The next normal: offices

When data for Q2 investment activity is released towards the end of July, the inevitable comparisons with the GFC will be stark. Last week, Chris Ireland, CEO at JLL told Bloomberg TV that what took five quarters in 2008 and 2009 took five weeks in 2020. “Investment activity in Q2 will be lower than anything we saw in the global financial crisis,” Ireland said. “The market for any new transactions has stalled and it will take investors time to get comfortable that now is the right time to buy. The short-scale shock is huge.”

Of course, investors will want to know how much real estate values have fallen across the different markets and sectors since the pandemic-induced lockdown. But it difficult to offer a reliable answer because the abrupt collapse in investment activity in Q2, means little price discovery to inform valuations. While valuations can technically still be undertaken, the limited number reduces confidence in the overall average value changes across different markets and sectors. However, as more data points re-emerge, clarity on value movements will become clearer. 

In the meantime, there are implications for investment and lending. While some opportunistic investors, such as private equity and hedge funds, are comfortable taking risks in uncertainty (and price accordingly), core, core-plus and value add investors will more commonly wait. Likewise, lenders will also fall into two camps: the cautious and the opportunistic, the former will wait for more robust valuation evidence, the latter will follow trusted opportunistic equity and charge a premium for it. Thus, the nominal discount opportunity funds can command on asset prices, compared to pre-pandemic, will be offset by an increased cost of debt. Later, as more transactional activity returns, a broader pool of equity and debt will return. Overall, the trends will likely not be uniform for some time, with a mix of positive and negative signals unevenly across the sectors. By now, most investors, lenders and advisers have resolved a consensus on which are the resilient sectors (e.g., logistics, warehouses and fulfilment centres, prime offices, food-anchored retail, PRS/multifamily, healthcare, data centres, life sciences etc), and the weaker sectors (e.g., retail, leisure and hospitality, shopping centres, retail parks). But there are some sectors and subsectors where expectations are divided (e.g. non-CBD and secondary offices, student accommodation, super-prime residential, prime high street retail, care homes/senior living). 

Across all these sectors, some of the pre-pandemic structural megatrends which have been assumed to continue into the coming decade – demographics, urbanisation, smart cities, sustainability – may prove to be less supportive for real estate sector demand (e.g., CBD offices, student accommodation, care homes/senior living), while future demand may emerge in locations and sectors currently less planned for (e.g., more regional sub headquarters office hubs, reconfigured and improved transportation infrastructure, diagnostics-led life sciences laboratories, etc). In this series of sector focuses, we will consider how the post-pandemic world might affect the office sector.

Offices and the future of work

For many businesses large and small, the transition from office to homeworking has been smoother than anticipated. “We are operating at 100% capacity today from our homes,” said a surprised Peter Pereira Gray, CEO and managing partner at The Wellcome Trust in the FT’s Global Boardroom virtual conference in mid-May. “It would be naive to not think our experience was similar elsewhere.” He said the CFOs will be asking themselves fundamental questions regarding future real estate office requirements including the necessity of expensive rent of their headquarters. “It is not inevitable we will see the destruction of major office city centre markets, but there will be some changes.

Several major banking CEOs have uttered similar thoughts. JPMorgan Chase Co-President, Daniel Pinto, said many staff could work from home on a rotational basis permanently, while his Pinto’s counterpart at Morgan Stanley, James Gorman, told Bloomberg in mid-April that 9o% of the bank’s 80,000-strong workforce has worked from home with “almost no issues”. “We’ve figured out how to operate with much less real estate,” Gorman added. “Can I see a future where part of every week, certainly part of every month, for a lot our employees will be at home? Absolutely.”

Barclays CEO, Jes Staley, went further suggesting that expensive skyscraper offices offices “may be a thing of the past” for its 70,000-strong worldwide workforce, adding that the pandemic had prompted a rethink of the bank’s long term “location strategy”. 

At the smaller end of the market, many small to medium-sized businesses may decide to leave cities like London, Paris, Frankfurt, Madrid and Milan and convert physical businesses into digital businesses, reduce staff, relinquish office space and set up in the provinces with Zoom. Businesses flock to the big cities for the networks of potential clients. If that has the critical mass of support online, the necessity of urban living is demoted to a choice, rather than a necessity. Of course, the vision of the next normal for office working – and by implication, future sector demand – is not without its critics. 

Many traditionally minded executives believe long-term office demand will not be materially reduced by a permanent rise in remote and homeworking. However, the correlation between the rate of working from home (WFH) and office space per worker is weak at best, according to Capital Economics. It suggests a 10% rise in the share of remote workers would reduce office space per worker by around 5%. Thus, demand for office space will reduce less than the proportional increase in remote working, according to this analysis. 

A far greater direct impact on future office demand will be reduced employment levels. Around 12 million full-time jobs are forecast to be lost during 2020, according to The International Labour Organization, which cited hospitality and food services, manufacturing, retail and administration among most at-risk sectors. Also, depending on the state of the economy, companies may seek to economise by marrying homeworking preferences while lowering operational costs. “We do not expect that job losses will be fully recuperated in all countries, even by the end of 2022,” says Amy Wood, property economist at Capital Economics. “Given the relationship with occupier activity, weak employment conditions will weigh on demand for office space over the next few years, particularly for markets within Central, Eastern and Southern Europe.”

Ben Cullen, head of occupier representation, London markets, at Cushman & Wakefield, says: “The office isn’t just a place of work, it’s a place of community. For me and millions like me around the world, it provides for friendship, motivation and challenge and, of course, sometimes, annoyance, disappointment and stress,” 

Mark Ridley, CEO at Savills, suggests a demand reduction in secondary office markets is likely, which tend to fulfil a more functional ‘work’ purpose, with limited emphasis on collaboration. By contrast, prime offices will still be in demand in key markets, according to Ridley. “The push will be to reconfigure offices as a centre to imbue company culture and to provide staff with a place of purpose. The future of the office is not over, but they will need to change – and become a better environment with a better design.”

Some corporates will look to remote working to compress their real estate footprint and rent and redirect investment into ‘business continuity planning’ space and remote-working facilities, as the appeal of large, dense, open-plan offices recedes, JLL wrote JLL in its Global Real Estate Implications Paper II.  “While it is too early to make bold predictions in terms of a shift in the quantum of space required by corporates coming out of this crisis, the physical office will take centre stage in facilitating interaction and collaboration and, ultimately, employee health, well-being and productivity,” JLL wrote. The future of offices might likely be to pivot to a host of ways corporate space can be used beyond simply a location to work every day into utilisation space as creative hubs for companies. All of which offers a glimpse into how the virus may permanently change the balance between office and homeworking and, by consequence, the office sector itself.

If coronavirus health risks remain with us over the medium term, some people will be apprehensive to return to large city environments, which could drive demand for more suburban hubs, where employees can commute to safely and creating a different type of future office real estate demand. As the economic slowdown starts to bite, second-hand office space will be released from occupiers as a result of job losses and insolvencies. Serviced offices and coworking are clearly on the frontline to absorb the impact on office demand from the pandemic in the short term which is expected to drive consolidation among operators. However, corporates may well be keen to reluctant to sign new large long-term leases, which could strengthen demand for flexible space over the longer term. 

UBS Real Estate says it is expecting European office prime rents to fall across most European markets this year, while outside core locations, a more severe impact on rental levels are expected. “As the retail sector found out several years ago, it will no longer be enough to provide a functional environment, if employees are going to go back into their offices there will need to be some value-add offerings in the locations to make it worthwhile.”

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