A Very Different Way to Think About OfficeMay 5, 2023
I admit I am fearful of (ridicule) in writing this article, but if fear of ridicule was the determining factor for The Real Estate Philosopher, it would have killed off at least half of my articles anyway. My job is to give you my honest, unadulterated, and analytical thinking, with the knowledge that I may be flat-out wrong. So here goes….
This whole situation with Office simply doesn’t add up to me.
All of my clients and friends of the firm like to basically buy low and sell high, and Office is low and getting lower every day, but (just about) no one is buying or even considering buying.
Instead, just about everyone is calling Office ‘a four letter word?’
Of course, I know the prices of office buildings have plummeted, and people are working from home and things like that, but let’s start by doing the math…..
We will assume we are working in the town of Smithtown. This could be a major city or a minor city, or a suburban office. In other words, Smithtown is a metaphor for a random location.
In Smithtown, there is – say – 2M square feet of office space – and three years ago, it was 93% occupied in a stable market.
Now occupancy is 80% and dropping and dropping and dropping. Owners are worried they will not – ever – be able to lease up the buildings. It is Office Armageddon.
But – going with the math – 3 years ago, there was a demand for 1.86M square feet of office space. Where did the tenants go?
Well, some are working from home. But how much is that? More businesses are now mandating a return to the office, and more and more people are starting to realize that WFH is boring, depressing, career-killing, and other negatives. Plus, unless you are three or a few days WFH, you can’t cut space that much with this anyway.
So – surely – WFH is reducing demand, but I think the real problem is that tenants just don’t want to commit to space right now due to uncertainty in the financial markets. I mean, if you are in the widget business and you think there might be a recession about to come and/or your cost of capital has skyrocketed, your logical decision right now would be to put off committing to new office space. Perhaps you can ride out another year in your somewhat substandard location until you see how your widget business is doing.
Consider that this exact thing is going on in real estate. Regarding parties buying and selling real estate – i.e., deals – deal flow has slowed to a trickle since there is so much price uncertainty. But we all know that – any day, week, or month – that situation will end, and deal flow will return. Meanwhile, deals are kind of dead or dormant. But we aren’t calling deals a four-letter word, are we? Instead, we are just saying they have slowed down for a while.
So why isn't it the same in the office leasing market – i.e., when calm is restored to the markets, the tenants will start leasing space again, and leasing deal flow will return?
That is a starting hypothesis.
Now let’s add some reduction in overall available office space due to the following:
- No new buildings are being built
- Foreclosures where lenders aren’t operating the buildings
- Changes of use, i.e., to residential
And then, finally, things start to stabilize with interest rates and the economy. Is it not then possible that we actually end up with a slight shortage of office space rather than too much of it?
And finally, if the economy grows strongly again, which is certainly a possibility, and tenants actually need more space than they formerly needed, does that make the shortage even more punctuated?
Plus, I will throw one other log on the fire and ask why, at least in NYC and some other big cities, Class A office is doing great, and Class B and C office is doing badly. Why is that? I mean Class A office costs a lot more because it is better. Did all the tenants just get richer to be able to afford more expensive space? That can’t be right. So why is Class A doing well but not Class B and C? It doesn’t make sense to think that everyone woke up one morning and said I am moving to Class A office space, and I refuse to be in Class B space which is now obsolete.
NYC has 451 million square feet of space. I couldn’t get a number on how much Class A space there is, but – I guess – about 10%. So that would mean about 45M square feet of Class A and about 400M square feet of B and C. If all of it was roughly 90%-ish leased before the office debacle, then there was demand for 360M square feet of B and C space.
Another way to look at it is that if there is a drop in demand, why didn’t the drop go across the board?
The answer may be a variant of what I was saying above; namely, wealthier tenants can afford to take office space even if it costs more. It is a smaller percentage of their overall overhead, but less wealthy tenants are the ones holding up their leases. If so, then it is only a matter of time before that demand comes back, right?
Okay – now let’s take a step back – and assess what I just said. I made some assumptions, and those assumptions might be wrong. Indeed, you may be rolling your eyes as you read what I wrote and are saying how little Bruce knows about these kinds of things.
And you might be right that I am completely wrong. But please consider that if you are skeptical about my (foregoing) assumptions, consider the assumptions you would inherently be making, which is your assumption that everything I said above is wrong.
But maybe you are wrong too.
We don’t really know. There is uncertainty.
So where does this leave us?
I would suggest that instead of the conclusion that almost everyone has come to that office is a disaster that will get worse and worse, we should be wondering about what will happen, i.e., instead of being sure it is Office Armageddon, we should be wondering about the denouement. Being uncertain of outcomes is certainly a lot different from a conviction determination to the negative about an entire asset class.
So – to conclude – I am sticking to my prior thinking – which is that this is not a time to just buy office willy/nilly – it never would be such – but when everyone hates this asset class, and every news article is railing about disaster, this is a logical time to poke around the wreckage, make very dire assumptions for a market recovery, and achieve some powerful bargains.
Bruce Stachenfeld, aka The Real Estate Philosopher™