Commercial Real Estate Outlook: A year of transition in the Office sector
By Cal Evans and Brooke Blackwell, Synovus Credit Market Intelligence
With 2020 finally behind us, it’s a great time to take stock of the CRE industry and gauge how well each of the sector types fared and to what degree the pandemic affected demand. The easiest to examine is the industrial/warehouse sector. E-commerce and an overhaul in supply-chain logistics made this sector 2020’s belle of the ball. Multifamily fared better than most market pundits expected (including this one) given the end of the first round of stimulus in August. Fourth quarter 2020 capital market transactions show the sector is still a popular option, which continues to appreciate in value for investors.
Retail performance covered the entire spectrum. Existing problems were magnified, and new ones spread like the virus itself through once-strong service tenants. On the flipside, some niche retailers posted historically high sales. The “necessities” they sold proved to be exactly that — essential to consumers and sold at high volumes. The hotel sector performed worst – many essentially shut down in the early stages of the pandemic. Isolated pockets of recovery could be found in the summer and fall, but this sector continues to be the most concerning of the major property types.
That leaves us with office, the great enigma of the CRE world and the hardest sector to predict. Before we look ahead, let’s look back on how office was positioned pre-pandemic.
The pandemic dramatically shifted office conditions.
In the Southeast, just before the onset of COVID-19, office development was fairly restrained though there were some pockets of large deliveries, many consisting of build-to-suit or pre-leased buildings. Corporate relocations to the region were common and took the lion’s share of development headlines. These larger scale moves generally took place in urban core areas away from the suburbs.
The modern office template was well-defined and generally consisted of a high degree of IT infrastructure build-out, a greater standard of amenities, and a declining area-per-worker ratio via common work areas and a smaller proportion of individual offices. The sector’s x-factor was communal workspace in the style of the “WeWork” model. With mixed success in 2019, the format had caused heartburn for appraisers and bankers who struggled to define exactly how to value this office variant.
Fast forward to March 2020 when most offices had been vacated. Ninety-five percent of U.S. workers were remote1, taxing even the best IT infrastructures, which were designed to accommodate emergency levels based upon an average of 25% to 50% of employees working remotely. Amenities meant little to nothing in buildings that housed no workers. Space dedicated to quality appointments and services now seemed better suited to more effective HVAC systems or advanced property technology management (“proptech”) solutions.
“Proximity” became an ugly word as social distancing reversed conventional wisdom on area per worker. This virtually eliminated the common work area, greatly reduced the efficiency of cubes, and drove a nail into the coffin of the already-struggling communal workspace model. Finally, the preferred locales for business relocations shifted away from urban cores and towards suburban areas as their decentralized and diffuse employee bases continued to work from home.
This sea change in office paralyzed the market as deals in progress, plans for expansion, and sales activity ground to a virtual halt over the second and third quarters of 2020. During that time, net absorption of office space (amount of space leased minus amount of space delivered) was -54.9mm square feet.2 More space was lost than the entirety of 2008 through 2010 (-47.6mm SF). Subleasing expanded by 50.7%,3 adding 141.5mm SF of available space (roughly the size of the entire Atlanta office market) to the U.S. market. At year’s end, sales volume of office properties was down 40% YOY, and the pace of appreciation slowed from more than three percent (3.8%) in 2019 to a little over one percent (1.5%).4
It was a lessee’s market as record-setting available inventory drove increased concessions and tenant improvement allowances. Lessors struggled with new health and safety costs, space reconfiguration, and measures to address proximity concerns. These challenges increased with building age, implying a varying degree of economic obsolescence associated with the new demands of the pandemic.
With all the volatility in the market, was there any good news? There certainly were some mitigating factors. Of that 55mm SF of negative net absorption in 2Q20 through 3Q20, 90% took place in three areas: Texas, California, and the New York City to Boston Corridor.5 The majority of the massive block of subleased space is comprised of tech tenants concentrated in markets like Seattle, San Francisco, and Austin. There was also a realignment of priorities among companies that needed blocks of space. The first priority was an inexpensive place to do business; the second was a reduced emphasis on mass transit availability; and the third was a preference for submarket space.
These three factors set the table for an increased interest in the Southeast, and metrics do prove the relative strength of the region. Compared to the U.S. average of a 143 basis points (bps) drop in occupancy rate, the top 10 markets within the Synovus footprint fell at a slightly less rapid pace of 131 bps.6 Where the Southeast truly outperformed was in rent growth, which is still positive at a 0.8% annual rate compared to a drop of slightly above one percent (-1.08%) U.S. annual rate.7 This year’s projections call for a general recovery in the Southeast as vaccine distribution settles volatility fears for the sector, and trends related to state in-migration and business relocation support that assertion. Though many challenges in the office category remain to be resolved, it’s safe to say that the Southeast will fare better than the rest of the country going forward.
Medical continues to remain healthy.
Given that a global viral pandemic created the current environment, it seems appropriate that the healthiest office segment is the medical subsector. Medical office continues to post impressive annual rent gains (noted as high as eight percent from some CRE data providers) and remains a popular target for investors. Medical office sales only dropped 13% in 2020 compared to 40% for office as a whole.8 Offices on or near major medical campuses or universities still command premium prices.
As opposed to general office, the medical office sector is “resistant” to the pandemic. A modern building design generally separates the sick from the healthy and allows for workflow processes in a manner that wastes very little space. The one concern is that supply has escalated over the past few years, so demand and competition should be carefully considered when evaluating locations.
Preferences, technology and efficiencies are shaping the future of Office.
So, what lies ahead for the office sector? That may be the hardest question to answer in real estate, but we can make a few educated guesses.
1. “Work-from-home” is here to stay because it meets both a worker’s general preference and a corporation’s desire to pare down CRE holdings to realize efficiencies. Not everyone prefers to work from home, however, and the value of networking and corporate culture will ensure that the office remains the major point of activity. Some jobs do not lend themselves to work-from-home, and some do. In general, well-paid professional jobs that require some degree of higher education are better suited for remote work, whereas administrative roles generally are not. That said, the degree of work-from-home will be driven by the types of jobs that make up a company.
2. Proptech will become a driving force in new office design. Health and wellness features such as air filtration, touchless access systems, and advanced cleaning capacities will become de rigueur in future construction. Advanced technologies and AI could drive complete building systems that interface with a company’s personnel database to identify where concentrations of sick workers may be located. The building management system could reroute employees to other areas of the building, directing cleaning efforts to the vacated area. Once clean, utilities could be rerouted away from the vacant section to the new worker concentrations.
3. There will be no quick resolution to the debate between whether urban core or suburban office locales are preferable. The most likely answer will be that a blend of both will be ideal. An example would be a smaller core headquarters location with suburban satellites. Workers who need to can travel to the core HQ when necessary and stay closer to home when not. Alternatively, worker bases can be divided into groups and rotated between locations, or the urban core HQ can use the hotel model for workers who need to be present on a short-term basis. Solutions will be as varied as the companies themselves, but both locations will be utilized.
2021 should lead to a clearer idea of how the office sector will evolve, but volatility and a seemingly limitless number of opinions on what comprises the ideal office will make for murky waters. Fortunately, the outlook for the Synovus footprint is less opaque and more positive than the country as a whole, and plenty of opportunity remains given the growth trends in our markets.
Contact Synovus Treasury and Payment Solutions or your Relationship Manager for more information on Georgia’s economy.
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Jones Lang Lasalle, “Better than Normal: Vision 2021,” January 2021
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