Office Update | How far it's come and where it's headed

Commercial real estate has undergone significant demand shifts since the onset of COVID-19. There have been rapid and intense changes in performance across investment strategies. Residential and industrial properties have been clear winners for investors over the past two years. Demographic changes and the need for more space to work from home increased housing demand, driving up residential rents and investment returns. Similarly, an acceleration in e-commerce adoption made warehouse and logistics space a clear out-performer.

Office investments, on the other hand, have underperformed. Office occupancy declined as firms implemented remote working policies and downsized leased space. Lower occupancy reduces property income and has a secondary negative effect of causing prevailing market rents to fall as available space grows. 

Despite these challenges, heightened by an uncertain economic outlook, we believe office occupancy is approaching a cyclical trough evidenced by recent positive net leasing activity. Additionally, average lease terms and tenant concession packages showed signs of a shift back to landlords, beginning in late 2021 and into 2022, according to MIM’s analysis of lease data aggregated by CompStak, a market research firm. Even while we believe this is creating select tactical investment opportunities, investors have been slow to respond. We say select because understanding the pace of future office leasing, the drivers of medium-to-long term office demand, and geographical trends will be critical elements for avoiding risk while finding value in office investments.

A look at future office demand
Forecasting office demand used to be a straightforward exercise. There was a consistent relationship between employment growth in office-using job categories and office leasing activity. Pandemic-era remote work, however, broke that relationship (Fig. 1).

The difference between 2021 demand and the trend above suggests that remote working caused a 4% rise in office vacancy or 150 million sq ft from the estimated four billion sq ft US office space. In other words, without remote working, we estimate that 12.8% of office space would be vacant, in line with the pre-COVID levels and historical averages, rather than the current elevated vacancy level of 16.8%. 

While remote working was to blame for rising office vacancy in the past two years, we believe demographics will dictate the pace of the office sector’s recovery in 2023 and beyond, as well as the types of office assets that we believe will outperform.

Impacts of the war for talent
Many economists were surprised by how quickly the unemployment rate recovered in 2021 and 2022, but we don’t think they should have been. Government stimulus was certainly a factor, but we believe the demographic picture today vs. the last recession was also important.

As the economy recovered from the 2008 Global Financial Crisis, Millennials were entering the workforce en masse, while the relatively small Silent Generation was reaching retirement age, creating a glut of workers. Today, conditions are reversed. Millions of Baby Boomers are retiring each year, while the relatively small Generation Z is entering the workforce. As such, the 2020s could exhibit persistently tight labor markets, and the ‘jobless recovery’ of 2009-2015 is unlikely to happen again following potential recessions that could occur during this decade.

This dynamic should create winners and losers within the office sector. Specifically, highly amenitized space will become an increasingly critical tool for employers seeking to attract and retain talent. This in turn could drive an accelerated recovery for the most desirable office assets (typically classified as “class A” or “Creative” office space), with amenities such as full service – and free – dining options, gyms, high quality air filtration, outdoor space, natural light from floor-to-ceiling windows, and high (12+ foot) ceilings with limited or widely spaced columns. Additionally, we believe there could be a widening premium for assets with walkable restaurants and access to main roads and public transportation.

The rent premium between class ‘A’ and class ‘B’ office space was approximately 45% in 2019, as tracked by VTS. This has since increased to just above 50% and we expect it to grow to 60% by the end of the 2020s. However, we do not believe investors are placing enough of a discount on class B or C office space, or enough of a premium on class A and creative office space.

Market targeting
The change in leasing demand across markets is playing out as we expected at the onset of the pandemic. The markets that are performing well have had high population growth, limited risk from remote working (as we outlined in December 2020), and a manageable amount of construction activity. Of the largest office markets in the US, 25 out of 30 have experienced an increase in rent and/or leased space over the last year.

Looking forward, we believe that several markets experiencing some of the most severe near-term challenges have the best long-term office demand drivers and could offer pricing opportunities in the current market. This includes stigmatized markets like San Francisco, as well as a handful of modestly better-performing markets such as Seattle and Denver, all of which have aggregated the talent that supports rapidly growing industries.

Conclusion
While vacancies have risen to near-record levels over the past two years, office demand is recovering. Downsizing office space has certainly occurred, but it has also been less practical than many companies predicted earlier in the pandemic.

Still, risks lie ahead, and investors should weigh those risks when considering pricing and return hurdles for new office investments today. Class B and C office space faces several negative headwinds in both the short and medium term, and many assets may need costly redevelopment into condos or apartments.

The war for talent is exerting a significant demand boost on the class A office segment, and we expect this to continue. If we are correct, we expect the highest quality offices to outperform most other real estate asset classes in coming years.

About
William Pattison, CRE, is a managing director and head of the real estate research & strategy team at MetLife Investment Management (MIM). In this role, he works closely with MIM's real estate regional offices and portfolio managers to craft the strategic house view, project capital market trends, and develop investment strategies. As a member of the Investment Committee, William is responsible for reviewing and voting on all U.S. real estate acquisitions. Prior to joining MIM in 2015, William worked for ten years in the real estate group at Aegon Real Assets. 

Michael Steinberg is an associate director of real estate research & strategy for MetLife Investment Management (MIM). He is responsible for development and maintenance of the team’s quantitative research models, market forecasting, and communicating the team’s investment strategies and economic outlook. Prior to MIM, Michael worked in both research and portfolio management capacities at UDR, a national multifamily REIT, and Reis, a leading real estate market research firm. Michael received a Bachelor’s degree in economics from the College of the Holy Cross and an M.B.A. from Columbia Business School.