Office: Altered states
The technology and energy sectors are bringing about fundamental changes in the use of office space in the US. Christopher O’Dea reports
While each wave crashing on a holiday beach can look the same as the previous one, there is normally a lot going on beneath the surf. For investors returning to work, the US office property market is in a similar state.
While net operating income (NOI) is expected to rise in coming years, cap rates are expected to remain stable – so valuation increases on office property will be restrained. But some participants say the tide is coming in for the US office market, with total office space usage rising after several years of flat growth. Investors will need to be attuned to how well assets meet the demands of tenants seeking to attract talent in US innovation industries.
The main factor that appears to be at work in the US office sector is declining square footage per employee – tenants are using less space. But beneath these headline figures, there are some important secular changes taking place in major coastal markets.
The major trend in the US office market has two prongs – increasing the functional effectiveness of office space while using less of it – says Tim Wang, director and head of investment research at Clarion Partners. The biggest office space users are finance, insurance and real estate firms – dubbed the FIRE brigade – and those industries are struggling from declining revenue and profit margins, increasing government regulation and falling employment.
“Traditional office tenants are not leasing as much space,” says Wang. Law firms, for instance, were the largest space users, taking as much as 330sqft per employee just a few years ago. Ten years ago, he says, companies used an average of 250sqft per office employee in the US; today that has dropped by 20% to 197sqft. “They are under pressure to reduce fixed costs, and put more people into existing space,” he adds.
Perhaps the primary strategy is to separate front-office and back-office functions, and move back-office personnel to less costly space far from the expensive central business districts that host the headquarters operations of most major FIRE tenants. Several recent announcements illustrate the trend. Credit Suisse, for example, is moving to reduce its New York office space from 1.8m sqft to 1.2m sqft, a 30% reduction. Similarly, Charles Schwab announced early in 2014 that it would move about 2,000 people out of 4,000 at its San Francisco headquarters to lower cost areas in Phoenix, Denver and Dallas. Dallas in particular, says Wang, is emerging as the new back-office capital of the US financial industry.
Reducing space can be a fast way to save some money. But at the same time companies must forge on and they are striving to raise productivity in the space that remains. Millennials and Echo Boomers like collaboration, open space and amenities that run the gamut from well-equipped kitchens to recreational areas featuring ping-pong tables. Natural light has become de rigeur in up-to-date offices, and parking – for bikes, not cars – has become a necessity, not a perk. In working areas, desks often adjust from sitting to standing positions, and treadmill desks are increasingly common. “This trend is like a wildfire,” says Wang. “It will have a profound impact on investment strategy.”
The impact is two-fold, analysts say. Premium-quality, new buildings with the latest technology and energy capabilities and amenities are drawing tenants willing to pay more per square foot when relocating from existing space. That migration is creating a growing inventory of assets that need to be redesigned, retrofitted and repositioned as space tailored to the needs of the new workforce. The alternative for class-B or older class-A buildings is a future of declining rents and falling occupancy.
The result is a highly competitive market, as property owners adapt to the needs of a new set of primary tenants. “With very few exceptions you need to have the right amenities and the right offer for the nature of the tenants,” says Douglas Poutasse, executive vice president and head of investment strategy and research at Bentall Kennedy. Institutional real estate investors today “need to be in the places where jobs are being created”, he adds, and that means US innovation and technology markets.
“Almost all of the work in a knowledge economy takes place in office space,” says Poutasse, and the two sectors driving most office growth are energy and technology. Most notably for tech firms, these clients “use space very differently.” Space where individual employees work can be configured in small cubicle desks or continuous desks that allocate as little as 100sqft per person. But this is the collaborative generation, and “you can’t sit in somebody’s office if all they have is a few feet of continuous space”, Poutasse says. When collaboration areas – from meeting rooms to recreational areas – are factored in, he adds, space usage often hovers at about 250sqft per person. That is close to long-term trends. Since 1991, the average square footage per employee in the US has ranged from 200sqft to 220sqft, standing at 215sqft per person in 2013.
At the same time, companies are wary of crossing the line between efficiency and reduced productivity. “New open floor-plan workplaces are not always well received by workers who lament the lack of privacy and quiet,” according to Bentall Kennedy’s 2014 US outlook. “Many firms will likely be careful not to employ such dramatic changes in space usage that they harm the overall productivity of their workforce or put themselves at a disadvantage when attempting to recruit the most talented workers.”
For its part, global real estate firm CBRE has decided to, in effect, eat its own cooking. Not only does it advise clients on adapting their workspace to win the talent war, CBRE’s people work from a cutting-edge “untethered free address” office space where no one – including the CEO – has a private office, and lighting is geared to circadian rythms to enhance employee wellbeing. The building, 400 South Hope Street in downtown Los Angeles, is owned by CBRE Global Investors.
The need for workers in innovation industries is reflected in the growth in total space occupied in key markets, Poutasse says. From the first quarter of 2013 to the first quarter of 2014, he says, occupied office space in tech mecca San Francisco rose 2.5%. And many headline deals announced this year are pre-leases that are not yet included in occupancy rates. “In the past few months, Google, LinkedIn and Salesforce have made major plays in San Francisco,” he adds. The story is similar in other primary markets where tech and energy firms congregate. Houston tallied a 4% increase in occupied space from Q1 2013 to Q1 2014, while Boston notched a 2% gain before counting lab space for its thriving biotech sector. In spite of the contraction in financial services, even New York saw a 1% rise in occupied space, as tech firms flocked to the Midtown South district, Manhattan’s answer to Silicon Valley.
The trend is not about to slow down. CBRE says 10 markets – mostly high-tech centres and energy hubs – account for nearly two-thirds of anticipated deliveries between now and the end of 2017. Houston is forecast to deliver more than 11m sqft of space by the end of 2017, more than twice the amount of second-placed New York. That demand is driving slightly better performance for property owners nationally. The US office vacancy rate ticked down by 10bps to 14.8% in 1Q 2014, a typically modest first-quarter performance during this office recovery, says CBRE. The national average asking lease rose 1.7% due largely to strong performance of downtown submarkets. Supply remains constrained – just 3.6m sqft was added to the market in the quarter. This has helped the average national asking rent rise 3.7% on an annual basis over the past two years, a trend CBRE expects to continue. Landlords in some markets are “gaining control of pricing power and rents are rising, particularly for class-A assets in CBD locations”, the firm says.
The strength of new-economy demand can be seen at the submarket level. JLL says class-A rents in the South Financial District of San Francisco jumped by almost 13% from 2Q 2013 to 2Q 2014, while in Midtown South year-on-year rental growth hit 10.4% for class-A space as firms flocked to creative space and proximity to major tech tenants such as Google. In Houston, the price for quality space in the Energy Corridor increased by 9.2% over the past 12 months, despite more than 5.9m sqft of construction, much of which is build-to-suit or fully pre-leased.
The situation is less favourable in traditional suburban markets. While there are some indications that suburban office fundamentals may have turned the corner, any improvement outside of the low-tax US Sunbelt states will come from a weak position. Suburban Chicago’s 155m sqft office market suffered 1.2m sqft of negative space absorption in the first quarter, leaving about a 23% vacancy rate, as large firms either decamped for the downtown business districts or consolidated activities into single locations. Except in sprawling Houston, “the abundant supply of [suburban] space has benefitted occupiers and challenged owners”, says CBRE.
But the drive towards efficiencies is not without difficulties. “Finding suitable office space becomes more problematic as vacancy declines,” says CBRE.
That spells opportunity for investors and owners willing to upgrade and reposition properties. In July, Roseview Group and PM Realty Group formed Roseview-PMRG Fund I, a $250m discretionary fund to acquire and reposition office properties across the US. The fund’s strategy is to acquire existing office assets below replacement cost, then upgrade – building common areas and mechanical systems – and fund tenant improvements and leasing commissions. Taking a hands-on approach, the group aims to operate buildings more efficiently, reduce waste and promote eco-friendly consumption. The fund will target mid-teens returns, with total investment per asset of $15m to $65m in primary and secondary markets, says PMRG.
Mesa West Capital invests approximately $1.5bn real estate debt markets per year and it has deployed a significant portion in office repositioning transactions. Key deals in 2014 have included a first-mortgage loan for the repositioning of a 155,000sqft office/R&D building in Moffett Park – a submarket of Sunnyvale, California that caters to tech firms such as Juniper Networks and Amazon – into class-A space. “The vacancy rate in Moffett Park has dropped considerably, given this demand, and as older office/R&D parks in the submarket have been slated for redevelopment as class-A office,” says Mesa West principal Ronnie Gul, who originated the loan.
For investors, it is the interplay between capital values and rents that ultimately matters. JLL tracks the relationship with its ‘prime office clocks’, which plot rents and values in major cities into four quarters of a clock face, running clockwise from falling, to bottoming out, accelerating and finally, slowing. At the end of the first quarter of 2014, most of the major US cities showed slowing capital values, with Washington having ‘passed midnight’ and moved into the zone of falling capital values. At the same time, rental values in the US are mostly accelerating, with Washington DC having bottomed out, and the hot energy and tech markets of Houston, Dallas and San Francisco slowing.
In primary markets, quality assets are trading at cap rates ranging from high 4s to low 5s, says Poutasse. NOI for office property is accelerating after a few years of virtually no growth, which will help yields tick higher, he says. But he cautions that yield projections are “idiosyncratic to each building.” Office leases are complex, and as new tenants replace older tenants at higher rents, for example, NOI can drop in the short term. But overall, “strong rent growth means the future will be better than without rent growth”, he says, and for US office property, “the tide is now coming back in.”