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While the question “What does the future of the office building look like?” Still on the minds of anyone who owns or is developing office space, it is clear that recent return to office activity is making our Allen Matkins / UCLA Anderson Forecast California Commercial Real Estate Survey panelists less pessimistic. Although sentiment in the office sector remains negative in the latest poll, it is weakening and it appears that this sector has bottomed out and is poised for a possible upturn. The current lull in office construction may be short-lived as demand for office conversions, low-rise office buildings and employment growth will increase in the coming year. The survey shows that developers wait less and give an early signal for a market turnaround. When workers return to the office, demand for the convenience office should drive construction activity higher than the mood suggests.
Industry leaders in the office market, Kevin Shannon of Newmark and Liz Wilgenburg of Allen Matkins, discuss what lies ahead for this sector of California’s commercial real estate market.
1. Although sentiment in the office market is relatively more positive than in the previous two surveys, most developers and investors still adopt a wait-and-see approach. How long will it take and what factors will change it?
Shannon: While the outlook for the office sector continues to improve, the office sector is simply more uncertain at the national level compared to other sectors such as industry, Sun Belt Multi Family, Life Science, etc. Research points to these popular sectors where post COVID data points are clearer and cheaper. Investment capital doesn’t like uncertainty, so many institutional office products investors have stayed on the sidelines to see what the ramifications of going back to work in the second half of the year when the supply doesn’t have strong WALT and credit. It searches for data showing that leasing markets have bottomed out and are clearly recovering.
However, some investors are bullish right now and want to lead the way before everyone else gets back on it. Investors are increasingly considering moving to office as returns in the more popular sectors are due to the enormous weight of capital in these spaces. Many of these “first movers” hoped for some distressed office opportunities, but they never really came to fruition. The first movers believe their acquisitions will be more attractive now than those coming next year.
The uncertainty about returning from work in the office sector will dissipate when companies bring their employees back to the office in the second half of this year. Only then will tenants understand their preferred work model, whether hybrid or full-time, which enables them to step out onto the street and make appropriate spatial decisions. I believe that over the next year both owners and investors will know how this work is done from home, which allows for more transparency about market conditions. This will lead to more sales transactions by reducing the bid-ask gap that exists in many markets due to the current different expectations of owners and buyers. This bid-ask gap is currently particularly large for value-add offices.
There are currently office markets that counteract these national trends described above. Bellevue, Washington; Burbank, California; and Sorrento Mesa / UTC, California, for example, are now cheaper than they were before COVID. Each of these sub-markets has important market drivers such as big tech, life science or content creation that have enabled them to thrive since the pandemic. The plot of land in Bellevue for special office development is on the decline and, for example, very competitive for bidders.
Wilgenburg: At this point, it seems like the developers are taking a “wait and see” approach without seriously considering putting their development projects on hold. The factors that will contribute to the end of this “waiting period” are mainly the continued availability of debt, the interest paid by tenants and, linked to this, whether the rental prices bear the development costs. Many of the tenants are currently coming out of their own “waiting” phases in which they received short-term renewals in 2020 while reassessing their current space requirements. These short term renewals are likely to end around 2023-2024. Meanwhile, other office tenants now seeking permanent solutions are facing fierce competition for first generation available development space that offers the convenience, wellness benefits, and easy access, while competing with the large expansion of life science tenants . All of this competition results in very good rental rates on these projects that seem to go higher and higher. Therefore, I predict that many developers will see these quotas and slow down their projects to meet the projected vacancies in 2023-2024. Meanwhile, the developers who did not act or only did so with a few months’ delay benefit from the current competitive market for first-class development projects in hot markets.
2. Two scenarios are forecast: 1. Less office space is required, as part of the workforce works remotely all the time; and 2. more space is needed to accommodate new health and safety guidelines. What is your forecast and why?
Shannon: I expect most employees will return to the office in the fall. Many companies will adapt hybrid models initially and many will insist that workers return full-time. Office workers will have a distinct competitive advantage, resulting in many remote workers returning to the office over time, especially before the Christmas bonus season. The reality is that most corporate CFOs want their employees back in the office, even if they publicly say they will be flexible about scheduling. There was no competitive disadvantage during the pandemic as everyone worked from home. That changes especially after Labor Day.
I anticipate that most companies will not need less office space and that many companies will start allocating more space per employee and reversing the trend towards less space per employee over the past decade. I am not aware of a single company that has said that offices will be shared because of a newly introduced hybrid work model. The employees want their own office even if they only want to be on site three to four times a week. There will definitely be fewer 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 tragedy of September 11th, nobody wanted to lease the upper floors of high-rise buildings, but that too changed over time.
Wilgenburg: For the foreseeable future, it is likely that in typical high-rise office buildings, due to hybrid work models, fewer employees will be employed on site than before the pandemic. For many companies in important markets, this ultimately results in a smaller footprint. For tech tenants who previously operated at extremely high density, however, it appears that these companies are now planning to convert individual cabins into flex space or collaborative spaces, which will not lead to drastic area reductions, and in many cases has to Tech tenants are looking for more space. In addition, many tenants want to get longer leases, which increases the profitability of many buildings.
3. We did not see mass exodus from major cities as predicted at the beginning of the pandemic, but there was significant resettlement to less dense communities. How will this affect office development in terms of location and design in the future?
Shannon: The great global innovation cities like Los Angeles, San Francisco, New York and Seattle will continue to be popular with investment capital because of the abundance of skilled talent and their inherent social benefits. There was no reason for many employees to live in the big cities during the extended lockdown, but recent data suggests that employees are flocking to those subways pending their return to the office. During the pandemic, tenants were looking for flexible space solutions, which were often short-term rental extensions until there was more clarity about the space requirements. Several companies have investigated spoke and hub models with smaller satellite offices closer to where employees live to reduce commute times. Even after the pandemic, co-working operations are being used more frequently by companies to increase the flexibility of employees.
The development of new offices will continue to take place primarily in sub-markets with clear growth engines such as big tech, content creation and life science. Bellevue, Washington, for example, saw the fastest pace in post-COVID-19 property sales for office developments on the west coast. It has also seen companies like Amazon, Microsoft, and Facebook shed millions of feet of new office space during the pandemic, so building new offices there is warranted and justified.
Wilgenburg: The pandemic didn’t change the design of most of the new foundation buildings, but it did accelerate certain design trends that were already in place. The buildings have already been relocated to reinforced outdoor areas and focused on sustainability, technology and wellness. All of these factors are now considered essential for tenants looking for new space. Developers who have established LEED certification, WELL certification, advanced air filter systems and contactless controls in their upcoming development projects have a great competitive advantage over existing spaces and are now highlighting these advantages in their marketing materials more clearly than in the time before the pandemic world .
However, the pandemic may have changed the desired location of many development projects from dense urban centers that relied on mass transportation to low-rise projects with easy commuting in suburbs, but I am skeptical of the certainty of this type of forecast. It seems clear that many people have no interest in maintaining their long commutes from the suburbs to the urban areas. In other words, as long as there is not enough living space in our metropolitan areas, office buildings in the vicinity will become more attractive. However, these concerns are undermined by recent evidence that residential property rental prices in densely populated urban areas are beginning to rise as people return from temporary pandemic housing options. This is good news for San Francisco development, and probably not an issue in Los Angeles, where low-rise construction projects were already popular and mass transportation was less popular even before the pandemic.
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