The Pandemic Might Have Broken The Office Market's Supply-Demand Dynamic. For Now.
You sell apples. Suddenly everyone wants oranges. What do you do?
Something like this dilemma confronts major office markets across North America and Western Europe, where the coronavirus pandemic has hit hardest.
The open question, as U.S. cases surge again and a speedy recovery seems less likely, is whether this is a temporary disconnect between supply and demand, one the market will speedily resolve as the pandemic and the social distancing it involves fade away, or has the coronavirus broken the property market in a more fundamental way?
“It’s an upside-down world,” Aviva Investors Director of Research for Real Assets Chris Urwin said. “What was good is bad, what was bad is good, one day we want lots of people together, the next we don’t.”
For years, office developers have sought to build increasingly dense buildings as close as possible to transit. "Densification,” “rightsizing” and “consolidation” have been corporate real estate buzzwords since the Great Financial Crisis as technology, the sharing economy and workforce preferences led companies to pack workers into high-rise office towers in the heart of downtowns.
But as social distancing and infection control take top priority, some companies’ focus has turned instead to low-density, suburban locations accessible by car.
The decentralizing impulse is being felt globally, as a recent Cushman & Wakefield examination of 40,000 global occupiers showed. The report suggests there will be no return to the office because the old office is no longer there.
The new workplace isn’t a building, the Cushman & Wakefield officials who authored the report wrote. Instead, it is a network of real and virtual places forming an ecosystem designed to support each individual business. Hub-and-spoke working may be part of the answer.
“The effect of three months of working from home has been that there is now a high level of trust between employers and employees, and more trust and collaboration between them,” Cushman & Wakefield International partner Charles Dady said. “So we’ll see corporations adopt various mixes of remote working, urban, suburban and drop-in locations.”
Cove founder Adam Segal, whose D.C.-based coworking company started with the concept of creating satellite-style offices for remote workers, said he expects to see a shift in companies looking to spread out their footprints. He believes it’s permanent.
“I think the pandemic expedited the future, which is, ‘How can I work closer to home?’” Segal said. “Generally, I think downtown will become less popular, except for those who do it right, and there will be a rise of smaller, suburban offices.”
The “hub-and-spoke” model — in which a company’s main office remains downtown but it opens satellite offices farther afield in the suburbs — has rapidly gained traction from Houston to the United Kingdom.
Manchester, England, was badly hit with the coronavirus, with over 2,000 coronavirus deaths in a city of roughly 540,000. The city is still subject to a partial lockdown, and its usually hyperactive market feels fragile.
Manchester’s high graduate retention levels, the UK’s highest outside of London, mean a large and constantly replenished pool of young, city center-focused talent. Few businesses will want to turn their backs on this for long, Cheap said. But some may feel they have to find suburban locations in the short term.
“Businesses are looking for floor space in which you can make social distancing work,” Cheap said. “That means nice, open floor plates, and if they can find that on flexible terms in the suburban business parks, and they need it now to make their business work, they will do it.”
He has multiple short-term deals in progress, he added.
Demand for out-of-town offices will go up if getting into town gets hard to do safely, or at least the public perceives that it has. In most big cities, that is already the case.
In the wake of the pandemic, most U.S. public transit systems adopted stringent cleaning procedures, including the frequent use of powerful disinfectants, said P.S. Sriraj, the director of the Urban Transportation Center at the University of Illinois, part of Chicago’s College of Urban Planning and Public Affairs.
The Chicago Transit Authority is limiting the number of riders on its 40-foot buses to 15, and Metra set a 50% occupancy limit on its commuter trains, requires all passengers to wear masks, and promised to clean and disinfect all high-touch areas at least once per day.
These efforts may not be enough to entice riders back onto trains and buses, Sriraj said.
“How do you convince users they will not be exposing themselves to added danger?” Sriraj said.
Mixing homes and low-tech “touchdown” workplaces in suburban locations could be an answer for companies that can't convince their workers to come downtown.
Instead of amenity-rich redevelopments, some companies have started looking for new locations in single-story buildings, old-style offices that had fallen out of favor, according to Colliers International Senior Vice President Alissa Adler. Such offices are simple, mostly in the suburbs, with no bells or whistles. They are low-cost, easy to manage and allow tenants 24-hour access. Individual offices tend to be small, usually about 1K SF, and can be quickly occupied without needing many tenant improvements.
“You can park your car right in front of your office, and these generally have no communal areas you share with other tenants,” Adler said.
The rub: There isn’t much supply of standing stock or a pipeline of developments to meet this need.
“People haven’t been building this product type for 20 years, unless it’s a build-to-suit,” Colliers International Senior Vice President John Homsher said.
Those properties are being presented as ideal for the changing demands of the largest demographic in the workforce today: millennials.
Chicago-based GlenStar Properties owns and operates 2M SF of office properties in the suburbs and Chicago’s central business district, as well as several office properties in the Dallas metro area.
GlenStar Properties Managing Principal Michael Klein said companies flocked downtown in the past decade after millennials gave up on the suburban lifestyle in favor of hipper urban neighborhoods, and a reverse migration is now starting to pick up speed.
Klein noticed a slow, gradual movement of older millennials out to the suburbs over the past 20 months or so as more got married and planned to start families, and the coronavirus may be pushing more to abandon city homes.
It is the same story in the residential sector. Jena Radnay of @properties typically sells around $100M of homes each year and said there has been a burst of interest from city dwellers this spring for homes in Chicago’s North Shore suburbs.
“It’s a knee-jerk reaction to COVID-19,” she said. “All of a sudden, they say they want a big backyard and are asking for a home with a pool.”
Unlike heavily suburban markets such as Indianapolis, St. Louis and Dallas, Chicagoland has a relatively modest amount of single-story offices. There are just 257 single-story properties of more than 20K SF, totaling about 10M SF, out of an overall suburban inventory of roughly 160M SF, and land costs make it too expensive to build new.
The supply problems in Chicago are repeated, with more or less depth and complexity, in all big-city markets of North America and the UK (though not in mainland European centers like Amsterdam, where large out-of-town hubs are the norm).
Two decades of minimal out-of-town and business park development leave occupiers with little choice.
The modern, Class-A suburban space occupiers want is scarce, or in some markets doesn’t exist. Before the coronavirus pandemic, few major companies wanted suburban offices, so few new ones were built.
What is on offer instead is either poorly located or fails the modern tests of well-being. In the wake of the outbreak, nobody wants an unhealthy office, and many old properties fall into that bucket.
The D.C. suburbs had a 17.3% office vacancy rate as of Q1, with 41.3M SF of vacant suburban office on the market, according to Newmark Knight Frank.
The Chicago suburbs had more than 20M SF of vacant suburban office as of Q1, according to NKF. The Atlanta suburbs had more than 20M SF of vacant suburban office, the Boston suburbs had more than 15M SF of vacancy, the Phoenix suburbs had more than 12M SF of vacancy and the Philadelphia suburbs had more than 8M SF of vacancy.
But a large portion of this stock is functionally obsolete, meaning it is unlikely to benefit from a sudden surge in demand.
When NKF last analyzed suburban office obsolescence in 2015, it studied five representative markets across the country and found that 14% to 22% of suburban office inventory is in some stage of obsolescence, suggesting that between 600M SF and 1B SF of suburban office in the 50 largest metro areas was not competitive in the market.
“The issue of obsolescence remains,” NKF Senior Managing Director of National Research Sandy Paul wrote in an email. “Modern suburban office product is likely to outperform the overall market in the months ahead, but older, unrenovated space has limited appeal.”
PS Business Parks Divisional Vice President Chris Auth said he expects to see a near-term increase in demand for the REIT’s suburban office products as companies shift offices to the suburbs, both because of health precautions and cost savings.
“Part of it is going to be a reluctance of some people to utilize public transportation, just given personal health concerns,” Auth said. “Some of it is going to be taking functions that are housed in a central office in an urban district and putting them in more suburban locations. Maybe core functions stay in the CBD, but administrative and back-office functions can work in a more spread out, less expensive per-square-foot suburban location.”
Prior to the crisis, PS Business Parks, which owns a nearly 28M SF portfolio of commercial space, had been building out move-in-ready spec suites in its vacant suburban offices to help spur leasing. Auth said he thinks those are poised to benefit from companies looking to move employees quickly into suburban satellite offices.
“A significant portion of our vacancy is geared toward, ‘If you want to move in, we can give you a lease and you can move in tomorrow,’” Auth said. “We’re already well-suited to handle that sort of potential interest.”
The blended workspace ecosystem advocated by the Cushman & Wakefield report has on-the-ground advocates. Adding suburban coworking to the mix is also increasingly common.
Coworking providers with large suburban office footprints are benefiting from companies looking for move-in-ready spaces. Industrious CEO Jamie Hodari said his company has talked to roughly 3,000 members who expressed interest in suburban office space.
Hodari said many businesses want to open suburban outposts in addition to their downtown hubs to provide easier commutes for employees living outside of the city. But timing is key.
“They want it now, not in 10 months,” Hodari said. “Most companies feel comfortable saying, ‘For the next couple of years, I’m going to be better served having a set of options across a metro area rather than forcing everyone to come into one place all day.’”
Industrious has more than 100 locations across more than 30 U.S. metro areas, and many of the deals it signed over the last few years have been in the suburbs. Hodari said this suburban shift was an intentional strategy that is now benefiting the company.
“We’re a bit lucky that we started making a push into the suburbs three to four years ago, and at this point for most American cities, we have options in the major suburban areas,” Hodari said. “It definitely benefits us. … We’re already seeing the evidence of that.”
Developers who have been building in the suburbs for years said the newer office properties, with accessible retail amenities and transit, are more likely to benefit from a surge in demand than older properties surrounded by parking lots. Foulger-Pratt owns office buildings in suburban Maryland and Northern Virginia, and in December it broke ground on a spec office building in Tysons, Virginia, a dense office market 15 miles outside of D.C.
“The notion of going back to suburban office parks with big surface parking lots, I just don’t see that happening,” CEO Cameron Pratt said. “Employers need to be located in places where employees can walk to lunch … they need to be located in places that are high-density that allow a host of restaurants to survive.”
Cresa CEO Jim Underhill, who leads the world’s largest tenant-only brokerage firm, said he is seeing companies look to create more dispersed footprints, adding satellite offices so suburban employees don’t have to commute downtown on transit. He also thinks the suburban properties that will benefit from this strategy will be those in walkable areas.
“The suburban markets that do best will have some proximity to mass transit,” Underhill said. “Those projects that have restaurants and other amenities within walking distance will greatly outperform the traditional suburban business campus that’s just a building standing alone.”
Industrious has opened coworking spaces in traditional suburban office parks, and Hodari said they have experienced strong demand. He said tenants are drawn to the downtown areas of suburbs with more walkable retail streets, but there is often much less office space available in those areas than in the office parks.
Hodari said there are ways for landlords and coworking providers to add amenities and food options to office parks to make them more appealing, and they also offer benefits such as higher parking ratios, more indoor and outdoor space for social distancing, and less reliance on elevators.
“Our suburban office park locations do well,” Hodari said. “I think they get a bad rap, but there are some very practical reasons, some of which are probably magnified during COVID, why they’re quite convenient places to work.”
Italy was among the first to experience the full force of the coronavirus, and its 34,000 fatalities rank it among the hardest hit.
The Lombardy region, whose economic engine is Milan, was the outbreak’s first epicenter outside of China, and if there is a fundamental shift in the office market as the pandemic retreats, it ought to be visible there. Yet there isn’t much sign of it.
Rather the opposite, with the acquisition during the outbreak of seven UBI Banca sites in the center of Milan (and the sale and leaseback of another), €1B of investment in new, high-specification and sustainable workspace in the Porta Nuova business district. The list of bidders reportedly included Blackstone, Varde, Lone Star Funds, Bain Capital, Cerberus and Apollo, but the winner was Milan-based development and asset manager COIMA.
“COVID-19 has accelerated the demand for high-quality and sustainable offices from both occupiers and investors,” COIMA CEO Manfredi Catella said. ”Not only do spaces such as Porta Nuova support the health and well-being of tenants, but they can also provide stable long-term income for investors who are increasingly focused on ESG metrics.”
Other experts also highlight environmental, social and governance goals as a reason to be wary of deurbanization. Cain International CEO Jonathan Goldstein said a workplace model that includes permanent work-from-home and suburban satellite offices might push companies in the wrong direction.
“Working from home will perpetuate inequalities because not everyone can do that,” he said. “Glass ceilings in race and gender will not get broken if we all work from home.”
Urwin, tasked with trying to track a path through the current uncertainties for Aviva Investors, agreed that a move to suburbanize offices will damage companies' ESG agenda.
“People need to be very aware of this,” Urwin said. “And it’s not just working from home, it’s working from suburban locations, which are often closer to wealthier areas, making it more difficult for other groups.”
An office market configured to satisfy the demand for dense urban floor space naturally has problems executing the kind of 180-degree turn the coronavirus seems to require. With limited new development in out-of-town locations, demand for hub-and-spoke solutions is hard to satisfy.
But if there is a disconnect between property market supply and demand, it is temporary, according to the Centre for Cities, a UK-based think tank that researches urban economies.
“The productivity benefits of city center staff outweigh the occupational costs,” Centre for Cities Policy Officer Simon Jeffrey said. “City centers are deep labor pools fed by good urban transport. You can measure the value of city centers to businesses by looking at the cost of office space per SF. It is cheaper out of town, which tells you everything about how people price the access to people, relationships and knowledge you get from face-to-face networks in city centers.”
Once today’s stunned reaction to coronavirus eases, the property market will resume its pre-pandemic urbanizing focus, Goldstein said.
Goldstein, a recovered victim of COVID-19, said most office workers will soon forget their fears.
“I’ve been at home for 100 days now, after having coronavirus in March, and I’m desperate to get back to the office, to see colleagues, to debate,” Goldstein said. “Yes, coronavirus will change working patterns for a while, but people have short memories.
“The truth is you can’t build a business on Zoom. You need to be near people, and you need young people, and they flock to urban centers because they do not want to sit in the bedrooms or in offices overlooking fields,” he added. “No amount of working from home can replace that human interaction.”
The markets are not broken, Aviva’s Urwin said, although he admitted he is struggling to make sense of two decades of intense urbanization, made possible by increasingly crowded mass transit and ever-more-densely occupied office buildings, which suddenly seems very last year.
The markets, and office occupiers, are just taking time to adjust, he said.
“Our upside-down world may be over soon if there is a pharmaceutical intervention for coronavirus. Or we may be living in an upside-down world for longer than we thought.”