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Issue 71
May 17, 2020
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Office Space, starring Jennifer Aniston and Ron Livingston released in 1999, is a comedy that portrays a group of disenchanted employees toiling at a software company at the dawn of the Internet age. The movie scored decent marks with critics but fared poorly on the big screen; it barely recouped its production cost. However, with the help of Comedy Central airing the film over 30 times, Office Space garnered a cult following, particularly with tech workers, and subsequently performed well on video and DVD, sold millions of copies and established itself as a classic film favorite among movie aficionados.

Office Space was a comedy. In contrast, the current state of the commercial office space market in America could be mistaken for a horror movie. Economic shutdowns enacted to stem the spread of Covid-19 have rendered office buildings across swaths of America eerily vacant. Many tenants are unwilling and / or unable to pay rent. In turn, landlords with existing mortgages are having difficulties servicing their debts and covering operating costs.

Pundits have chimed in, claiming the behavioral changes forced upon us by the coronavirus will permanently impair the market for office space. As companies quickly conclude that their employees can be equally as productive working remotely as they can “at work,” they will look to cut costs by reducing their office footprint.

Stocks of publicly traded real estate investment trusts (REITS) have been decimated. The shares of Vornado (VNO), which owns office towers in major metropolitan areas, have been halved. New York City stalwart SL Green’s (SLG) stock is down by almost two-thirds. Conversely, shares of Microsoft (MSFT), Zoom Video (ZM), Teladoc (TDOC), and other companies that benefit from the physical-to-digital shift have soared despite the recent stock market malaise.

In our view, near-term vacancy rates will increase, rental rates will probably decline, and some over-levered owner/operators will lose their properties. However, calls for a permanent demise of the commercial office space market are woefully overblown. Indeed, the idea of office buildings in cities throughout America sitting half empty in perpetuity is simply too draconian a conclusion to draw.

This Time Is Different

Often, when “experts” utter the phrase “this time is different,” it’s often a signal we are at, or near, an inflection point where things begin to revert to “normal.”

In 1975, New York City was on the verge of bankruptcy. Services were cut, the city was filthy, crime was rampant, and residents were departing in droves for the suburbs. “Experts” concluded that New York would continue to de-populate, leaving behind a blighted city in irreversible structural decline. They were incorrect. The year 1980 marked the “low” in the city’s population, which rose 3.5% to 1990 and surged 9.5% to the year 2000. Services were fully restored, new clean green space was created, and crime plummeted to historic lows.

Following 9/11 in New York, “experts” argued that few people would be willing to work downtown and occupy high floors in statesman-like residential properties. A decade later: the office (and newly established residential) market was thriving in NY’s financial district. Additionally, record-setting transaction prices for apartment buildings 50+ stories high became commonplace.

But This Time Is Really Different

Let us assume this time, that things really are “different.” A material percentage of the workforce that once plied their trade in office towers will now telecommute permanently. We would argue that even if this time really is “different” and the “experts” prediction about the workplace comes to fruition, their forecast about the demise of the market for commercial office space will still be proven incorrect.

Office Space

Over the last decade, offices have become denser. In America, the “average square footage per employee has declined from 225 square feet (sq ft) in 2010 to 176 sq ft in 2012 to 151 sq ft in 2017.” In desirable markets, office space per employee can be even less. Put simply, workers have a smaller amount of workspace than ever before.

However, the current layouts of many offices no longer support a safe working environment. Work spaces will need to be re-designed to be less dense. Social distancing rules enacted to mitigate the spread of COVID-19 will result in lower maximum occupancy levels. Hence, while the total number of employees hanging their hats in the office will probably decline, the space needed per remaining on-site employee, will almost certainly need to increase.

For example, let us assume that before the COVID-19 pandemic, 1,000 people worked in office X. In the post coronavirus era, 25% of those employees will permanently work remotely. But the remaining 750 employees will require 50% more room. The result: the company leasing space in office X would need 12.5% more real estate for the remaining 750 employees.

Ironically, one upshot from the coronavirus pandemic might very well be more demand for commercial office space.