Five things keeping office landlords up at night

Offices are facing a reckoning. For institutional managers, this means a re-evaluation of how investments in the sector will be underwritten.

Countries around the world are cautiously reopening after months of lockdown, but there is still no consensus on when people will be able to return to their offices. The uncertainty surrounding the future of workspaces has been private real estate’s biggest talking point since the outbreak of covid-19. In PERE’s July/August cover story, we set out to explore institutional investors’ key concerns surrounding the underwriting of current and future office holdings, especially since most of the pre-covid assumptions just do not hold true anymore. Here are the top five factors influencing their current decision making:

Pricing: There will be a reset in office pricing once regular dealflow resumes. The question is by how much. The buyers’ and sellers’ bid-ask spread has already started growing, as evidenced by first quarter data. Real Capital Analytics estimates that offices was the sector with the highest number of busted deals last quarter, both in the US and Europe, with approximately 37 percent of sales falling out of contract.

Investment strategy: Equity and debt managers will become more conservative in their underwriting and return assumptions. Executives at European manager Barings and insurer AXA IM – Real Assets believe a narrower definition of what constitutes a core office asset will be applied during this market correction. Managers will also need to accept more capex to make their buildings covid-proof. Meanwhile, PERE understands office lending across the capital stack has now widened by about 150 basis points in the US to factor in the uncertainty over future rent and occupancy levels.

Location: The jury is still out on whether central business districts in gateway cities will be as appealing as before to office tenants, given the challenges around public transit and densification. However, suburban demand is only expected to increase as firms set up more satellite offices and millennials choose to live farther out. As Brandon Huffman, managing principal and portfolio manager for equity investments at US manager Rubenstein Partners says, the gap between US suburban and urban office vacancies is the lowest it has been in the past 15-20 years.

Tenant profile: As the risk of occupier defaults grows, managers will focus more on underwriting tenants’ credit. The stability of the occupier base will also depend on the type of industries that will continue to take up meaningful amounts of office space. Two of the largest marginal takers of office space – technology companies and co-working groups – are re-evaluating their physical office footprints. Josh Zegen, co-founder of New York-based firm Madison Realty Capital, believes other premium rent-paying financial services firms, like some hedge funds, might not come out on the other side of this catastrophe either. Life sciences companies and certain high-tech institutions are expected to fare better. Hong Kong-based Gaw Capital Partners’ June acquisition of the Euro America Financial City Tower 6 in Hangzhou, China provides an example of this. The firm was able to pre-lease a substantial portion of the space to e-commerce giant Alibaba’s cloud computing division.

Lease structures: Standard office leases are typically eight to 10 years, but future lease structures could look very different. There are anecdotal examples of occupiers that are only interested in taking up temporary space for three to six months instead of being locked down in the current volatile environment. If co-working spaces become less attractive, groups previously inclined to move towards hot-desking would want to negotiate similar leases with their existing landlords. Ultimately, however, most managers believe the balance of power and negotiations will decide whether landlords, or occupiers, will benefit from altered leases.

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