The Office

• Office CMBS delinquencies and distressed sales up, but only marginally
• NY Office REITs share prices fallen by 40%, whilst some now focus on office to residential conversions
• Energy costs are estimated to account for more than 7% of total office occupancy costs
• 20-30% of offices never to be leased again but development pipeline subdued

In 1967, author Oliver Marriott wrote a book called “The Property Boom” and chronicles the post war years from 1945 to 1965, which was almost exclusively focussed on office development. It should be required reading for investors and developers. Its beguiling how many similarities exist to today, both in the UK and the USA. To the vaulting ambition of avaricious developers, to the dynamics that underpin real estate development, not much has changed (save for the focus on ESG).

It talks about quixotic characters and their exploits, such as Sidney Blum, the promoter of Berkely Square House who left to find further fortune in Rhodesia, to the Ziff brothers in Leeds who started Town Centre Securities after observing so many office developers in London making millions. “It's not all that difficult. Why shouldn't we?” they are quoted as saying. Then there is Harry Hyams who at the age of 31 built Oldham Estates from ￡25,000 of share capital to ￡60 million in a very short period of time. The strategy underpinning the development of one of London’s first skyscrapers, Centre Point, was to be let only to a single tenant of undoubted covenant. Felix Fenston, Hyams peer, commented at the time “keeping a building empty is just a question of how much money you've got.” It remained empty for the next 16 years until he finally relented and leased the building floor by floor. Then there’s Jack Cotton of City Center Properties, who after conquering London offices, put up $25 million to construct what was said to be the largest office building in the world, the Pan American Building in New York. The investment marked the single biggest post-war movement of funds from Britain to the United States, and at a time when American banks and insurance companies halted lending completely. Further, unlike in Britain, the banks would not lend money against speculative construction of an office building, but Cotton embodied the “two British ingredients in development: hunch, and an ability to persuade banks to lend money.” He turned out to be right, and in the mid-1960s while still demolishing the old buildings above Grand Central Station, leased 25% to of the 2.4 million sq ft to Pan Am.

Unlike the post war period however, office demand has slumped. Jack Creedon, Ropes & Gray co-Head of Real Estate, suggested in comments to the Financial Times that the U.S. market “could see 20%-30% of the existing office market” wiped out, never to be leased again. The Financial Times reports that the distress experienced by the segment, particularly in second-generation and older offices, will likely persist for the foreseeable future. Even if investors keep the faith and wait for a rebound, obtaining finance will not be easy, “The secondary office sector in the US is not uninvestable, but no one wants to finance it,” PGIM Global Chief Investment Officer Raimondo Amabile said in comments to The Financial Times. "There’s a belief that that’s a stranded asset."

Commercial loan delinquencies have not yet risen in response to the distress in the leasing market. In October, the office CMBS delinquency reported by Fitch stood at 1.23%, up from 1.19% in September, but still behind delinquencies for hotel, retail and mixed-use properties. Trepp reported the office delinquency rate for the month at 1.75%, up from 1.58% in September. The firm’s researchers tied the increase to lease expirations in the sector. Meanwhile, Moody’s reported the conduit delinquency rate for office properties at 2.69%, up 13bps from September and 30bps from a year ago. Similarly, data from MSCI Real Assets shows only about $1.1bn in distressed office sales this year, or about 1% of the total of $93bn in office sales overall.

Since January, shares of SL Green and Vornado, two publicly traded REITs that are among New York’s biggest office owners, have fallen by half. The small collection of offices with the finest amenities and locations, are still in high demand, according to Ruth Colp-Haber, head of Wharton Properties “The real danger lurks downstairs in the class B and C buildings that are losing tenants at an alarming rate without replacements”. Colp-Haber estimated that roughly 40% of the city’s office buildings “are now facing a big decision” about their future. Bob Knakal, chair of investment sales at JLL, sees a growing horde of “zombie” office buildings in Manhattan that are still alive but have no obvious future. One of New York's most prominent office developers, Silverstein Properties, is now seeking to raise $1.5bn to convert office buildings to other uses, particularly residential.

Despite this background, in Midtown Manhattan, Governor Kathy Hochul is pushing ahead with one of the largest real estate development projects in American history: 10 towers of mostly offices around Penn Station, the busiest transit centre in the country. Cotton was right almost 60 years ago, Hochul might be too. The buildings would help pay for the renovation of the dreary underground station. The plan is moving forward whilst office vacancy rates in nearby Hudson Yard approach 40%, according to the real estate firm Avison Young, as companies scramble to try and find other tenants to take over their floors. More than half of all office construction in Manhattan, about seven million square feet, is under development there.

The story in the UK is not dissimilar. Older offices have always depreciated and been recycled into either new office space or an alternative use. In the UK, analysis of business rates data by law firm Boodle Hatfield, found that in the year to March 2022, around 20m square feet of office space was lost, representing over 2% of the total market accelerating a trend that has resulted to overall floorspace shrinking by over 6% since 2014.

Despite this fall in stock, the relatively greater reduction in demand is expected to lead to a fall in a 38% fall in the value of office buildings in London in the next two to three years, according to Citi. The bank’s real estate analyst, Aaron Guy, said this is “driven primarily by likely recessionary impacts on higher unemployment and continued work-from-home office shrinkage”. The average London office property would have to sell for over 40% discount relative to its current market value so that the buyer could make an “investible return” based on Citi’s estimates.

Soaring energy bills are also pushing UK businesses to further economise on office space to save money, according to the boss of one of the world’s biggest workplace services companies. Companies are urgently considering how to reduce power consumption, said Jacob Aarup-Andersen, chief executive of ISS. Energy costs are estimated to account for more than 7% of total office occupancy costs.

Developers anticipate a 10% reduction per head in the overall requirement for office space due to hybrid work but the demand for high-quality space has continued to drive requirements for office refurbishments in London, according to Deloitte’s most recent London Office Crane Survey. Developers are also increasingly focusing on refurbishing existing supply as a means of addressing “stranding risk”. Construction cost inflation remains a concern to nine out of 10 developers, down from 10 out of 10 in the last survey.

CBRE expect that declining developer profitability due to increased costs and lower availability of debt will mean that new European office space development will be limited, growing by only 1.1% pa over the next five years. This will allow office markets to rebalance, with demand being less impacted by WFH than previously expected and the modest supply pipeline likely to erode further. CBRE projections show net absorptions to be ahead of new additions to office stock pushing vacancy rates back down to below 6% by 2027 from their peak as of end of 2021.

Office life has long been fodder for satire. When Dwight stages an all too real fire drill in season five of The Office, his poor co-workers think that they've been trapped inside a burning building. Michael Scott then gets real about how ill-prepared he was for an emergency: “I knew exactly what to do. But in a much more real sense, I had no idea what to do.” This dilemma encapsulates what investors and developers think of the office today. The world of the office is in flux: 50% of office workers have left their jobs since the start of the pandemic according to JLL and most C-suite executives have returned to the office, but their subordinates have not. Bosses, developers, investors, Governors and lenders recognise that the typecast of the office will not revert to pre-pandemic norms, but those quipped with the “two British [sic] ingredients in development: hunch, and an ability to persuade banks to lend money” might very well succeed.?