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- Last Cast Letter #6: Some Thoughts On The Office Sector
Last Cast Letter #6: Some Thoughts On The Office Sector
Plus, my thoughts on July 4th.
Hi All - Happy Friday. It’s the last day of the month, which means it’s time for the Last Cast Letter.
I can't decide if too much or too little has been written about what's happening, and what's going to happen, in the office sector.
On one hand, every time I see another doom and gloom article on Bloomberg, CNBC, etc, I think to myself, "Okay, we get it, office is in a bad spot right now." It feels like a lot of outlets have just been beating the same drum over the past 24-36 months. And for a good reason too, but the content starts to sound recycled.
On the other hand, some of the stats in these pieces still catch my eye, and make my internal monologue say, "Yikes." Take this opening paragraph from a Bloomberg article last week, for example:
"US office buildings are unlikely to regain their peak pre-pandemic values until at least 2040 as demand for desk space weakens, according to a forecast by Capital Economics.
Values are expected to plunge 35% from the peak by the end of 2025 and take an additional 15 years or more to recover as hybrid and remote work reshape real estate, the London-based research firm reported Thursday. It’s a trend that mirrors the collapse of shopping malls as e-commerce grew."
I mean, if true, that is absolutely brutal. You start to think about the downstream impacts of something like this, and it just feels like it's going to exacerbate other issues. If downtown centers are dead, does that mean crime and homelessness get worse? And if cities become more dangerous as a result, will fewer people want to live there? And if fewer people want to live there, do property values in other assets sink as well? Some of this looks like it's slowly unfolding already.
New York City’s Comptroller is projecting revenue to drop by 1.4% if property tax values decline by 40% in the coming years.
Now cities have to find money elsewhere, so this might be why the MTA is proposing an increase to the subway and bus fare to $2.90 by Labor Day.
I don't know. This is that "urban doom loop" theory we've heard about, that, in my opinion, appears to be impacting a place like San Francisco much more than New York.
New York is a weird beast right now because even though some of the above is happening, you can also see a massive line of people waiting to view a $5k/mo 5-story walk-up, 2 bedroom, 1 bath in the West Village or Williamsburg because it has a washer and dryer in the unit. Interns still struggle to find housing for the summer and plenty of new grads still want to move to the Big Apple.
So, yeah the office space is confusing at the moment. And a lot of what has been written tilts towards the "if it bleeds, it leads" spectrum of reporting. As a result, I wanted to see if I could find any articles on the sector that were slightly more glass-half-full.
I came across one on Loopnet that I thought was fairly interesting, and worth injecting into the conversation, because it looks at another point in history when "a death sentence [had] been issued for the office sector." This came just after the September 11, 2001 terror attacks. Take a look at the graph below.
Office vacancies were hovering around 8% in 2000. In the years after the attack, they doubled. Then they slowly started to drop until we hit the Great Financial Crisis, after which they climbed again.
If you look at the Manhattan market specifically in the 2010s, office vacancies never quite make it back to the low levels seen at the turn of the century.
However, there is a clear cyclical pattern at play. An optimist (otherwise known as a contrarian at the moment) might tell you that we are in the early stages of another one of these cycles, and they might be right. But, per the Bloomberg article we started with, it just seems like this cycle is going to take a lot longer to sort itself out.
This cycle also seems fundamentally different. The Financial Crisis was the result of systemic issues within the banking system – today’s problems, on the other hand, are due to a change in human behavior. Addressing the Financial Crisis required quick thinking, savvy banking, and an infusion of capital. This change in human behavior could end up being much harder to address.
The Loopnet article did a great job of summarizing how real estate professionals are thinking about what comes next, in order to address, or at least react to this seismic shift in human behavior. We recommend reading the original piece, but here is an overview.
Takeaway 1: The Office Comes Last
Steve Martin, a managing principal at SDM Partners, noted that a fundamental shift has happened in terms of America’s workplace. Decades ago, especially during the golden era of suburbia, the office came first. Just like a water source, office buildings represented the anchor that cities were built around. Employees were essentially anchored to specific cities because that’s where their employment was. Over time, other establishments like restaurants and hotels got built around existing office buildings. This dichotomy will be completely different moving forward.
Today’s workforce no longer needs to be anchored to one location, nor do many people desire to be. In today’s world, the office will come last, not first. Instead, people will naturally flock to areas that are nicer to live in since they are not necessarily tied to one location. Additionally, they will prioritize their living choices based on the leisure and entertainment options that surround them. Only after people have found a place to live, that they like, will they search for a place to work.
Bottom line: developers need to invest where people want to live. Not where the office is.
Takeaway 2: Office-To-Residential Conversions
The most immediate idea for office owners is to convert the existing buildings into residential communities. Somewhat ironically, while office vacancies are elevated, the nation is still experiencing a dramatic shortage of residential living space.
That said, converting existing structures is much easier said than done. It’s also not necessarily realistic for every office building.
A recent assessment by Avision Young found that there are roughly 9,000 office buildings in North America that could be converted fairly easily. However, even for buildings that have the potential to be repurposed, it will ultimately come down to building economics.
In other words, is it financially viable to gut the building and install the necessary plumbing, kitchens, washrooms, life safety systems, storage, etc that are required for a residential building? For many of these buildings, that answer will be no.
Additionally, there’s also the question of community: is the building in a location where people would reasonably want to live? Is it located close to shopping centers, restaurants, and outdoor amenities?
Office conversions are a nice thought, but a beast to execute. There’s probably money to be made here, but only in the right locations. I think some high-net-worth families are on to this in New York City.
Takeaway 3: It’s Time To Rethink The Workplace’s Role In The Community
At the end of the day, “the office” will never vanish completely. After all, the office is just a community. Moving forward, it’s just a matter of determining what the “office community” looks like.
I’m a big proponent of working from home. I really don’t miss the commute on the New York Subway or the London Tube. With that said, however, I love the idea of having an HQ and hybrid work policy. In my discussions with numerous people, who work in various industries, this setup resonates with them as well.
I also think that more flexible work arrangements would drastically help women in the workforce, but that is a whole different can of worms that I won’t open in this edition. Maybe another time.
That’s my riff for this month. I’d love to hear any thoughts you have and as always, if you’re interested in investing alongside us, please fill out the investor form below. We’ll see you at the end of July, I hope everyone has an incredible July 4th.
— Brooks
PS: If you love America like I do, then maybe you’ll find this intro interesting. I wrote it for our daily newsletter, The Flag.
As of today, we are officially halfway through 2023. Wild! But it’s cause for celebration, as is the weekend before our favorite holiday of the year: July 4th.
Our independence from Britain 247 years ago made the world a better place. Before the United States, much of the Western world was organized in a vertical order known as the “Great Chain of Being” — a world ruled by priests and monarchs. It was a world in which, if you were born at the bottom, you had virtually no chance of ever making it to the top.
The Declaration of Independence, the Constitution, and the Bill of Rights took that existing framework and bodyslammed it against the ancient moral grounds it had been resting on for thousands of years.
The vertical order began to tilt, becoming just horizontal enough that, if you were born into a poor Mississippi family in 1954, you could go on to host a TV series called The Oprah Winfrey Show and end up with a net worth of $2.5 billion. Or, you could be the child of two immigrants and become a millionaire by age 23, giving the world the iPhone along the way, like Steve Jobs.
And the tilt didn’t end at the US borders. Our country’s inception compelled humanity to think about concepts like equality and individual rights. It provided a framework for a new economic model called capitalism — which, say what you will, has lifted more people out of poverty than any other framework before it.
Now, we still have a lot of work to do. A lot. Our country is far from perfect. But, if you’ve spent much time outside the United States, you probably know, all things considered, we have it pretty okay back home. Which might be why more than 40 million people living in the US were born in another country, accounting for about one-fifth of the world's migrants.
Nothing is easy. Nothing is perfect. But on a relative basis and historical terms, we think the world is much better now than it was before 1776. At the very least, we don’t have to answer to a King this weekend. And that alone, even 247 years later, is worth celebrating. Cheers.
