Is office space the Tortoise or the Hare?
It's almost odd now to write about commercial real estate trends looking backwards at the final quarter of 2020. So much has happened in a small amount of time. Fiscal and monetary policy dominate headlines, capital markets reactively gyrate, Covid news changes daily, and political tensions sway in the wind like palm trees on a deserted island (which most days is where I prefer to be now). Time seems to speed up with the low viscosity flow of news, opinions, and superfluous banter. Yet commercial real estate seems to plod along in its own illiquid terrain like the proverbial 'Tortoise', unaware of the sucking vacuum of air and tunnel of dust being kicked up all around it. It is under this context that I present the findings of the final quarter for the office sector, perhaps the asset class that most suffers from an identity crisis. I should note that how am I describing the asset class is not directly in line with the parable, in that I am not predicting a winner or loser, but merely suggesting that the delta at which the speed and route of recovery it takes is large enough to question the manner in which it gets there. Compounding the problem, perhaps in an effort to subliminally steer the race, is the amount of sideline prognosticative reporters breathing heavily into microphones. But alas, I may be one of these sweaty correspondents as I give my cloudy outlook at the end of the report. <sigh>
As we reported towards the end of 2020 in our Q3 Report, sublease space was hitting historical records as companies reevaluated their workforce needs and work from home policies. We wrote last quarter, that "sublease space is now larger than during the dot-com bubble and could feasibly reach 150 million square feet of availability by the end of 2020." The good news is that we didn't hit that grave milestone, the bad news is that we didn't miss it by all that much either. According to JLL research, sublease space nationally now sits at over 141 million square feet with potentially more on the way as additional companies reconfigure their office arrangements. Taking into account normal long-term vacancy rates, sublease increases, and increases in delayed construction that started pre-Covid and it's no wonder absorption was underwater again for the third straight quarter.
With these statistics and declining rent collections it is no wonder that according NCREIF Property Index (NPI) the benchmark for investment returns and capitalization rates, the fourth quarter wasn't able to post returns above 0.50%. Office had annual returns for the year of 1.57%, with only Covid-decimated retail and hospitality posting lower returns for 2020.
Another trend to consider is the decline in average leasing terms for the office sector as companies look to trim liabilities and increase logistical flexibility. It will be interesting to note and see if this continues to be a long-term trend. If so this could have significant implications in terms of how investors view asset risk, what it means in terms of leasing structure (ie. tenant improvements), vacancy turnover rates, and obsolescence.
So the burning question for 2021 is, where do we go from here in the office sector? As vaccines rollout and the nation digs itself out of snow and ice, let's turn to our sideline reports on the 'Tortoise and Hare' race and see if you can get a sense of what's happening:
-Nearly 70% of CEOs expect to downsize offices - KPMG September 2020
-The office, as you know it, is dead - CNN August 2020
-The Office Isn't Dead, It's Evolving - Forbes September 2020
-Law Firms Are Dumping a Significant Amount of Office Space -NREI online October 2020
-Amazon Bets on Office-Based Work With Expansion in Major Cities - WSJ August 2020
-Remote Work Is Here to Stay - Flex Jobs December 2020
-Statistics Show Remote Workers Are Frustrated, Many Still Unprepared - Forbes August 2020
Is everything clear now? One thing that is clear is that remote work has been accelerated and is likely to become part of the corporate mandate. It makes sense in that businesses are now not geographically restrained to find talent and companies can trim expenses. Here's a list of large corporations already adopting robust work from home policies, including Amazon, Facebook, Saleforce, Twitter, Target, Microsoft and more: https://www.flexjobs.com/blog/post/companies-switching-remote-work-long-term/. These policies have to have an overall effect on demand, right?
So under this context let's look at how Portland fared in Q4 and "potentially" what it could mean for the future.
In commercial real estate, everything starts with demand. Office demand comes in the form of employment, and more specifically in employment from "white collar" classifications such as information, finance, and professional business services. Employment trends are the catalysts for understanding future growth and demand in office.
Obviously employment nationally and locally has taken a significant hit, with the Portland MSA actually trailing the US average in terms of employment growth. Usually this would mean that we should have a more pronounced downturn in the area affecting consumer spending, housing, and future investment, but let's look at how those numbers are broken out.
As you can see from the Bureau of Labor Statistics chart, some office employment sectors fared better than other sectors, such as leisure and hospitality and government. The former due to business closures and the latter due to budget cuts and limited tax revenues. Yet professional and business services seemed undaunted by the pandemic and barely registered a decline in year over year employment (-0.8%). This could help buoy the office segment as professional services remain steady and finance (-6.8%) and information (-9.4%) rebound.
But before we get all rosy, let's bring it back around to the fact that vacancy rates increased again in Q4 as the pandemic continued on and companies reevaluated their positions, especially in the downtown CBD. In fact, direct vacancy rates have been increasing overall since the trough in Q4 2019, still dragged down by overall declines in employment.
With delayed construction deliveries, increasing sublease space (now totaling 1.5 million square feet) and tepid demand at the end of the year, it understandable that we have a severe drop in absorption rates, totaling a negative 1M square feet on a weighted average.
Despite these significant headwinds in supply/demand, lease rates haven't moved much at all as pricing between owners and users remains disconnected. Certainly there have been concessions since the downturn including increases in free rent and tenant improvements, but landlords are so far holding steady (for the most part) on leasing rates. We do expect to see these rates begin to drop more in the first half of the year as landlords look to fill up the supply leftover from the previous quarters of negative absorption.
There's no doubt Portland had a rough 2020, between civil unrest making national headlines, Covid shutdowns, and political ineptitude. Yet stories of Portland's demise may be greatly exaggerated ("Portland is the New Pompeii") as the city continues to enjoy net in-migration (population) and office sector categories (employment) that have moderately weathered the storm. One rare general consensus among pundits though, is that the first half of 2021 is forecast to get slightly worse before things turn around in earnest towards the second half. I wouldn't bet the house, but in general terms this should prove true as the vaccine rollout begins to open things up.
So where do we go from here? Is it a tortoise or hare recovery for office in Portland? The short answer is...no idea. I do know two truths in this regard, however: (1) the market will change, and (2) if anybody tells you that they know for sure, they are trying to sell you something.
We'll continue to watch both employment trends and absorption rates in the next couple of quarters to see if we can turn around demand quickly. After all, we don't want an even worse scenario of braised hare and turtle soup.
About the author:
Michael Hironimus, CCIM is the Certified Investment Advisor and Principal Broker for Duckridge Realty Advisors specializing in commercial real estate investment portfolios and asset management for high net worth private clients, with focuses in market, financial and risk analysis. He is also a faculty instructor for the CCIM Institute, teaching professionals globally in the CI-102 Market Analysis Core Course.
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