Office Developers Signal an Upward Turn in the Market

While the question, “what is the future of the office building?” is still on the minds of everyone who owns or develops office space, it has become clear that the latest return-to-office activity has our Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey panelists becoming less pessimistic. Although the office sector sentiment in the most recent Survey remains negative, it is becoming less so and it appears that this sector has bottomed and is ready for a possible upturn. The current lull in office construction could be short-lived as the demand for office refitting, low-rise office buildings, and growth in employment increase over the coming year. The Survey reflects that developers are taking less of a wait-and-see approach providing an early signal of a turn in the market. The demand for the amenity-rich office should push construction activity higher than the sentiment indicates.

Office market industry leaders, Kevin Shannon of Newmark and Liz Wilgenburg of Allen Matkins, discuss what lies ahead for this sector of the California commercial real estate market.

1. While the office market sentiment is relatively more positive than the previous two Surveys, there is still the lingering “wait-and-see” approach with most developers and investors. How long will this last, and what factors will change it?

 
Shannon: While the outlook for office keeps improving, there is still simply more uncertainty in the office sector nationally compared to other sectors such as industrial, Sun Belt multi family, life science etc. Research is pointing capital to these popular sectors where the post-COVID data points are clear and more favorable. Investment capital doesn’t like uncertainty and therefore many institutional investors have remained on the sideline for office product to see how the return to work in the second half of the year plays out unless the offering has strong WALT and credit. There are looking for data that shows leasing markets have bottomed out and clearly started recovering.  

Some investors though are bullish on office now and want to be first movers before everyone else jumps back in. Increasingly, investors are considering rotating into office as the yields on the more popular sectors continue to get compressed to record low levels as a result to the tremendous weight of capital in those spaces. Many of these “first movers” were hoping for some distressed office opportunities, but these never really materialized. The first movers do believe that their acquistions now will be more attractive than those that will be coming to the market next year.  

The uncertainty surrounding return from work in the office sector will dissipate as companies get their employees back in the office the second half of this year. Only then will tenants understand their preferred work model whether hybrid or full time which will allow them to stop kicking the can down the road and make appropriate space decisions. I believe that next year both owners and investors will know how this work from home tension plays out, which will allow for more transparency on market conditions. This will lead to more sale transactions by narrowing the bid ask gap occurring in many markets due to the current difference in owner and buyer expectations. This bid ask gap is especially wide for value add office currently.  

There are office markets right now that are bucking these national trends described above. Bellevue, Washington; Burbank, California; and Sorrento Mesa/UTC, Caliornia, for instance, are pricing better now than they did pre-COVID. Each of these submarkets have key market drivers like big tech, life science, or content creation that have allowed them to thrive since the pandemic. Land in Bellevue for spec office development is on a tear and is very competitive for bidders as an example. 

Wilgenburg: At this point, it seems that developers are in the “wait-and-see” approach, but without actually seriously considering shelving their development projects. The factors that will contribute to the end of this “wait-and-see” period are mainly the continued availability of debt, interest of tenants, and relatedly, whether the rental rates will support the development costs. Right now, many of the tenants are coming out of their own “wait-and-see” periods where they entered into short-term renewals in 2020 while they reassessed their current space needs. These short-term renewals will likely come to an end around 2023-2024.

Meanwhile, other office tenants that are now looking for permanent solutions are facing stiff competition for available first-generation development space that has the amenities, wellness benefits, and easy commutes, all while competing with major expansion by life science tenants. All of this competition is resulting in very good rental rates at these projects, that seem to be going higher and higher. Therefore, I predict that many developers will see these rates and take the brakes off of their projects to meet the projected vacancies in 2023-2024. Meanwhile, the developers that did not take the “wait-and-see” approach, or only delayed by a few months, will receive the benefit of the current competitive market for first-class development projects in hot markets.

2. Two scenarios are predicted: 1. less office space will be needed with a portion of the workforce permanently working remotely; and 2. more space will be needed to accommodate for new health and safety guidelines. What is your prediction and why?

Shannon: I predict that most workers will return to the office in the Fall. Many companies will adapt hybrid models initially and many will insist that workers return full time. Workers in the office will have a distinct competitive advantage that will cause many remote workers to come back to the office over time especially before Christmas bonus season. The reality is that most company CFO’s want their employees back in the office even if they are publicly saying they will be flexible on scheduling. During the pandemic there was no competitive disadvantage because everyone worked from home. That is changing especially after Labor Day. 

I predict that most companies will not need less office space and that many companies will start allocating more space per employee and reverse the reduced space per employee trend that has occurred over the last decade. I am not aware of a single company that has said because of a newly adopted hybrid work model that offices will be shared. Employees still want their own office even if they are only planning on being there three or four times a week. There will definitely be less hot desking concepts and more space per employee initially although that could change over the years as we create more distance from this pandemic. After the 9/11 tragedy, no one wanted to initially lease the upper floors of high rises but that changed too as time passed. 

Wilgenburg: It seems likely to be true for the foreseeable future that typical high-rise office buildings will have less on-site employees on a daily basis than pre-pandemic levels, due to hybrid work models. For many companies in major markets, this will eventually result in reduced space needs. However, for tech tenants that were previously operating at extremely high densities, it seems that these companies are now planning to convert individual cubicles to flex-space or collaborative space, which will not result in drastic space reductions, and in fact, in many instances, has resulted in tech tenants seeking increased space. In addition, many tenants are looking to sign longer leases, which will increase profitability of many buildings.   

3. We didn’t see the mass exodus from major cities as first predicted at the beginning of the pandemic, but there has been a significant amount of relocation to less-dense communities. How will that impact office development, in terms of location and design, in the future?

Shannon: The major global innovation cities like Los Angeles, San Francisco, New York, and Seattle are going to continue to be popular with investment capital because of the abundance of skilled talent and their inherent social advantages. There was no reason for many employees to live in the big cities during the extended lock down, but it is clear from recent data that employees are flocking back to these metros in anticipation of returning to the office. Tenants during the pandemic looked for flexible space solutions which, frequently, were shorter term lease extensions until there was more clarity on space needs. Several companies have explored spoke and hub models with smaller satellite offices closer to employee homes to reduce commute times. Co-working operations will also be utilized more frequently by companies post-pandemic to provide greater employee flexibility.  

New spec office development will still occur primarily in submarkets with clear growth engines like big tech, content creation, and life science. As an example, Bellevue, Washington, has had the strongest velocity of post-COVID land sales for office development on the West Coast. It has also seen companies like Amazon, Microsoft, and Facebook take down millions of feet of new office space during the pandemic so new spec office construction is justified and warranted there. 

Wilgenburg: The pandemic has not changed the design of most new ground-up development buildings, but has accelerated certain design trends that were already in place. Buildings were already moving to increased outdoor amenity areas, and focused on sustainability, technology, and wellness. All of these factors are now deemed essential to tenants seeking new space. Developers that have established LEED certification, WELL certification, advanced air filtration systems, and touchless controls in their upcoming development projects have a major competitive advantage over existing space, and are now more prominently highlighting these benefits in their marketing materials than in the pre-pandemic world. 

The pandemic, however, may have changed the desired location of many development projects from dense urban centers that relied on mass transportation, to instead low-rise projects with easy commutes in suburban areas, but I’m skeptical of the certainty of this kind of prognostication. It seems clear that many people are not interested in maintaining their long commutes from suburbs into urban areas. This means that so long as our urban centers do not have sufficient housing, office buildings that are located near housing will be more attractive. However,  this concern is undercut by recent evidence that housing rent prices in dense urban areas are beginning to climb as people return from temporary pandemic housing options. This is good news for San Francisco development, and likely not an issue in Los Angeles where low-rise developments were already popular, and mass transportation was already less popular before the pandemic.