- Class A offices in the Sun Belt are gaining in popularity, reflected by higher prices.
- Flexible offices are emerging amid an uptick in remote and hybrid work.
- Conversions to industrial and residential space will continue to absorb excess office capacity.
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The arrival of the omicron variant in November 2021 added more uncertainty to lingering worries about the future of the commercial office sector. Amid the increasing shift to remote and hybrid work patterns, office occupancy remained depressed at 27.9% in the first week of January, down sharply from 99.05% in February 2020, according to Kastle Systems, an office security and data firm that tracks office occupancy in major U.S. urban centers. Kastle noted that occupancy hasn’t risen above 40% since the onset of the pandemic. Despite these discouraging numbers, the sector has several opportunities that will help define its future.
Class A and sunny
Class A offices located in Sun Belt states offer one viable solution. The pandemic has pushed residents and businesses to sunnier climates, as individuals seek better lifestyle choices, including more temperate weather, and more space and affordability amid flexible work styles. Pandemic health protocols have created demand for new offices with touchless access points, enhanced air filtration systems and year-round access to outdoor space for social distancing. Kastle’s Back to Work Barometer shows average occupancy of Sun Belt offices at 38% since May 2020, compared to the national average of 27%. By comparison, New York, the nation’s largest traditional office hub, had average occupancy of just 17% during this period.
Sales data shows that high-end offices in sunny places are attractive to investors too. Class A office trades through December 2021 represented 27.4% of the total national Class A office trades by dollar, about 5% higher than prior to the pandemic, according to CoStar, which tracks real estate transactions.
The migration of business and employees to the Sun Belt has increased capitalization rates and market rents for Class A offices in that region, two important metrics for investors. Average cap rates there largely held steady at 6.9% from January 2019 through December 2021, compared to 7.8% nationally. The spread between Sunbelt cap rates and the broader national average increased to 0.14% from 0.11% in the same period. The spread between market rents has surpassed pre-pandemic levels more dramatically. In December 2021, prices averaged $37 per square foot, a premium over $31 on average nationally. Continued positive fundamentals for Class A properties in sunny locales will create a bright future for this segment of office and help to define recovery for the sector.
Flex to increase occupancy
Following pandemic-driven shifts in work patterns, office workers have expressed their interest in continuing to embrace a hybrid work model, combining periods of in-person collaboration with remote work. The new model has landlords and corporate business tenants wondering how to optimize their real estate. Offering flexible workspaces to new and existing tenants provides a solution, allowing landlords to increase occupancy and obtain a new income stream. According to global real estate brokerage firm Jones Lang LaSalle, landlords are offering flexible space in their own properties or entering into management agreements with flexible space operators. Management agreements are unique in each situation, but they typically include a base fee and a variable component tied to key performance indicators, different from traditional office leases, which are long term and fixed without regard to usage or occupancy. JLL estimates that flexible space in offices will reach 30% by 2030.
Flexible space also aligns to tenants’ needs. Corporate tenants still require space for collaboration but with reduced allocation and lesser frequency than before the pandemic. Smaller tenants struggle with managing growing workforces, and all corporate tenants are rethinking the cost of their space. Flexible locations reduce physical space, while lowering rental costs and capital outlays for tenant improvements. Respondents to a survey in April 2021 by global real estate brokerage CBRE said they expected to increase their use of flexible office space by approximately 26% on average over the next two years. The power of flexible space resonates with both tenants and landlords as they navigate the future of commercial office buildings.
Conversion
The most creative solution for overly abundant commercial office space involves converting it to another purpose. While real estate’s residential and industrial sectors have held up through the pandemic, they are constrained by limited supply. Large suburban corporate campuses represent opportunities for industrial investors and developers, while traditional office buildings in central business districts create viable options for multifamily developers.
Some recent high-profile conversions highlight the possibilities. Chicago’s historic Tribune Tower, home to the Chicago Tribune, is finishing a conversion to luxury condominiums and retail in 2022. In suburban Illinois, national insurer Allstate entered into an agreement in November 2021 to sell its longtime headquarters to Dermody Properties, which plans to convert the property to approximately 3 million square feet of distribution space. In New Jersey, pharmaceutical giant Novartis in December 2021 sold 62 acres of its office campus to Onyx Equities, which is building over 800,000 square feet of industrial space.
The fundamentals of the multifamily and industrial sectors incentivize investors to look to office conversion as a development option. CoStar data shows that national multifamily market rent per unit has increased 9% since 2020 and national industrial market rents per square foot have risen 7% over the same period. In contrast, office rents have remained flat, with a less than 1% increase since the beginning of the pandemic in early 2020.
The case for office conversion is underscored by absorption, the rate at which available space is leased in a given period. Absorption factors in both the build-out of new space and the removal of existing space. Industrial and multifamily absorption has increased nationally by an average of 52% and 38%, respectively, since January 2019, according to CoStar. Office absorption in the same period has fallen 125%. The combination of rising fundamentals and absorption rates for industrial and multifamily creates a compelling solution to less favorable office fundamentals.
The takeaway
Office space clearly will continue to evolve, following pandemic-induced shifts in work behavior, and the future of commercial office space will take many forms. Whether it be newer high-tech facilities in the Sun Belt, flexible spaces in urban office towers, or the repurposing of suburban office campuses for use by other sectors within real estate, U.S. office space is being transformed by seismic shifts in the economy.
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