Investing in Office Real Estate

A version of this article was originally published on June 7, 2019.

The office building is one of the four major commercial real estate asset classes, along with 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 tenant. This article addresses some unique qualities of the office real estate asset class. Continue reading to learn more.

Current Trends Shaping Demand for Office Real Estate

Co-Working & Remote Work

Over the last several years the “co-working” model became mainstream. While some continue to question the model’s long-term viability, others see the dynamics presented by COVID-19 as a unique opportunity. A likely outcome may be that traditional offices and office leases will yield part of a building or 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 them to expand into new labor markets with premium workplace amenities and in-person collaboration for employees that may otherwise be full-time remote. It remains to be seen how, exactly, the co-working model will evolve post-COVID, but chances are, leaders in the space will realize the benefits of having a portfolio of strategic locations.  

Not long ago, the ascent of communication and collaboration technology had some pundits calling for the end of the office as we know it. COVID-19 then introduced additional speculation about the future of the workplace. While the successful introduction of “working from home” is likely to increase remote work and flexibility, it is improbable that remote work arrangements will render the physical office obsolete. In fact, a 15% increase in remote work and a 15% increase in office space per worker would likely only lead to a 2% decrease in overall office demand, according to CBRE. And 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. On that note, recent survey data suggests 98% of office tenants expect to re-enter their office by Q3 of this year.

Changing Remote Work Patterns

Source:  Bureau of Labor Statistics, CBRE Research*

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. If current trends continue, we may also see the “suburbanization of the urban core,” with office real estate incorporating more green space, as well as pedestrian and bike-friendly infrastructure. 

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. So, what will this mean post-COVID? The majority of employees who can telework are currently working from home. And while some will eventually return to the office full-time, many knowledge workers appreciate the flexibility of remote work. They may opt to do so part-time, or even relocate permanently, since their managers now know they can still be productive in a virtual environment. 

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.

This mindset has led to the adoption of open office floor plans, which are designed to increase collaboration. After the pandemic ends, we will likely see additional design innovations. For example, more space may be devoted to conference rooms and informal meeting areas. 

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. 

That said, the uncertainty of COVID-19 has allowed some office tenants to renegotiate their lease terms. Colliers International notes that future occupiers will likely gravitate to shorter-term lease commitments, creating a shorter income stream, with implications for valuations and hold periods.* 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 Real Estate

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, CBRE reports the tech sector has been responsible for roughly 20% of major office leasing activity in the past few years, and as of 2019, the sector was still expanding at about twice the rate of the overall economy. 

This has particularly benefited markets like the San Francisco Bay Area and Seattle, but also emerging, lower-cost tech hubs like Salt Lake City-Orem-Provo, Charlotte, and Phoenix. Overall, tech remains the most active industry in U.S. office leasing, despite the impact of COVID-19.

U.S. Office Leasing Activity by Tech Industry, Q2 2020
Top 10 Markets by Square Footage Leased

Source: CBRE Research and CBRE Tech Insights Center, Q2 2020.*

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. In light of COVID-19, additional health and safety measures may need to be considered. See below for a few recommendations from the CDC:

• Modify workstations to maintain social distancing of 6 feet, where possible.
• Improve building ventilation, in consultation with an HVAC professional.
• Conduct daily health checks (e.g., symptoms and/or temperature screening) before employees enter the office.

Predictions for the Office Sector in 2021 and Beyond

Prior to the COVID-19 pandemic, the U.S. economy experienced a record streak of positive job growth. With historically low unemployment and a generally healthy economy, office developers built speculatively in many markets. Fast forward to 2021, and we’re now seeing a vastly different picture. With increased vacancy rates in central business districts across the U.S., some wonder whether the office sector will ever fully recover.  

However, we remain optimistic. There may be an increase in satellite offices and flexible working arrangements, but this does not mean the urban office core is obsolete. Investors should be able to find plenty of opportunities for yield in the near future, as talent continues to migrate, and Tier 1 markets begin to stabilize. Perhaps companies will switch to a “hub and spoke” model, complementing their urban headquarters with several suburban offices. They may even downsize their footprint, or relocate to cheaper markets. Either way, there will always be a need for office space, as most jobs require a combination of some work, which can be done from home, and some work, which is more effective in-person.

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, 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.  

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*https://www.cbre-ea.com/docs/default-source/ea-viewpoint-reports/cbre-ea-viewpoint_remoteworking

*https://www2.colliers.com/en/research/special-report-office-space-in-the-post-covid-era

*https://www.cbre.us/Real-Estate-Services/Industry-Solutions/Technology-and-Media/techinsights-Tech-Office-Leasing-Activity-Drops-in-Q2-2020 

*https://www.cdc.gov/coronavirus/2019-ncov/community/office-buildings.html