10 Challenges and Opportunities for Office Investors in 2022
Office properties are experiencing a number of challenges, if not an existential crisis, as employers experiment with hybrid work arrangements and employees slowly return to the physical workplace. To help investors navigate the current uncertainty around office assets, LoopNet spoke with experts in the sector who compiled 10 challenges and opportunities investors should be mindful of as they navigate the current cycle:
1. Pricing That Doesn’t Reflect Risk
2. Leasing Momentum
3. Occupancy Over Rent Growth
4. Capital Catch-up
5. Space Planning for Tomorrow
6. Flight to Quality
7. Suburban Versus Urban Properties
8. Conversion Possibilities
9. Company Culture
10. Office Space as a Service
1. Pricing That Doesn’t Reflect Risk
According to some of the investors LoopNet spoke with, office valuations do not yet reflect the risk associated with two anticipated changes that are expected to impact the sector. The first concern is the potential decline in the amount of space required by tenants, as they implement more robust and long-term hybrid and work-from-home policies. The second risk relates to the possible need for greater capital expenditures by landlords in order to implement building improvements that will attract tenants, such as enhanced outdoor workspaces. How will the capital markets for the office sector evolve to accommodate these challenges?
In some instances, investors are attempting to safeguard against these risks by obtaining additional cash flow of about 100 basis points at the time of purchase. However, low interest rates have contributed to an abundance of capital seeking to invest in office projects, especially in core and core-plus assets. This situation, in turn, is leading to cap rate compression and a focus on mitigating potential risks associated with owning an office asset in the present climate.
2. Leasing Momentum
Prior to the COVID-19 delta variant outbreak, leasing tours for office space were picking up, but most took place for exploratory purposes, not because tenants were seeking to fill an immediate need. For the most part, tenants still seem to be seeking short-term solutions and biding their time until there is more clarity about how tenants will use and build out their spaces and how much square footage they will need. The experts LoopNet spoke with advised that office investors need to keep an eye trained on leasing momentum and carefully watch for an uptick in long-term lease transactions.
3. Occupancy Over Rent Growth
Many of the office landlords that are completing leasing transactions are offering significant concessions in order to secure occupancies. The experts LoopNet spoke with suggested that investors should watch for the moment when landlords shift their focus from chasing occupancy to increasing rents.
4. Capital Catch-up
When leasing prospects are weak, owners often delay deploying capital, because they can’t justify capital projects when the outlook for rent growth is anemic and costly concessions are required to secure tenants. Consequently, buildings fall behind in competitive positioning, further slowing leasing velocity and rent growth. This becomes a vicious cycle. Currently, investors are monitoring the situation closely and looking for the moment when landlords begin deploying capital once again.
5. Space Planning for Tomorrow
At this point landlords don’t know how office space will be used going forward. Tenants and their employees don’t have much clarity on the issue either. Alternative work arrangements are in the trial stages with final long-term decisions not likely to follow for a few years. How can a tenant make long-term leasing decisions when uncertainty reigns over how they will use office space? Should the office become more of a collaborative space with mostly meeting rooms? Staying close to architects and space planners who work with tenants will provide guidance about how these types of questions are answered.
6. Flight to Quality
Currently, quality buildings in prime locations have advantages over basic, lower-quality structures. When cycles favor tenants over landlords, tenants typically commit to quality buildings first, leaving many basic office buildings to lease up later or become candidates for conversion or tear-down. Thus, investors currently placing capital are primarily focused on Class A, functionally relevant buildings, as these are the properties that are likely to remain competitive in the current market.
7. Suburban Versus Urban Properties
One question investors are pondering is how will alternative work arrangements affect where employers choose to locate? Urban offices that are centrally located can draw commuters from all over a large metro area. Suburban offices, on the other hand, are convenient to household populations and rely on drawing most of their workers from a specific slice of a metro area. As office users make long-term occupancy decisions, will they bet on centrally located urban locations or prominent suburbs where most employees live? Answers to that question will depend on numerous factors such as the historical positioning of a market (e.g., Los Angeles is by nature a suburban office market, whereas New York City is not); the types of office-using industries in a region; and the residential areas in which workers with key skills are clustered.
8. Conversion Possibilities
As pricing for some office properties pauses and the outlook for the asset class remains unclear, alternative uses are being considered. Depending on the market, conversions are happening in a wide variety of ways, transitioning office buildings into residential, life sciences and medical uses. As office building owners look to the future, new uses that may not have been financially feasible before the pandemic are now emerging as viable.
9. Company Culture
Drawing from the article “Culture Trumps Strategy, Every Time,” published in the Harvard Business Review, it’s prudent to remember that companies continuously struggle with balancing the preservation and growth of their cultures with alternative work arrangements. How can companies effectively train their new staff, cultivate collaboration and trust and ultimately increase employee loyalty? Finding the balance between alternative work arrangements and in-person interactions will drive many tenant occupancy decisions. With any leasing tour or negotiation, landlords will benefit from investigating the prospective tenant’s culture and understanding how office space can strengthen that culture.
10. Office Space as a Service
As software-as-a-service permeates both personal and professional aspects of our lives, the next evolution in office use is likely to involve tenants that move from leasing space to using it as a service. Tenants large and small can benefit from this way of using office space, albeit differently. The foundations of this trend emerged in coworking businesses like WeWork. Using space provided by and managed by an operator, rather than making a long-term commitment to a landlord, gives tenants flexibility, which in uncertain times like these, should be quite valuable. Some investors are monitoring how this trend plays out and considering how they can incorporate it into their properties.
