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Offices Face Quantum Shift Post-COVID

The Metamorphosis of the Office Market by Paul Fiorilla No sector of commercial real estate faces more uncertainty going forward than offices. Companies found during the pandemic that work can be accomplished productively from home, and many workers found that they prefer shorter commutes and more flexibility. Demand for office space will be reduced, and workspaces will be redesigned. The only question is how much of a disruption will occur. Offices have taken quite a hit from COVID-19, even though the measurable cost has been obscured by the long-term nature of office leases. The U.S. office vacancy rate climbed to 15.9 percent as of April, up 280 basis points year-over-year, while sublease space has more than doubled during that time, according to Yardi Matrix. That bump, however, is just the tip of the spear. Only about a quarter of downtown office workers nationally reported to an office as of April, with the percentage closer to 15 percent in New York City and San Francisco, according to security firm Kastle Systems. The question is not whether companies will reduce their office footprint post-pandemic, but by how much. Demand for space barely scratches the surface of the considerations faced by owners and occupiers. The industry must come to grips with a host of factors, including when workers can safely return; how many people will use offices and how often they need to be there; where offices should be located; how offices interact with lifestyle preferences such as commuting and walkability and, how to re-design space to attract and maintain talent while meeting functional needs. The industry is facing a “quantum fundamental shift,” according to Jeff Adler, vice president of Yardi Matrix. “The sector is at the beginning of a wrenching multi-year rethinking of the nature of work. Everything is in play.” Where to Work? The primary question hanging over the industry is how office utilization will change after the pandemic ends. “Every tenant is asking the same questions about how and when to get back,” said Benjamin Breslau, chief research officer at JLL. Breslau said that the percentage of workers reporting to an office is expected to triple by year-end, to 75 percent, and that work-from-home will double to 20 percent of workers from 10 percent pre-pandemic. Many companies have found that workers can be productive from home, but to what extent can it be done without impacting corporate culture and collaborative efforts? A consensus has formed around the idea that most companies will adopt more flexible arrangements, but what that means for office space demand depends on the details. In terms of how much space is needed, there is a big difference between giving employees a choice to be fully remote or requiring them to be in an office part-time. Those decisions are complicated not just by employee preference but by the nature of the job and the industry. Some types of knowledge work (such as programming) can be performed well anywhere, but others are more productive in a collaborative environment. Daniel Ismael, a senior analyst at Green Street Advisors, said the average office worker’s time in the office will likely drop to 3.5 days a week from 4.5 days a week pre-pandemic. While a part of the office space decision will be driven by the type of jobs and corporate culture, companies will also have to bear in mind the preferences of employees, which is another complex issue. If proximity to an office is no longer important, how will that change workers’ preference for where they want to live? In the years leading up to the pandemic, the default assumption was that young knowledge workers wanted to live in an urban environment. Job growth over the last 20 years has been concentrated in urban areas,even in secondary and tertiary metros. However, the pandemic prompted a drop in population in urban submarkets in gateway metros. Young families moved to suburbs to get more space while others who were suddenly unmoored from the need to commute moved to different parts of the country. Some moved to lower housing costs, but part of the movement was driven by the closure of entertainment and cultural venues. When those venues re-open, some will move back to urban areas, but others have left permanently. Companies could deal with this by shifting offices to the suburbs or moving to less expensive metros, or by adopting a “hub-and-spoke” model with a city headquarters and outposts in the suburbs. Mark Grinis, hospitality and construction leader at EY Global Real Estate, said during ULI that a more distributed workforce is at odds with the need for collaboration. Studies done by EY of workplace productivity found that secondary locations—the “spokes”—had the worst performance. Lifestyle Changes COVID-19 has prompted many people to think about lifestyle and where they want to be. Many workers were relieved to avoid long commutes of more than 30 minutes, but “walkable” neighborhoods with access to shopping and other amenities remains popular. Diane Hoskins, co-chief executive officer of design and consulting firm Gensler, said that many are choosing smaller cities and inner-ring suburbs, especially in the technology sector. “There’s a real appetite for reconsidering how cities work,” Hoskins said. “When you look at real estate as an investment in people, you say how do you do it in a way that optimizes … competitiveness to be able to thrive in a global environment.” One difficulty for picking a location is that few metros are configured to meet conflicting worker preferences.  Lifestyle considerations mean that office buildings themselves need to be re-thought to meet the new paradigms. For example, workers may demand less density for health considerations. If workers come to the office less frequently, then more collaborative space is likely needed to make efficient use of the time they are together. Companies may have to redesign space to add amenities to retain workers and/or entice them to come to the office. The myriad redesign changes, and even downsizing, are likely to require costly capital expenditures at a

COVID Cash Kicks Off New Policy Era for CRE

Besides providing a short-term boost to the commercial real estate segments most affected by the pandemic, the $1.9 trillion COVID-19 relief package signed into law by President Joe Biden promises to be a taste of the type of progressive policymaking Democrats will implement while they control Congress. The American Rescue Plan funds a wish list of programs sought by the industry, including nearly $40 billion of aid for rental housing, $25 billion to prop up the restaurant industry, and nearly $200 billion for state and local governments to assist small businesses, tourism and hospitality. That’s in addition to the elements of the bill – including stimulus payments to individuals and extended unemployment aid – that will help families pay rent and spend on consumer goods, providing an economic shot in the arm. The bill also signals a change in policy with Democrats in control over the legislative agenda for the first time in more than a decade. Although they have a razor-thin legislative majority, limited by the Senate filibuster and lockstep opposition of Republicans, Democrats have an ambitious agenda. Now that the relief package has been passed, Democrats are likely to move on to immigration, climate change, and infrastructure, where some bipartisan support may exist. Given the political reality as long as the Senate filibuster remains in effect and the scope of President Joe Biden’s agenda, big-ticket spending items such as infrastructure, aid for affordable housing and tax reform may have to wait until the fall. The stakes for the industry will become more complicated then. Handing out aid in COVID-19 relief is popular, but there is less agreement about the benefit to changing the tax code or implementing new environmental regulations. Commercial real estate industry has a wish list of legislative priorities that includes a mix of program funding and regulatory relief. As new outlays have been scarce in recent years, the industry’s success in Washington has mostly come via tax and regulatory issues. However, COVID-19 has transformed the policy dynamics. With the economy down more than 9 million jobs from its peak, and demand for relief for struggling families, concerns about the deficit have taken a back seat to getting the economy back on track and making whole businesses that have closed and workers who lost jobs through no fault of their own. Housing, Retail Among the Beneficiaries The American Rescue Plan has a mix of indirect and targeted measures that should prove beneficial to commercial real estate. Indirectly, provisions such as the $1,400 payments to individuals earning less than $75,000 and couples earning less than $150,000, $300 a week in extra unemployment assistance through September 6, and the enhanced child tax credit should “put money in consumers’ pockets and help pay rent,” said Justin Ailes, managing director of government relations for the CRE Finance Council. The bill also contains provisions that will have a more direct impact on commercial real estate. In particular, the bill funds a range of programs sought by the multifamily industry. Those include $21.6 billion in rental assistance payments to be disbursed through the Treasury Department’s Emergency Rental Assistance Program (ERAP), $5 billion in housing vouchers that can be used for rental assistance, $5 billion for homelessness assistance, $750 million for rental assistance for tribal, native, and Hawaiian populations, $100 million for rural rental assistance. Other housing-related provisions include $4.5 billion for utility payment assistance and $120 million for counseling and fair housing. “Of the three (relief bills passed by Congress since the start of the pandemic), this is the most helpful to the industry,” said Mike Flood, a senior vice president of commercial/multifamily policy at the Mortgage Bankers Association. “We’re hopeful that, combined with the last bill, that will be enough to keep people in their houses and apartments and keep their refrigerators full until we get to the new normal.” All that funding comes on top of the $25 billion in rental aid passed in in December in the Consolidated Appropriations Act. While not covering every item on the multifamily industry’s wish list, industry advocates are “excited” at the amount of money targeting housing, said Cindy Chetti, senior vice president for government affairs at the National Multifamily Housing Council. “For the federal government to commit this kind of money to housing issues is unprecedented,” Chetti said. The federal aid should go a long way to making apartment owners whole. Tenants are behind on rent payments by as much as $70 billion, but they have largely been able to stay in place because of eviction moratoriums in various federal, state, and local jurisdictions. The rental assistance will enable property owners to collect unpaid rents and help pay mortgages and other bills. It remains to be seen how efficient the distribution of funds will be – the funds will be distributed to states and cities to be disbursed – but the infusion of cash will be a shot in the arm for the multifamily industry. Retail property owners will be helped by the $25 billion in grants targeted at restaurants that have been forced to close or scale back operations due to COVID-19. As of February, food service employment remained down by 2 million, or 16.3% less than it was at before the pandemic, according to the Bureau of Labor Statistics (BLS). The aid will help restaurants to pay rent and retain workers. The allocation of $350 billion for state and local governments – whose workforces have shrunk by 1.4 million (7.0 percent) year-over-year through February, per the BLS – is another area that will help boost commercial real estate. In addition to helping governments to avoid more layoffs, the relief package earmarks $195 billion toward helping governments assist households and small businesses, improve water and broadband infrastructure, and help mitigate the impact of lost travel and hospitality spending. Big Policy Goals Ahead Beyond the immediate stimulus to the economy, the ARP signals that Democrats will “go big” on policy goals to the extent they can with a one-vote margin in the

Industry Data

COVID-19: A Game Changer for Multifamily

The COVID-19 pandemic ended years of healthy multifamily fundamentals. Will the industry’s pain be short-lived or the start of a new trend that is less favorable for the sector? After nearly a decade of solid growth, multifamily asking rents dropped 0.4% nationally in April and May, with twice as many metros seeing rents decline (71) as increase (35), according to a study of 107 U.S. metros by Yardi Matrix. Metros with the most rent growth since the pandemic started—led by Portland, Maine (1.7% in April and May); Mobile, Ala. (1.3%); and Memphis (1.3%)—are primarily smaller markets, many in the Southeast and Midwest. Primary and secondary metros, with concentrations of urban properties in coastal centers, felt the most impact. Asking rents fell at least 0.6% in all primary markets, with the biggest decreases in Boston (-1.5%), Los Angeles (-1.4%) and San Francisco (-1.0%). Demand has weakened, and renters are increasingly looking for more inexpensive stock. Newer luxury units with the highest rents have fared worse than more moderately priced units. Rents of luxury Lifestyle units nationally decreased by 1.2%, compared to a decline of only 0.5% for working-class Renter-by-Necessity units. New units coming online are taking longer to lease up, prompting owners of more expensive units to offer concessions or lower rents to attract tenants. Whatever pain the industry feels over the short term, however, pales in importance to the potential long-term impact. Economic growth is now negative, and the shape of the recovery remains unclear.  More important, the pandemic is spurring changes in working conditions and social trends that will impact housing demand for years to come. Rent Growth Cycle Ends Multifamily had a long run of strong performance—asking rents grew by 26% nationally between January 2015 and the first quarter of 2020—until the coronavirus hit. Since mid-March, more than 40 million Americans have lost jobs, at least temporarily, and the unemployment rate skyrocketed to 14%. The layoffs were disproportionately concentrated among hourly low-wage workers, who tend to be renters. Suddenly, property owners’ primary concerns were collecting rent payments and maintaining occupancy. Many are rolling over leases of existing tenants with no increases. Nationally, asking rents dropped 0.4% since then (all rent data cited is from Yardi Matrix). Energy-dependent Midland-Odessa, Texas (-8.6%) saw the biggest immediate decrease, but major markets were among the hardest hit. The 13 metros that experienced rent drops of 1.3% or more include San Diego (-1.8%), San Jose and Nashville (-1.7%), Boston (-1.5%), Los Angeles and Denver (-1.4%), and Austin and Seattle (-1.3%). Some metros did see rents increase in April and May, mostly smaller or tertiary markets. Of the 18 metros that saw rent growth of 0.6% or more during that time, none are among the top 20 largest metros by population and half are in the Midwest. Those metros include Omaha, Cleveland, Columbus and Toledo (0.8%), and Grand Rapids, St. Louis, Wichita and South Bend (0.6%). Reasons for the metro-level differences are varied. The initial impact occurred in large states with major travel hubs such as New York, New Jersey, California and Illinois that were the first to impose shelter-in-place orders that closed businesses. Coastal metros with high rents were affected, as property owners found it difficult to raise rents given the uncertainty about employment, calls for rent forbearance and eviction prohibitions. Some affected metros have concentrations in major industries such as energy or entertainment—Las Vegas and Houston, for example. Also disproportionately hit were some metros with a large amount of new inventory coming online, such as Nashville and Denver. Issues related to urbanization and social distancing also loom large. With offices, restaurants, entertainment venues and schools closed, and residents ordered to stay six feet from others, the social advantages that led to the growth of walkable downtowns turned into drawbacks. Many city dwellers, especially those with children, decided they preferred to quarantine with relatives or friends in the suburbs, move to vacation or second homes, or in some cases make permanent moves outside of urban centers. Asking rents are likely to drop more throughout the year as demand wanes. The economic shock from layoffs and furloughs will impact household formation, as some young adults will live with family or friends rather than rent on their own. Immigration into the United States has dropped steadily in recent years, falling 595,000 in 2019, the lowest level in 30 years and 43% less than 2016, according to the U.S. Census Bureau. Immigrants overwhelmingly rent rather than own, which cuts demand in large urban areas where they tend to migrate. Changing Work, Lifestyle Preferences The question for the industry is whether these negative trendlines are a short-term blip that recovers quickly after COVID-19 is under control or if the pandemic will create trends that are unfavorable for multifamily over the long term. One key issue is whether social distancing will reverse the decades-long trend toward urbanization. Cities have benefited from trends that include growth of knowledge-based jobs. More than 70% of jobs created in the 2010s decade were in urban areas. City centers have thrived as adults—young and old—increasingly opt for their experiential lifestyles and the ability to live near jobs and avoid long commutes from suburbs. As offices across America are now shut down or operating at partial capacity and many corporate employees are working from home, the composition of future multifamily demand depends to some extent on how workforce issues are resolved. It seems certain that office working arrangements will become more flexible, but to what degree? Will corporations find that they no longer need to congregate in high-cost metros such as New York, San Francisco and Chicago? Will they increase use of remote offices in secondary and tertiary markets? Workers who are completely remote have much more freedom to live where they want than those who must work at an office two or three days a week. Will giving employees a choice of work location create an exodus from cities? Undoubtedly, for some it will. The pandemic has given many families with children

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