Upspecing and Downsizing
Many habits have been broken in the two years since the Prime Minister’s stay at home edict. Take the tie, the first thing most people will think when you wear a tie to the office now is, “What the hell is that guy doing in a tie? Has he got an interview? Weirdo.” Out of boredom, Stephen Fry rummaging through his eclectic wardrobe during lockdown began to comedically post on Twitter his tie fetish, which he recently chronicled into his book Fry’s Ties. He said: “Ties were associated with authority, convention, maleness, if not masculinity.” Indeed, even the name implied “they tied you up and they tied you down.” Some will no doubt stick to the tie as a deliberate anachronism.
Of course, the lock down had led many to question whether the office itself is in danger of becoming an anachronism. The enforced period of absence has proven that many organisations can survive without a return to the office. Average office occupancy levels remain below 25% across the UK, far lower than pre-pandemic levels, according to research by Remit Consulting. One large investor mentioned this week that following a portfolio purchased at a Covid discount, occupancy remains stubbornly at 50%.
The small uptick in occupancy more recently has encouraged ‘tourist investors’ to re-enter the market for modern, amenity-rich office buildings, with three c￡1bn deals in train in London. In Chicago, a venture led by Oak Hill Advisors has agreed to buy a controlling interest in a new 55-story office tower located on the Chicago River. ‘Wacker’ opened in October 2020 with a 45-foot lobby, numerous dining options and a secondary air-filtration system that was added during the pandemic.
The low occupancy has begun to feed through into higher availability for sub-prime stock as larger tenants upgrade to new stock and are not replaced with smaller occupiers seeking more affordable space. Lenders on larger buildings with high tenant concentration are therefore particularly vulnerable to default. Blackstone for example reportedly turned over the keys of 1740 Broadway, a 26-story office tower a block from Carnegie Hall, to the special servicer on its $308 million commercial mortgage-backed security. Blackstone bought the 621K SF tower from Vornado Realty Trust in 2014 for $605 million but has lost two major tenants in recent years.
Such properties are among the 30% of U.S. office buildings - worth an estimated $1.1 trillion - that are at high risk of becoming obsolete as tenants’ tastes change in the hybrid-work era, according to Randall Zisler (as quoted in Bloomberg), an independent consultant and former head of real estate research at Goldman Sachs Group Inc. “We’re not saying bulldozers are arriving en masse,” Zisler said. “But you’re going to see a repricing and, in some cases, reuse of these buildings.” Average U.S. office values remain 4% below their pre-pandemic levels, the worst performance of any type of commercial real estate, Green Street data through February show. A deeper look shows a divided market: While prices for newer, amenity-filled offices have gained about 15%, they’re down 20% for smaller, older properties, Zisler said. The impact of the changes in the office market are clearest on the returns on existing portfolios. The FTSE EPRA Nareit Developed Europe Index ended the year up by 18.3%. Looking at sub-sector total returns, although it began to recover throughout 2021 (+12.6%), Office is still posting a 15.6% decline since Feb 2020. Similarly in the unlisted European office funds delivered a 7.8% total return in 2021.
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The refurbishment option for buildings in weak locations may not generate sufficient value to justify the expense. Empire State Realty Trust Inc. added a gym and dining facility in 2019 to a Norwalk, Connecticut, building that was only 46% occupied as of December. The company stopped paying a $30 million mortgage rather than spend more money to lease up space, Chief Financial Officer Christina Chiu said on a conference call last month. “The math favored handing the keys back to the lender,” said Danny Ismail, a senior analyst at Green Street. “Increasingly, that’s a risk going forward.”
Some lenders are giving up too. MUFG Union Bank is selling a $190 million mortgage on a Chicago complex with its biggest tenant, BMO Harris Bank, moving to a new riverfront tower this year. The debt matures March 31, positioning the note buyer to assume ownership on an “attractive basis relative to new construction,” according to a marketing memo from JLL.
The contrast to new buildings with impeccable credentials is stark. CoStar report that AXA is on the hunt for ￡1 billion of debt secured against the 1.3 million SF 22 Bishopsgate. The building cost ￡1.3 billion to build and was developed using equity from a consortium of investors: AXA, Singaporean fund Temasek and Canadian investors PSP and QuadReal. The financing could value the building at ￡2 billion or more. Earlier this week, Apple agreed a deal to take more space at the building, increasing its occupancy from 125 thousand SF to about 200 thousand SF. That deal would mean the building is more than 80% occupied. All this partly explains why investors like Allianz Real Estate, Edge and BVK joined forces for a €1.3bn German ‘smart offices’ scheme fund.
That said, a new report published recently mentioned four in ten occupiers surveyed said they wouldn’t pay a rent premium for green offices, so this might not seem like a slam dunk strategy either. Similarly, as evidenced by the FT, a hybrid set-up has many advantages, but lower carbon emissions are not one of them. For sure, full-time homeworking tends to be a lot more environmentally friendly than daily trips to the office. The energy saved by closing the workplace and cancelling the commute more than offsets the extra heat and light needed to work from home. But for hybrid working, the equation is more complicated. A half-empty office needs much the same heating and air conditioning as a full one. Giving up the commute two days a week may not be enough to cancel out the extra heating and lighting needed at home. That is the case for a British worker who lives alone and — like 69% of his compatriots — drives to work.
The strong investor and occupier demand for modern office space proves that depreciation favours brokers more than investors and lenders. CWK saw the largest increase in investment fees of 80% y/y, followed by JLL (62% y/y) and CBRE (54% y/y). Leasing similarly saw robust growth for CBRE, CWK, and JLL, with fee revenues up 60%, 65%, and 68%, respectively in 4Q21. Quarterly leasing revenue exceeded pre-pandemic levels across firms, as management teams noted the markets are in a transition from recovery to true growth.
When all is said and done, we go to the office each day, and on occasion are even sartorially equipped with a tie. Apple’s marketing campaign for the original iPod didn't make an ad that said: "3GB of storage." they made an ad that said: "1,000 songs in your pocket." In other words, investors should focus on benefits over features. Workers may occupy these buildings as they might a top hotel, but the future of the office relies on benefits, not features, the most important of which is co-operation. Let’s meet.