In late May, Apple walked back its latest attempt to mandate in-office work at least three days a week. With COVID cases rising and employees insisting that remote collaboration is effective, the company took a pause. Not even Apple’s new and stunning $5 billion, amenity-laden Cupertino headquarters could lure back its workers, who would still rather do their jobs from home.
This is just one example of how employers are adapting to the changing relationship between work and the office—which has important implications for investors in the real estate sector.
More than two years after the start of the pandemic, office use still lies well below pre-COVID levels. Now, commercial real estate operators are facing another challenge—the prospect of an economic slowdown. These conditions call for caution when looking at potential REIT investments. With the recent market sell-off, valuations for office REITS have dropped from near peak levels, but they could fall further and may remain low for the foreseeable future. There are bright spots for investors, though: Some commercial markets are recovering faster than others, and sectors beyond the commercial office space market may offer greater growth potential.
Work from home leads to office downsizing
The pandemic dramatically upended work patterns, and it looks as though some changes are here to stay. During the majority of the pandemic, more than 60% of office workers worked remotely. Today, that number remains at about 24%, according to BLS survey data. The return to the office has plateaued and utilization remains down significantly, with card swipes indicating that office use is at 40%-60% of pre-COVID levels
Employees are demanding this continued flexibility. Gallup polls suggest more than 90% of employees want some remote work flexibility and 24% of people would like to work from home exclusively. We believe over the long-term, 15% of workers will be remote at least three days a week—three times the rate we saw before COVID.
With more people at home, companies will consider desk sharing, smaller office spaces, and other steps to save on real estate expenses and match their space to new work arrangements.
The risk of a hard landing and rising vacancy rates
During the economic recovery, hiring by growing companies helped offset reduced office use. The Sun Belt, in particular, has seen strong job growth—with Austin and Dallas leading the gains—but all of the markets we track have seen job numbers improve.
However, that may not be the case for long. The risk of a hard landing for the economy has grown, and that could mean job growth stalls or even reverses, further reducing demand for office space. We’re especially concerned about the tech industry, which drove much of the growth in office leases during 2021 but now faces a hiring slowdown or even job reductions.
If those conditions lead to rising vacancy rates, there could be trouble ahead for the commercial real estate market. Our analysis shows that when vacancy rates rise above 10-11%, commercial real estate operators lose pricing power.
We use a four-factor model to examine vacancy rates. Changes in office use driven by work from home and the risk of an economic slowdown are two key factors, but another is density—how much space does each employee need? We believe employers will look to increase space per employee by about 10 square feet. That may partially offset some demand destruction from WFH, but the extent could be limited. The fourth factor we consider is supply—how much new space is coming into the market for a given city.
Based on that analysis, we believe vacancy rates could lead to limited rent growth or falling rents in many cities, including San Francisco, New York City, Chicago, Atlanta, and Charlotte. Vacancy rates suggest less risk in other markets, including Raleigh, Nashville, and Austin.
Looking for attractive alternatives to office REITs
Given the potential for reduced pricing power in commercial real estate, office REITs are an area of concern. The market may still be underestimating rent declines, especially with metrics such as vacancy and peak-to-trough rent showing similarities to levels at previous market downturns like the Dot Com Meltdown and Global Financial Crisis. That’s why we advocate a strong, defensive approach, selectively focusing on REITs with below-average execution risk (lease expirations) and balance-sheet risk (leverage, maturities, and variable rate debt).
Investors should also look to other sectors of the REIT market that are better positioned than others. For example, senior housing and healthcare appear poised to benefit from the aging population and increased demand for these services.
Finally, consider an option that may benefit from changing trends: WeWork (WE), which provides flexible workspaces, offices, and office suites. The typical commercial real estate lease lasts 10 years, and currently only 2%-3% of companies hold short-term office leases. But given the ongoing evolution in work-from-home arrangements, employers may be drawn to the flexibility of WeWork’s shorter-term leases—at least until the future of the office becomes more clear.