Don’t get too comfy in that waist-up, work-from-home-wear. Some of the world’s top institutional real estate funds—UBS and Brookfield among them—are staying constructive on the long-term prospects of global commercial office space.
“We do not envisage a world anytime soon where a significant proportion of office-based work is done fully remotely,” writes UBS’s Head of European Real Estate Research & Strategy Gunnar Herm and his team in the firm’s latest 2020 strategy update and 2021 outlook. “Many of the recent statements by CEOs on the future of the office are largely overdone in this regard, although we do acknowledge that COVID-19 is likely to act as an accelerator of some trends.”
Covid-19 has had a clear and obvious impact on investment in commercial office space this year. Earlier this month, commercial real estate investor CBRE reported that the office sector’s share of overall net-lease investment in office, industrial and retail properties, declined in the second quarter of the year to 26.6%, down from 37.2% in the same period one year ago. CBRE attributed this figure to a “lack of clarity over the future of U.S. offices.”
Aberdeen Standard, the U.K.-based institutional investor whose mandate includes $45.7 billion in global real estate assets, struck a grim tone on U.S. offices in their third-quarter outlook. Analysts observed that while office properties had “held up well” in the crisis to date, significant weakness may lie ahead, with continued underperformance for lower-quality assets, and “increased adoption of flexible working arrangements” posing a longer-term risk for the sector.
But at UBS, a look at the European office market shows resilience that may well be applicable to prime office properties in major U.S. gateway cities, as well.
UBS’s analysts acknowledged a “marked decline in office take-up as occupiers have looked to reappraise deals in light of the market uncertainty,” but did not see increased surrenders of active leases, meaning that overall European vacancies had increased only slightly during the period.
Rental declines have been few and far between in most European centers, they note. While rents declined in London’s West End and City markets—a development at least partly attributable to uncertainty over Brexit—Paris office rentals actually grew 2.2% quarter-over-quarter in Q2.
And while UBS notes that several high profile companies (to wit, Twitter) have announced plans to make flexible work options a permanent fixture after covid, they expect demand for well-located, high-quality office space to continue.
“High frequency indicators show that employees have been returning to work in locations where the government is perceived to be effectively containing the virus,” they wrote, adding: “On the supply side, there has been a slowdown in construction activity in most European centers, which is likely at least to ensure that there will not be a supply shock.”
Social distancing—>More office space, not less
Brookfield, the real assets giant with $203 billion in real estate assets under management, is positively buoyant about office trends in its latest market outlook. The firm expects Class A (premium) office properties—which make up the bulk of their real estate holdings—to outperform older assets in less desirable locations or higher levels of deferred capital expenditure. Moreover, this segment could even see increased demand as offices become less crowded due to the widespread, long-term adoption of social distancing behaviors.
Brookfield said in its August 2020 outlook that lease collections were mostly unaffected through June of this year. Given the long-term nature of commercial office leases, which typically involve lease terms of 10 years or more, the segment would likely withstand any downturn in market valuation or sentiment over the next 12-18 months.
Additionally, Brookfield notes, extended remote work arrangement could pose distinct compliance risks to companies, particularly those in financial services. Analysts cited a recent report by the U.K.’s FICC Markets Standards Board, which concluded that “widely distributed remote workforces pose more than 40 specific risks to companies,” notably in cybersecurity, confidentiality, and productivity.
Longer-term adoption of social distancing behaviors in the absence of a vaccine may increase demand for space, they find. Brookfield expects that even after covid, offices may plan to allocate 200 square feet of office per employee, equivalent to the average density of a decade ago—before efficiency trends like “hot-desking” and co-working took hold. This, they say, could increase office space needs by a factor of one-third.
Brookfield’s analysts say maintaining an extended weighted-average lease term (WALT)—i.e., a longer term to lease expiration—as well as maintaining a higher credit-quality tenant profile in the portfolio can counterbalance short-term market downturns.
“The original Brexit referendum in 2016, for example, did not have a significant impact on our London assets,” Brookfield’s analysts write. “Our leasing continued with no interruptions through headlines proclaiming the demise of London as a global business center. In fact, during that time, our office occupancy levels remained stable, and the city has only further solidified its leading role in the global economy since then.”
PropTech: A Test Case
In addition to office real estate defending well in the current downturn, Brookfield points to emergent real estate technology applications (commonly known as “proptech”) in Silicon Valley startup land, that may safely usher office properties through future phases of workforce development.
These include virtual marketing and leasing technologies, that allow tenants to explore rental spaces virtually, and landlords to lease space remotely. Space-utilization analytics technologies will let office employers track occupancy levels in spaces like conference rooms, to comply with the density requirements of covid-19 (or any future infectious disease crisis). Autonomous janitor robots powered by the Internet of Things (IoT) can be used to sanitize office spaces overnight, limiting human exposure to heavily trafficked spaces.
Finally, Brookfield has seized the opportunity afforded by the pandemic to introduce new air-quality enhancement technologies at its office properties. Before the onset of covid-19, the company began piloting a bipolar ionization system, emitting charged ions that can attract, bind and neutralize virus particles in the air, while reducing overall energy usage and emissions.
The company plans to roll out the system to all its office properties pending third-party testing and validation of the pilot program.
And there are regional pockets of global resilience in office investments, as well. Aberdeen Standard is constructive on selected Asia-Pacific markets, notably Singapore, where it forecasts Class A office rents to rise 1.3% over the next three years, having entered the crisis from a position of relative strength. They note that the vacancy rate for this segment was 4.1% at the end of 2019, compared to average of 6.5% per year over preceding decade, with new supply scheduled for completion in 2020-22 accounting for just 8% of the end-2019 stock (versus an average of 9.3% in the past 10 years.)
Aberdeen Standard expects similar stability in the Tokyo market, where widespread adoption of flexible or remote work arrangements may occur much more slowly. Their analysts note that during the state of emergency period, 60% of Japan’s total workforce continued to come in to the office.