Why Townsend is not afraid of a 12% dip in office demand

Prashant Tewari, partner and member of the investment committee at the Cleveland-based firm, says prime office is a top priority despite sector uncertainty.

Changes are coming to the office sector. With much of the global workforce remaining productive despite being confined to their homes during the pandemic, office occupiers are reconsidering their space needs.

As many as 40 percent of US jobs could be done from home, according to an analysis by the Townsend Group, a Cleveland-based gatekeeper and investment manager. According to a note written for investors and advisory clients at the end of the last year, the firm also sees less corporate resistance to at least part-time home working.

On balance, Townsend expects demand for US office space to fall between 9 and 12 percent in the coming years. But the firm is not backing away from away from the property type. In fact, Prashant Tewari, a partner at the firm and a member of its investment and global macro strategy committees, sees it as a prime time to invest.

In an interview with PERE, Tewari said he is happy with the office exposure Townsend has built for its $18 billion fund business as well as for its institutional advisory clients. And he expects those portfolios to grow by year’s end. “When the transaction market starts to thaw, we have sharpened our pencils enough to be a ready investor in this market,” he said.

In the interview excerpt below, Tewari shared further perspectives on the US office market with PERE.

Looking at your forecasts on office demand, what findings stand out to you and what are your initial thoughts?

Tewari: high-quality office assets will recover quickly

There has been a lot of talk in the media about the demand for office space, and people love to talk about if we are all going to work from home from now on. But this story has happened many times in the past. It has happened with New York after the 2008 crisis and after September 11. It happened in San Francisco after the dotcom bubble burst, and Houston has seen its fair share of slumps. What most people don’t realize is that coming out of those slumps are some really good investment opportunities. If there is a sector within the asset class that you want to be focused on because everyone else is trying to avoid it, it’s office, because it’s cyclical.

We wanted to come out to remind people that this is not a first-order effect, where decisions need to be made, but a second-order effect of finding out what happens. Everybody knows there will be fewer workers in the office, but what happens to those who do go to the office? What is the supply reaction when the demand doesn’t grow? If supply gets curtailed, the supply-demand balance can get restored a lot sooner than what people might expect.

This note was a reminder, because there are so many investors, clients and prospective clients concerned about the office market and, in general, it helps everyone if there’s more of a rational reaction. I would love for office assets to trade at a 40 percent discount, but it sets the wrong precedent in the market. So, it’s important to remind people of the fundamentals for the longer term.

Sounds like you wanted to put a real figure on it rather than just having this nebulous idea floating out there that demand could fall by 50 or 100 percent. Were you trying to counter that speculation by saying ‘actually, it is more like 9 to 12 percent’?

The 9 to 12 percent reduction is taking into account the deeper decline in the number of people working in the office then counterbalancing that with more square footage required per individual. And, in the grand scheme of things, that 9 to 12 percent balance can be restored in the office market in a period of about three years if the supply significantly curtails. So, we need somewhere between a two- and four-year period for demand and supply to rebalance and for rent growth to be restored, which is the big picture here. When that happens, you need to make sure your entry point compensates you for that waiting period. If it does, it makes it a good investment.

So, you think this move toward more square feet per employee will be long lasting?

Yeah, absolutely. There is a huge cyclicality of square footage per person over time. It’s not that square footage per person has been constant. It has been on the decline for a good part of the last decade, but the 10 years before that, the square footage per individual was increasing. And now there are new factors. We just don’t want to be that close to each other. A lot of studies have come out from respectable institutions in our country that say being too close to each other is hurting productivity; people are being distracted by other people talking on the phone or having conversations. So, the space had to be reimagined, and that trend started prior to covid. Now that covid is here to stay – like flu season, there’s going to be a covid season – we’re all going to want to be away from each other. So yes, the trend is going to reverse because it hit its natural limits. You and I cannot work in the same cubicle and still be productive and enjoy that experience. The only options were to remain at that level or go up. So that gives us the confidence to assert that it is likely to go up.

If there is that 9 to 12 percent decrease in demand, what does that mean for institutional portfolios? How should investors apply this to their current office exposure and the exposure they will build in the near term?

The number one thing is not to panic. Over time, we’ve been investing in some very high-quality assets as investors and gatekeepers. In both those roles, we have been judicious in picking the right assets and locations. Those assets are seeing very low occupancy today and that is causing some concern. But we’ve looked at how these cycles pan out and every single time, high-quality assets in good locations come out on top. Yes, there will be less demand for office but that is going to hurt lower-quality office buildings. After 2008, tenants upgraded their space and moved into the city locations as opposed to shying away and moving out into the suburbs to cut costs. And that happens every single time. This time is going to be no different, because as soon as we feel comfortable being close to each other again, we’re going to go back to high-quality locations.

The number two message is to sharpen your pencils and be ready for investment opportunities, because if there is a time to come into the office sector, this is it. If there are write-downs, there is a need to invest. When you see what you own coming down in value, it’s very difficult to buy more of those assets, but that is exactly the behavior that is needed, because if the marks come down for high-quality assets at this low cost of capital, those are not going to be the right marks from a long-term standpoint. We believe in that and we’re evaluating those opportunities.

A lot of folks are looking at the capex requirements for office being generally higher than other property types and the adverse effect that has on net operating income. How does that factor into your thinking?

Everybody knows that we have those expenses and overhead, so it’s only a problem if you have underestimated those. It is a problem that has plagued the industry and the reason it comes up in conversations is because, on average, an investor in the office space tends to underestimate those expenses. But that creates opportunities for those investors who can rightly estimate what they will be. If the market is underestimating those expenses, it becomes a market where we can find some good exits because we get paid a cap rate that is lower than it should be.

Over time, investors have become more sensible about estimating expenses. I wouldn’t say they have fully understood it, but the understanding today is different than it used to be. Very soon, I think, that will stop being an issue, as the market learns to rightly estimate the overhead expenses related to office space.

You’ve expressed strong positivity that this is going to be like other downturns in which demand rebounds quickly. But those instances were not driven by a public health crisis, one that you’ve said is probably here to stay. How are you so confident this will play out in a similar way?

No crisis is similar to any other crisis. Everything is different and unique in its own way. But, at the end of the day, the set of factors that drives people to work together in one location, the concentration of workforce, that’s not new, it’s been going on for centuries.

Car manufacturing plants used to be all together. The big competitors in the artistic world, let’s say Hollywood, they all want to be together. Even if being together means your competitors know what you’re doing, there is a much bigger value in being together than being apart. Tech companies tend to be together. Financial services companies tend to be together. And that is what has driven the importance of CBD locations. This pandemic would have to be so big that it changes the mindset of human beings that has built over centuries, but I don’t think it rises to that level, especially if vaccines can take control.