When COVID-19 kept a big part of the U.S. office workforce home throughout much of 2020 and 2021, the fear in the commercial real estate industry was that the office sector would take a huge hit. Even now, some media headlines continue to predict the permanent obsolescence of the office as a concept. But a June report from Moody’s Analytics found that the pandemic has not had as a great of a negative impact on office sector fundamentals as did the Great Financial Crisis and previous real estate downturns.
The report found that the U.S. office sector registered more moderate occupancy and rent declines in the wake of the pandemic than it did during the previous three downturns; that office loan delinquency rates never spiraled out of control; and that office equity returns continued to be largely positive for institutional investors.
There are also indications that in spite of the challenges associated with remote work, commercial real estate investors remain bullish on the office sector, especially when it comes to class-A properties in strong locations.
To find out what’s going on in the sector, WMRE recently spoke with Kevin Fagan, head of CRE economic analysis with Moody’s Analytics and one of the authors of the June report. Fagan talks about a comparative analysis of office properties today vs. previous downturns and explains what might have softened the impact of the pandemic on the sector.
The following Q&A has been edited for length, style and clarity.
WMRE: How does the state of the office sector today compare to what happened during previous real estate downturns?
Kevin Fagan: The loss of rent, occupancy and value in office buildings and defaults on office loans have been significantly less in this downturn than the typical boom-bust cycles over the past 40 years. We’ve been broadly tracking office performance metrics at Moody's Analytics CRE (formerly REIS), and two years after the 2020 recession a lasting, historically deep deterioration stemming from the pandemic has yet to materialize in traditional indicators.
WMRE: What trends in property fundamentals have been the same during the pandemic downturn with previous ones, and what trends/themes have differed? How important are those differences?
Kevin Fagan: Office sector fundamentals in this down cycle did not follow past cycles, which came on the heels of loss of office-using employment and corporate defaults that traditionally soften demand for office space and, therefore, office values and investment. Office-using employment and corporate performance were resilient after the 2020 hit. While employment losses in 2020 as a percent of total U.S. jobs were the deepest since the Great Depression in 1929, the vast majority of those lost jobs were in the service and hospitality sectors. Those are are generally lower-pay, lower-skill jobs than typical professional services, office-using jobs.
Therefore, in combination with government fiscal and monetary support, the economy and corporations rebounded quickly without reducing or abandoning their office spaces en masse, despite not actively utilizing the space during the triage work-from-home period of the pandemic. Of course that wasn't true across the board, so pain in business world did ultimately flow through to the office sector, just not nearly on the scale of past cycles that are financially driven and hit professional service firms hard.
WMRE: Can you explain why office revenues didn’t take as big of a hit during the pandemic as during previous market downturns?
Kevin Fagan: In the period between 2008 and 2020, we didn't see as much overbuilding in the office sector compared to the usual ramp-up before other downturns. This largely had to do with High Volatility Commercial Real Estate Rules (banking regulator rules for high-risk projects that require a more robust capital buffer than less risky projects to mitigate the bank's risk) that resulted in less construction lending in this cycle than prior up cycles.
WMRE: Why hasn't there been a huge impact from the pandemic on office equity returns?
Kevin Fagan: Unlike the stock market or other trading markets, commercial real estate capital markets move slowly. Price is determined by sales. Volume of office building sales was down over the past two years, and those that did trade were either already in process before the pandemic or simply weren't the forced, distressed sales that percolate during downturns.
Broadly speaking, building owners didn't have the revenue decline that needs to happen to force a sale, either by the ownership trying to cut losses or lenders selling through a foreclosure or lender REO. If more distressed sales were forced to happen, we likely would have seen a greater drop in office values. But, as it was, the implied values from the sales that happened and [their] appraisals remained largely intact. Indeed, many saw implied value increases. Repeat sale indices from many different commercial real estate analytics companies, including Moody's, recorded a slight dip at the national level, but a double-digit office price increase over 2021.
WMRE: What was one of the biggest surprises your research revealed?
Kevin Fagan: For us, the research wasn't surprising because our business is to track these metrics closely. Those that don't track them as closely may find it surprising to learn that this has been one of the most benign cycles for offices, given the deluge of negative headlines about the apocalyptic future of office. Our intent was to make it clear that if that apocalypse is to occur that it hasn't happened yet, relative to the numbers in past cycles.
WMRE: How does the implementation of remote and hybrid work correlate with office vacancies?
Kevin Fagan: We have seen some early evidence that markets with the lowest physical office utilization rates—where companies have been slower to make a "return to the office"—have higher vacancy rates. It's not clear by any means yet that this trend will continue, but could be because “the great return to office” really will not begin until fall 2022. Many companies will require "anchor days" each week when employees must be in the office, so we expect to see a resurgence in occupancy rates in the big, dense urban markets during 2023.
The biggest question now is how or if companies can shed significant space if employees are in the office less, but there will be a long experimental period, with different companies taking different [routes] that best suit them. Very few real estate pros or consultancy firms that are advising tenants on space usage believe that companies can translate their employees being in the office 40 to 50 percent less on average to 40 to 50 less office space occupied. Companies that need their employees to interact or collaborate will have to resolve how to keep interactions happening.
There have been excellent studies that show "incidental collision" between workers is very important to the overall productivity of a company, and those collisions are reduced dramatically every day or week fewer employees come together in the office. Companies, therefore, will need to weigh the ability to cultivate collaborative workforces against a desire to save on real estate costs.
WMRE: What are the biggest issues facing the office sector today that need to be resolved? How much time do you expect it will take to resolve them?
Kevin Fagan: The biggest issue by far is how companies come to rationalize their space needs against what makes their workforce the most efficient. Real estate costs would be nice to cut, but only account for around 4 percent of a company’s revenue—[and] much less for big tech firms. On the other hand, the costs for human capital are typically 5 to 10 times higher than the cost of office space and very important to get right.
Remote working actually has a 40-year history, starting with IBM in 1983. There have been a lot of real world experiments and academic studies on the pros and cons of diversified workforce practices for workers, employers and society in general.
That experiment will have to continue on a much larger scale coming off the pandemic, with companies trying out anchor days, a minimum or set number of days when employees are required to be in the office; allowing team managers to try different in-office strategies, like a mix of reservation-style "hot desking" and private offices; taking more co-working or flex office space; and all other manner of in-office approaches to get workers together to interact and collaborate.
It's unlikely that the first approach for a company will be the permanent state of things, so we're most likely looking at multiple years of experimentation to see what works best. This will enable tenants to rationalize their space needs longer term, but it will be a number of years before they can make a determination and their current leases expire.
WMRE: How long do you expect it to take for the market to gain clarity on the ultimate fate of the office sector? Do you have some scenarios for how it might go that you can share with WMRE readers?
Kevin Fagan: The direction that the office market goes will largely require us to wait until companies start making those long-term decisions after returning to the office. Since the delay from the Omicron variant and the lull of the summer, it's likely we'll see very early indicators starting in the fall of 2022. However, those early indicators could be spurious anomalies, and we'll have to be careful before making dramatic conclusions of apocalypse or no apocalypse.
We'll likely get more hard, reliable data over the course of the second half of 2023 through 2025. And, even if we do see some widespread reduction in demand for office space per employee, that doesn't necessarily portend a mass decline in office rent, occupancy and value.
Starting in the 1990s there was a major shift in the office market that caused companies to eventually cut the amount of space per employee in half, from about 250 sq. ft. feet to about 125 sq. ft. per employee. Over that period, however, office rents and values continued to grow, especially for CBD offices.
The natural growth of office-using employment, assuming we don't have a glut of new office construction, could cause absorption of space even with less demand per firm and employee.
WMRE: Is there anything else you want to add based on your findings?
Kevin Fagan: Office management is very likely to change significantly going forward, with more of a hospitality kind of angle. Also, tenants will be more selective with office space. They’re likely to either want deeply discounted rents or high-amenity type spaces. Owners and operators that improve their services, focus on health and sustainability, common area spaces, a variety of food options and so forth are the most likely to survive and thrive in the post-pandemic office world.