COVID-19 Impacts on Commercial Real Estate Markets: Omnibus Article

Over the past month, I wrote three articles on the effect of COVID-19 on Australia's commercial office markets: one on the impact for landlords, one about the impact on tenants and a third forecasting the impact on commercial real estate (CRE) service firms.

Here are all three articles in one omnibus post. This debate continues to progress, and I have seen a range contrary views, including some which predict workspace ratios will double (meaning offices will be half as densely populated as they were before the crisis). This is expected to be offset by working from home becoming more commonplace (to what degree, I don't think anyone knows yet).

While some are saying that hot-desking will go out of vogue, people aren't predicting (to my knowledge) that people who spend most of their time working from home will all get their own allocated in the seat in the office. The natural conclusion, therefore, is that some hot-desking will remain.

My reading of all this is the clear beneficiaries could be workplace strategists, project managers, interior designers and fit-out companies. The one thing everyone seems to agree on is that the future of work will change, and that will inevitably involve some reconfiguration of existing workplaces, which will need to be planned and then implemented.

Impact on landlords

Here are three predictions of the impact on landlords of major office buildings in Australia in a post COVID-19 world.

1. A loss of momentum towards in-house leasing

It seems inevitable that vacancy rates are going to increase substantially. There was already a lot of new office stock recently completed or under construction in our largest capital city markets. A fall in demand, as a result of a decentralisation trend, a greater propensity to work from home and lower-than-previously-expected economic growth, will result in higher vacancy rates than were previously forecast.

More vacancy means that some owners who had been increasingly relying on inhouse leasing resources will need to rethink their strategy. For portfolios with huge amounts of backfill space, the notion of inhouse leasing teams having the market coverage necessary to lease huge chunks of space – in a market where there is much more competing stock for lease – becomes unrealistic.

I expect that some owners will move back to an outsourcing model, as leasing agents’ expertise becomes more important in the process – or they will at least shift the balance towards outsourcing by adopting a hybrid approach.

If certain landlords stick with the inhouse leasing model, they will probably need to more aggressively incentivise tenant representatives (which many, who carefully guard their independence, will resist), and provide higher fees to other agents, to generate incoming opportunities.

Alternatively, they could recruit more high-powered in-house leasing teams, but the cost of this exercise may be ineffective at a time when demand is expected to be lower – it would be cheaper to just pay agencies the commission.

In a higher vacancy market, the prudent approach will be the traditional agency model.

2. A pause on placemaking, with fewer experiences and less events

Prior to COVID-19, there was a trend towards placemaking, experiences and events in Australian office buildings.

The events industry was booming. People wanted more immersive and interactive experiences, and landlords were responding by putting on all sorts of events as they curated a community for their buildings. Some events and common areas were enticing for outsiders to enter the building.

How quickly things have changed. The focus on placemaking and the creation of more event space at the expense of leasable area should be reviewed. Expansive coworking-style spaces in lobbies will probably be cut back or completely removed to discourage congregation. There will likely be less pop-ups and fewer landlord-sponsored events.

Some of the costs of maintaining common areas can be shifted to the tenant via outgoings (e.g. common area cleaning charges will increase as more preventative disinfectant becomes the norm), and tenants may still appreciate the provision of common area amenity.

However, the allocation of so much space to the general public and event uses, in an age where people are more germ-conscious, no longer make senses – at least for the foreseeable future. Indeed, before there is a vaccine, the need for contact tracing makes it likely that such events and gatherings will be discouraged or disallowed.

Landlords will also review building policies and start to restrict tenants’ ability to have in-house events, while more proactively limiting the number of guests within leased areas at any one time (or even imposing a capacity limit over a period of time).

This means that Eventbrite or Meetup-style events within flexible space providers, tenant break out areas and building common areas, which were growing quickly before COVID-19, will likely be banned or severely restricted. Placemaking will be sidelined in favour of curating safe spaces.

3. A shift in focus from environmental sustainability to technological connectivity

NABERS, the National Australian Built Environment Rating System, rates the environmental performance of Australian buildings and tenancies. While landlords have been focused on improving their performance in this area over the past decade, I expect that more will seek to compete on technological connectivity moving forward.

Wired Certification is a CRE rating system for landlords to understand, improve and promote their buildings’ digital infrastructure.

As companies become more comfortable with, and reliant on, virtual meetings as a way to communicate internally and externally, the review of a building’s Wired Score (or a competing measure) will become part of the decision-making process for tenants when deciding on space. This will, therefore, influence the capital expenditure priorities of asset managers.

According to the Wired Score website, there are currently only 2,000 Wired Certified buildings globally. If Wired Score becomes the industry standard by which a building’s digital infrastructure is measured, I expect there will be a trend for buildings to become certified and, as buildings seek to differentiate themselves in a challenging leasing environment, more investment in the measures that result in a Gold or Platinum grade.

Therefore, the recent arms race between buildings on sustainable design features and end-of-trip facilities will likely evolve into a competition for digital infrastructure supremacy.

Impacts on tenants

Here are three predictions of the impact on tenants of office space in Australia in a post COVID-19 world.

1. A rise in occupancy costs for many – and outgoings are going up

The broad consensus seems to be that tenants will emerge from this crisis with a lower real estate cost base. The logic goes that a combination of a higher propensity to work from home, a smaller workforce and a fall in effective rentals mean that occupancy costs will go down. In and of itself, this is true.

However, many tenants are locked into long term leases. Unless tenants have the opportunity to take advantage of the current circumstances to negotiate lease restructures, or have an upcoming lease expiry, the temporary rental relief that some are now entitled to under current guidelines will disappear.

Once the market reverts to existing leases, the escalations that were previously in place will still apply and rent reviews with ratchet clauses will prevent rents from falling. Yes, market rents will be lower, but that won’t help tenants stuck on leases negotiated before March 2020.

Furthermore, for tenants looking to drop space, subleasing, which was previously commonplace, will become harder as demand falls and more direct vacancy becomes available in competition. Even if subleasing can be done, the achievable rents for that space will be lower, too.

For tenants who have the opportunity to renegotiate their leases, their cost-base could fall due to space reductions and lower effective rentals. However, it’s not clear to what extent tenants will be able to reduce their footprint.

Yes, some employees moving towards more flexible working arrangements that includes a greater propensity to work from home (or elsewhere) means that there will be less people in the office each day. However, social-distancing measures mean employees will be resistant to close quarters, potentially requiring some remodelling of current seating configurations. Existing meeting rooms will need to be remodelled, and regular cleaning put in place. This will all create cost and offset some or all of the space savings as a result of more people working from home, or due to smaller workforces.

In addition, landlords will not be absorbing all the additional costs that are associated with disinfecting high-touch areas in buildings. Common area cleaning charges, other operational upgrades like contactless security and elevators, and various other measures that tenants demand and social distancing practices require, will create more operating expenses. These additional costs will not be absorbed by landlords – particularly given the extent to which owners have been forced to absorb short-term financial impacts under the current regulations.

There may be a case for outgoings (known in other markets as common area management fees) to be temporarily lower right now due to land tax savings and reduced operating capacity, however the cost of operating buildings will inevitably go up, and these costs will be passed through to tenants via higher outgoings.

2. Working close to home – a hybrid approach

Prior to COVID-19, employees had two choices: working in the office and, if an option, working from home (typically one day a week). Over the past couple of months, most have had one choice: working from home.

After months at home, people are now questioning the extent to which commuters will be willing to be packed into public transport, or sit in traffic every day, once they are “allowed” to return to the office.

At the same time, many people will probably be sick of working from home, and the need for human connection will give rise to individuals wanting a new alternative.

Enter the work-close-to-home option within co-working spaces. This would provide people with the opportunity to work in a professional and built-to-purpose office setting, without having to stay at home. It would reduce travel time substantially, cutting congestion on our roads and taking the pressure off over-crowded public transport.

Large companies could reserve many seats in these suburban co-working premises every day given they have clusters of staff living close by that would each be using the spaces a few days a week. Utilising a co-working provider and providing it as an option for employees would be more efficient for larger and smaller companies than directly leasing smaller spaces to cater for suburban-based employees all over the metropolitan area.

Furthermore, larger companies could have branded “hubs” within the suburban co-working centres to facilitate interactions between their staff. The curated hubs would create collaboration opportunities that working from home can’t cater for, while also ensuring people maintain a sense of connection with their employer that is not possible when not in the office. The work-close-to-home model would improve the human experience element and put in place measures to stop employee engagement levels from falling.

In terms of where these spaces will be, even before COVID-19 there was talk about discount department stores like Big W and Target closing underperforming locations, and other large format discretionary retailers shedding space. These spaces will need to be filled, and they can’t all be gyms, restaurants and child-care centres! A new alternative use for these spaces is suburban co-working. In terms of accessibility, they’re well set up: the locations already have an abundance of car parking and the majority are also located at public transport nodes.

A couple of co-working operators I have spoken to recently have also referred to a hotel management-style agreement with landlords of suburban office buildings to fill this expected increase in demand. If this model has potential, it will underpin the viability of some new construction of suburban office buildings that are not currently on the development radar.

3. A more flexible and contingent workforce – accelerating the activity-based workplace trends

As noted above, there may be some reversal in the contraction of workspace ratios trend due to social distancing measures. Tenants will also need to introduce disinfecting protocols to ensure shared workspaces are kept clean. However, due to a more flexible and contingent workforce, activity-based working solutions will become more common.

Australia has a relatively low level of workplace flexibility (in terms of employment laws) compared with many other liberal democracies. Furthermore, Europe and North America have a far higher proportion of their workforce classified as contingent (i.e. temporary or contract based). This Coronavirus crisis will result in a closing of the gap between Australia and comparable nations i.e. there will be more contingent workers here in the future.

Of the scores of people who have already been made redundant in the past two months, many will start their own consultancies or begin work as independent contractors – partly due to necessity, because full time work is not available. These professionals may well find they prefer the increased flexibility that comes from being a consultant, and as we enter economic recovery, businesses will also be attracted to hiring consultants over permanent employees due to the lower fixed costs. The idea of paying for outcomes rather than input or work hours is also consistent with the current working from home experiment.

Further to this, the federal government is already talking about using COVID-19 as an opportunity to increase flexible workplace arrangements. WorkChoices was first introduced back in March 2005 – given all the water under the bridge since then, those types of employment law measures could yet make a comeback. Regardless of whether it’s the Coalition or Labor who introduces the next round of workplace reforms, I seriously doubt the result will be greater employment security for workers.

The real estate impact of all this is that a more flexible and contingent workforce means it makes even less sense for tenants to provide their works with an assigned desk in the office. This will result in activity-based workplace design principles becoming even more common than they already are.

Impacts on CRE firms

Here are my three predictions of the impact on commercial real estate service firms in a post COVID-19 world.

1. Prop-tech investments will begin paying dividends – and feature more heavily in client solutions

Over the last four or five years, there has been a lot of talk about digital solutions for clients. CRE firms have acquired various prop-tech start-ups or recruited experienced technology personnel into their senior ranks. There has been a greater emphasis on technology in the way CRE firms operate.

These initiatives have been enthusiastically embraced by sections of CRE service firms, including most of the C-suite, and there is plenty of thought leadership promoting the various initiatives.

However, these changes have been more tentatively adopted by the employees who interact most with clients and actually implement these solutions on the ground. Furthermore, the technology that has been adopted has not yet created the kind of leverage and efficiencies that it is intended to achieve.

For example, there are tenant concierge platforms for the operation of space that are in place, but have not been universally adopted by end-users. In other cases, facility managers spend as much time showing people how to use the platforms as they would have taking work orders manually.

There are CRM and other SaaS systems for internal use which have the potential to disseminate information and monitor productivity more quickly and consistently, but are not consistently applied throughout firms (or in some cases, even within teams).

The technology already exists to conduct inspections of space completely remotely, but the industry was not operating this way. I expect the massive slowdown of the airline industry and the closing of borders will give this technology solution a big push.

There are also tenant-experience apps to book meeting rooms and remotely grant visitors entry to a building or office, artificial intelligence for property management that monitors buildings and identifies maintenance requirements before they cause operational issues, and valuation software that can accurately estimate values based on data that the firms already have.

All of these capabilities exist, but for whatever reason the adoption rates have been low. I expect that CRE firms will be further developing and then pushing these solutions more, and that clients will be far more receptive to implementing them.

2. An increased focus on workplace strategy – an add-on or “nice to have” will quickly become a lead generator 

Over the past decade, workplace strategy has been more of a thought leadership generator than a profit centre. It was a good way to start a conversation with some prospects (usually with those of a certain size or level of sophistication), or to add value to an existing client. Generally, only the stickiest and largest clients of CRE firms were using these add-on services on a regular basis.

Now, all of sudden, workplace strategy has come into the mainstream and it is not just a debate about the pros and cons of hot desking or, for more sophisticated discussions, the productivity benefits of activity-based working.

Workplace strategy has been catapulted to the forefront of the public debate about what the lasting impacts of COVID-19 will be in the way offices operate. Organisations are right now seeking to answer questions from anxious employees who want to know where they will be working in the near future and how social-distancing will be achieved within existing workplace configurations.

To answer these questions, human resources teams will be relying on futurists who have been discussing these trends for a while, but previously didn’t have much of a captive audience outside of our industry.

Despite the relevance of workplace strategy to tenants and landlords, some agents had been reluctant to take their workplace strategy colleagues to a client meeting.

Why take someone to a meeting who creates more steps between now and getting a deal done? Perhaps adding value, understanding the client better, and creating cross-selling opportunities is a reasonable answer to that question.

However, I don’t think that logic was prevailing often, or there was a lack of resources to enable it; workplace strategy teams within CRE service firms remain relatively small.

Now, it will be the clients who will be requesting advice and insights from workplace strategists. Workplace change and transformation facilitators will be in high demand for implementation. The transactions side of the business will be chasing internal thought leaders to learn about the trends.

Future of Work thought leaders will be increasingly asked to join client meetings, and the workplace strategy team will become a source of leads for the transaction and accounts-based business, instead of it being predominantly the other way around. An economic slowdown and space-contractions by occupiers will only amplify this trend, further shifting power-centres within CRE service firms.

3. A changing of the guard – new leaders

New and more innovative ways of providing solutions for clients and managing people remotely will mean that some leaders will be left behind.

As noted above, prop-tech will become a much more important part of client solutions, requiring leaders who embrace technological change and are capable of promoting it.

The old-fashioned command style of leadership, which focuses on input rather than output and was already in decline, will become extremely irrelevant with a workforce which is increasingly dispersed. The leaders of the coming decade will be required to increase engagement and drive performance by managing remotely. These are new skills which some existing leaders are not well equipped with.

To be clear, I am not saying that all long-tenured leaders are an endangered specious, or that leaders over a certain age are not capable of adapting. Don’t worry, the new senior leaders will not be all millennials just yet!

Indeed, many of the existing leaders are there because they have the very skills needed to adapt and will be more than capable of getting the most out of their people in the future office. In fact, many firms regularly implement leadership changes, putting in place leaders they believe are “future ready” and ensuring that emerging leaders get their opportunities at the right time, before they get restless and jump ship.

What I am saying, though, is that some of today’s leaders won’t make it because they are unable or unwilling to adapt, with their style of leadership not being congruent with the new way of working. Some of these leaders may well be a lot younger than the ones who will do a great job in the 2020s.

This changing of the guard will be part of the cycle of leadership churn that some firms regularly implement and all firms eventually go through. The Coronavirus will provide the impetus to accelerate the process for firms that previously perhaps didn’t have the time or motivation to make strategic leadership transitions, while other firms will be forced to confront these realities out of necessity.

Now what?

I hope you enjoyed this three-part article about the potential lasting impacts of COVID-19 on commercial real estate, with a focus on Australia’s office markets. Some people agree with these predictions, and others have different views. I have shared these thoughts to stimulate discussion and contribute to the debate – I welcome your thoughts to move the conversation forward further.

Time will tell if these predictions come true. If you have opinions to share, and would like support in enhancing your own professional profile by creating and sharing content, I would be happy to help you get started.

Finally, if you would like to know the five attributes that help people working in commercial real estate achieve success more quickly, you can read my new eBook. It's called The 5 Ps of Commercial Real Estate Success, and it's available to download for free for a limited time. Get your free copy here: https://www.cresuccess.co/ebook