Despite the grim headlines, we see some investment opportunities in the office space sector.
Have you heard the news? The “way we work has changed forever,” and so commercial office space is in a free fall.
Of course, you’ve heard that already. The bad news seems to be everywhere for commercial real estate. The pandemic’s work-from-home revolution — or at least a hybrid version of it — has fundamentally changed the math for office space landlords. Time to look elsewhere, right?
At Social Discovery Ventures, paradigm-changing declarations like “office space is dead” always make us pause to take another, closer look. One area the crowds have left behind but where we still see some opportunity is Class A office space. Recent renovations may be the key to separating the winners from the also-rans in this still-challenging market.
Indeed, it’s hard to find an asset class more avoided by investors and lenders right now than office real estate. Remote or hybrid work seems to be the new normal, office vacancies keep climbing, and some banks are in trouble over delinquent loans for office properties.
We often try to identify lucrative opportunities in markets with strongly negative investor sentiments. As a starting point, we believe that not all office properties are equally affected by the work-from-home trend. Recently renovated Class A properties are still in high demand. And given the shortage of capital in the space, investors could enjoy double-digit yields even for high-quality properties with long-term contracts and low vacancy.
We expect that in the midterm, investors will realize that not all office properties are created equal. We don’t expect any rebound for high-vacancy Class B properties, but we think that the properties with consistently low vacancies and healthy contract renovation are well-positioned for upward rerating and lower cap rates.
We also think there are some persistent and unsustainable gaps in expectations between the commonly accepted narrative that the “workplace has been transformed forever” versus the facts on the ground. Consider these three examples:
OCCUPANCY
- The common view: Office occupancy went flat at around 50%. People don’t like to go to the office, so the vacancy will remain permanently elevated.
- Our view: Indeed, workers don’t like to go to the office. But employers actually do want them at their desks. That’s why there is a growing gap between people who are looking for remote positions (50%) and companies that are offering them (15%). Given the cooling labor market and a growing number of layoffs, bargaining power is expected to shift to employers again. Plus, employees working from home have a 35% higher chance of being laid off.
DELINQUENCIES
- The common view: Delinquencies in offices are growing steadily, and higher vacancy rates result in operating problems for all office properties.
- Our view: There is a flight-to-quality trend among tenants. Recently renovated Class A properties in premier locations account for about 80% of demand. Landlords owning such properties enjoy healthy growth in net operating income and a strong tenant pipeline.
INVESTMENT
- The common view: Investment activity in the office sector has effectively stopped. Investors are not ready to take any office risk.
- Our view: Investment has dried up — yes! And that’s precisely why trophy properties are becoming available at double-digit cap rates, which we consider to be a compelling opportunity.
The one potential downside of this emerging back-to-the-office trend: Watch your investments in golf courses. How else do you explain a 52% increase in golfing since 2019 — with virtually all of that increase coming from people playing on weekdays?
We’re joking, of course. But employers are not amused, especially as they see that lack of workweek visibility playing out in a 20% loss in productivity, as several reports have noted, and the back-to-the-office-mandate drumbeat continues to pick up.
Which is one more reason we think the paradigm-changing assessment ultimately might be closer to: “The way we worked changed for a while.”