worth Ventura Indianapolis Houston Pittsburgh San Antonio San Diego Newark Las Vegas Nashville Denver Albany Trenton Stamford Raleigh West Palm Beach Austin Long Island Baltimore Albuquerque Oklahoma City Seattle Orange County Tampa Wilmington, DE Tucson Jacksonville Tulsa Fort Lauderdale Orlando Phoenix Norfolk Richmond Washington, DC Miami Salt Lake City Unemployment above prior low Current unemployment rate, % Source: BLS, Moody's Analytics, Principal Real Estate Investors, Q Our research suggests that tenants are indeed spending more on space through both leases and capital expenditures and that most are focused on quality, rather than focusing on quantity. For example, internal data on managed leases shows that between 2002 and 2016, spending on tenant improvements has increased on average roughly 4.5% each year, more than twice the rate of inflation over the same period. While some of the increases are being negotiated into new leases by way of landlord concession on tenant improvement packages, our experience suggests that new tenants are spending as much as twice the typical improvement package. Part of the reason for this is that the battle for talent particularly in tech-focused markets has become elevated to the point where modern work space and top-of-the-line amenities can sometimes make the difference in the recruiting process. Focused on quality In theory at least, most redesigns of office space are focused on employees and enhancing their experience and overall productivity. Real Estate 3

4 Exhibit 3: Occupiers are sparing no expense on outfitting space Real average and median tenant improvement (TI), $(2016)/sf Average TI, $/sf Median TI, $/sf Source: Principal Real Estate Investors, As discussed, CEOs and hiring managers are facing as tight a job market as they have seen in decades. Increased expenditures on outfitting office space with the latest technology are a necessity in today s business environment, but so is employee retention. As a result, we have witnessed an expansion of the types of space configuration used to enhance employee experience as well as the amenities offered onsite or brought in from outside vendors to enhance the workplace experience and environment for employees. So far as office space is concerned, the evolution of the modern office remains fluid and continues to evolve. It is increasingly common that floor plates are no longer designed with perimeter offices surrounding centralized cubical banks. In fact, both offices and cubicles are on the verge of extinction as modern office design has favored task-oriented work spaces in favor of traditional arrangements based on titles and seniority. While we anticipate that office spaces will continue to favor open arrangements, we also believe there are limits to the amount of open space and densification of work environments that can be accomplished before they impede on worker productivity. As an example, our asset management teams have received feedback from tenants that suggests pushback on extreme opened spaces and more modern solid surface materials, which lack noise mitigation and may harm worker productivity. Such feedback suggests that the future of office layouts will experience an ebb and flow of openness, densification, and perhaps a mix of more private office designs. Principal experience: What are tenants demanding? Open office concept with increases in common area space is the dominant theme More amenities: kitchens, dining (on-site or nearby), fitness/wellness space, bike storage Denser work space for office, cubical, or desk areas in favor of collaborative space Leases are not decreasing in total square feet, but layouts are increasingly efficient for the number of workers In warm weather locations, demand for outdoor seating and meeting areas, as well as wi-fi access outside buildings Real Estate 4

5 How will current trends affect the demand for office space? There is little debate among real estate professionals that demand for office space over the past cycle has been less robust than historical norms might predict. While the rise in technology, teleworking, and overall desire for more efficient use of space are all culprits, we still believe that the demand for space remains critical for professional and business services, high tech, and the financial activities industries that account for the lion s share of overall demand. One thing is clear. The office market today is not likely to regain the form it had in the 1980s and 1990s when a frenetic pace of late-cycle leasing caused demand to surge during those periods it was common to see net absorption approach 100 msf on an annual basis. Since 2010, average leasing has netted office demand of just 38 msf per year, supporting our view that equilibrium demand will be more subdued going forward. While even the most sophisticated statistical models compare historical performance and account for secular trends when forecasting future demand, a simple accounting of office workers and net absorption may provide some insight into the future of demand. Historically, both models and market researchers have converged on a rule of thumb that each new office worker uses roughly 200 sf of office space. Since 2010, that figure has dropped to just 120 sf. While some of this decline can be partially explained by shadow vacancy early in the recovery, the overriding trends in leasing suggest a more conservative approach to space utilization. Based on employment and net absorption data over the last decade, we estimate that if the current trend persists, cumulative demand for office space could be reduced by roughly 44% relative to prevailing industry forecasts.1 To be sure, this is a lower bound or worst-case scenario. With the proliferation of common areas and onsite amenities, the actual usable space within offices will likely mitigate such sharp declines in overall demand. Exhibit 4: Office demand will continue to slow, but by how much? Total office demand, millions of square feet Baseline net absorption Alternative net absorption (@120 sf/worker) Historical average ( ) (f) 2020 (f) 2021 (f) 2022 (f) 2023 (f) 2024 (f) Source: CBRE EA, BLS, Principal Real Estate Investors, Q While the reduction in demand in the chart above represents a lower bound estimate, slower demand does have important implications for developers, landlords, and investors. First, we will need less new office supply over the next decade than we are accustomed. Slower demand coupled with slower population and job growth nationally will likely act as further constraints on demand, which will need to be factored into any development decisions. Investors will also need to focus on quality over quantity. Principal Real Estate Investors', experience suggests that well located assets and onsite amenities are at the top of a tenant's list of requirements. 1 The alternative forecast assumes that each additional office worker hired would add just 120 sf, which based on forecasted office-using job growth from CBRE EA and Moody s Analytics would result in cumulative net demand of msf between 2018 and CBRE EA is currently forecasting total net demand of msf over the same period. The total cumulative reduction in demand is our worst-case scenario with a total reduction of 43.66%. Real Estate 5

6 Additionally, demand is not perfectly correlated across markets. We focus on two themes for office demand, the first is demographics. Historically, and especially during the current cycle, markets with stronger than average population growth displayed more space market demand. Even through the ebb and flow of cycles, markets with strong demographics tend to be more resilient and have the ability to recover more quickly during expansions. The second key theme that aligns with our overall real estate strategy is technology. High-tech markets both primary coastal gateways like Boston, San Francisco, and Seattle, as well as smaller markets like Austin and Raleigh we believe have upside potential. Technology industries tend to pay higher wages and have a high multiplier for secondary industries in markets where they are concentrated. Moreover, information services, biotechnology, software development, and engineering industries all demand significant amounts of office space. Exhibit 5: Office demand will follow population growth and technology Demand and population growth forecast, 2-yr average annual % change Investors will need to focus on quality over quantity. Principal Real Estate Investors' experience suggests that well located assets and onsite amenities are at the top of a tenant's list of requirements Green shaded denotes high tech markets San Jose 5.0 Net absorption rate, % San Francisco Detroit Baltimore Chicago Philadelphia Los Angeles Boston Washington, DC Cleveland Newark San Diego Orange County Denver Seattle Atlanta Dallas Raleigh Phoenix Austin New York Pittsburgh Oakland Minneapolis Houston Population Growth, % Population growth, % Source: Moody's Analytics, BLS, CBRE EA, Principal Real Estate Investors, Q Implications for commercial real estate office investment As with any discussion about commercial real estate and space markets, the ultimate questions are what are the implications for investment, and do we believe there is a viable future for office as part of institutional portfolios? The short answer to both is yes. We believe that Office will remain a critical element of an institutional portfolio. Real Estate 6

7 As it stands today, office comprises roughly 36% of the current NCREIF National Property Index (NPI), and while many investors are reducing office exposure late in the cycle a time when returns for the property type tend to moderate this will likely change if we encounter any market correction or significant asset repricing. Office is perhaps the best example of a high-beta investment, where return performance is maximized when economic growth is most robust before trailing off prior to downturns. Though this cycle has been different in that respect, we expect office performance to be tied quite closely to economic growth going forward. We also believe that balanced space markets will support future office investment performance. Though demand has slowed, it remains healthy, and supply has for the most part adjusted to more moderate occupancy improvements. Development underwriting has arguably never been more conservative in terms of both financing and pre-leasing requirements on new construction. Supply has also largely been dictated by demand for new space with most new supply coming online in markets with the strongest economic and occupancy growth. In addition, at this stage in the cycle, development remains subdued relative to historical standards. Exhibit 6: Office returns are healthy, but more moderate Total return by property type, % Apartment Industrial Office Retail Source: NCREIF, Principal Real Estate Investors, Q Conclusion Investors need to be increasingly vigilant when it comes to office. Monitoring both costs and emerging trends in building and space design. Increases in technology have now far outstripped the impact of teleworking. Buildings today need to accommodate smart features that regulate heating and cooling systems and adhere to evolving environmental standards and shifting parking ratios that will be impacted by incremental adoption of autonomous vehicles. Office owners need to incorporate both increases in tenant improvement and rising capital expenditures in their investment underwriting. This trend will continue as owners seek to remain competitive amid changing occupier preferences and technology is increasingly integrated with building design. We continue to see office as one of the primary property types in any investment portfolio and believe that, with the proper underwriting, it can provide a steady cash return. Investors should look for opportunities to reposition and renovate existing assets in well-positioned markets and submarkets. Core opportunities in coastal gateway markets have become increasingly difficult to obtain, but we recommend select acquisitions where the deal-level economics make sense. Our focus will remain in high-growth markets with solid underlying demographic trends. We strongly believe that tactically, these markets have the best potential demand profile and short-term durability as we continue through the current extended cycle. Real Estate 7

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