The Next Decade of Office: Bending With Time, Space

Alex Snyder

Divining the future is a fool’s errand. Anybody who didn’t believe this assertion prior to a globe-sweeping pandemic has most likely been convinced otherwise by this point. But just because we can’t predict anything with exact certainty does not mean we can’t often foresee major trends—the big themes—coming as they start to form from the ether.

Office is an asset class that has been disrupted more than most real estate sectors in recent years. While we don’t know exactly what an office building will look like in a decade or how it will be used, we can be sure it will be different than it was before the world changed. We are starting to see some compelling themes emerge in this regard.

Present Performance

Starting with the present, it is clear that office has found a bottom in fundamentals. Even with Omicron hampering activities, national office space managed to punch out positive absorption in the fourth quarter of 2021 for the first time since 2019. Market rents are no longer falling. Concessions are still high but have stopped rising. The conundrum is that the good news isn’t evenly spread across landlords. It is precisely here where the big picture is forming.

Quality is a word you will hear repeatedly if you listen to any earnings call about office space. The best assets are still desirable. The worst office space is becoming obsolete, valued more for its steel, or even just its dirt, and best repurposed for other uses. On its recent quarterly call, Boston Properties shared a fascinating illustration of this dichotomy. They asked CBRE to dice up San Francisco, the hardest hit office market in the country, and posed the question: Exactly how much better is quality space performing? The availability rate, which includes sublet space, of the entire San Francisco office market is about 27 percent. But looking at the Class A trophy buildings? The availability is just 8 percent. The bifurcation between quality space and everything else is enormous.

The analysis begs the question: How is quality assessed? For industrial real estate, proximity to end customers matters most (even a garden shed in Los Angeles is gold if used as last mile distribution). For office space today, it’s all about getting employees together and boosting their productivity. For the average company, real estate is less than 10 percent of its costs whereas people are around 90 percent. If an employer can spend 10 percent more on real estate and get a 2 percent boost to workforce productivity, it is money well spent. For decades office has simply been seen as a box to store humans as they make widgets. But viewed through this new lens, office is a tool to enhance productivity. The office of the future is a device, like good software, that makes your people better. What does that mean in practice?

In a world that was forced to embrace remote work only to subsequently understand that it can be a productive (and preferable) alternative, an office needs to be part of a hybrid solution. As we recover from the pandemic, the first role of the office is to entice people back. Any company can demand workers return, but great employers know that office space is better used as a carrot than a stick. To wit, many of the largest landlords in the country are exploring the hospitality model for office, making the space as inviting as a nice hotel. Coming to the office will be about sparks, personal interaction and culture building. Here, quality office will need common areas that encourage facetime. Lobbies will transform from pass-through gateways into destinations that compel you to linger, gather and engage in open, dynamic spaces. And more “on-campus” amenities including food service and package lockers will keep employees close during the workday and eliminate errand time.

Flexible Future

The future office needs to bend with time and space. This suggestion is not science fiction. In fact, it reflects a growing reality that employers need to be nimble, because tenants want to be able to expand and contract square footage, reconfigure their space, and manipulate lease terms at will. Coworking firms like WeWork have proven that tenants are willing to pay a premium for evergreen flexibility. The office of the future—and the terms set forth by landlords—will reflect that preference.

“Location, location, location” has always been the favorite phrase of real estate investors, but the importance of this mantra has only grown. It has been said many times over the last couple of years, “employees don’t hate the office, they hate the commute.” As many people have fled to suburbs and gotten used to not commuting, the need to be in a central location near public transit has become ever more important for office buildings. To wit, leasing in Manhattan last year was strongest around Grand Central Station where more than 250,000 commute through each day.

Tenants are also demanding environmentally friendly buildings. And landlords are building them because these new, green properties have captured the holy grail: pricing power. Employees want to be in a space that they know is better for the environment. Many cities and states are demanding these efforts ensue with regulations. And it’s not just the environment that experiences benefits; employees in healthy offices fare better as well. Fresh air, access to outdoor space and plenty of natural light are all hallmarks of new buildings. They have been shown to increase the productivity of the people working inside them. This positive externality, in turn, allows landlords to command higher rents. Green makes green.

To satisfy the needs of the modern tenant, the next 10 years of office is poised to see more than its fair share of new construction and major renovations. It will be expensive, but those landlords who can lean into the change and flex their nimbleness will win big. The losers with obsolete, older properties will end up with archaic square footage looking for a new purpose outside of providing workspace. The ones in the middle may muddle along for a few years, but at some point, they will need to choose a path, or one will be chosen for them. Office space is changing. And while the tea isn’t fully brewed, we can read the leaves enough to know that it’s time to adapt.

Alex Snyder is a portfolio manager for CenterSquare Investment Management’s real estate securities group. Snyder joined the firm in 2015 and supports the portfolio management team, conducting full investment analyses and valuations for the securities within his U.S. REIT coverage universe.