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Empty (Office) Spaces

"What shall we use to fill the empty spaces where we used to talk?"

Pink Floyd, The Wall

The COVID-19 pandemic ushered in several new societal norms, perhaps one of the most significant was the creation of large-scale work from home (WFH) policies. Adopted by both large and small companies, these policies enabled companies to maintain their operations while providing safe working conditions for employees. As COVID-19 vaccination rates rose and infection threats diminished, expectations of a massive surge of workers returning to their offices (and normalcy) heightened.

However, that surge never happened. WFH persisted as both employers and employees discovered significant benefits from this new arrangement. As illustrated nearby, US office worker occupancy levels are persistently below 50% nearly three years beyond the depths of the COVID-19 pandemic.

20221115-chartClearly, WFH is mutually beneficial – with WFH, work is no longer limited to where it is performed, enabling a larger worker
candidate pool for employers and broader potential opportunities for employees. With commuting time and costs eliminated, employees have more time and lower stress levels which can enable additional productivity, loyalty and longevity.

WFH has become the “new normal” - for millions of knowledge workers, the “working in an office” paradigm appears to be all but dead and WFH has become far more permanent than originally envisioned.

WFH Impact on Commercial Office Real Estate

With virtually empty offices and estimated annual office costs at roughly $7,500 per employee per year,1 companies have been aggressively reducing real estate costs by shrinking their footprint and/or subleasing unused space. With shrinking demand for office space and rising vacancies, commercial office real estate valuations are tumbling.

Researchers from Columbia University and New York University recently published a study on the far-reaching impacts of remote work on the commercial office real estate sector. They found a 45% decline in office values in 2020 and 39% over the longer term (10+ years), the latter representing a $500 billion haircut for commercial office space valuations across the US.2

According to Green Street, commercial office REITs now trade at a 43.8% discount to net asset value (NAV).3

Many office buildings are financed via commercial mortgages which are usually five- to 10-year interest-only loans with balloon balances. Over the next decade, many thousands of office buildings will need to be refinanced – albeit with balloon mortgage balances backed by an asset that may be worth perhaps 50% of its original value. Clearly, there are significant risks ahead effectuating commercial office real estate valuations and related financing vehicles.

Municipalities are also starting to experience the effects of reduced retail economic activity and related property and sales tax revenues. A recent study found that commercial real estate accounts for 37% of total property taxes across a sample of eight large cities where current vacancies created a negative revenue impact of -5% to -8%.4

At this time, commercial office real estate owners, along with local government leaders and local retail business owners, face a significant conundrum in how to transform empty spaces into a new economically viable ecosystem. This process could take a decade or more and is riddled with significant risks and potential for substantial value destruction along the way.

While this transformation is underway, investors may want to re-evaluate their exposure to office real estate, commercial real estate brokers, commercial mortgage backed securities (CMBS), private real estate debt and other commercial office space-related financing vehicles.

Important Disclosures & Definitions

1 Global Workplace Analytics, The Business Case for Remote Work, 2021

2 Work From Home and the Office Real Estate Apocalypse, National Bureau of Economic Research Working Paper, Arpit Gupta, Vrinda Mitta, Stijn Van Nieuwerburgh, September 2022

3 Green Street, as of 09/30/2022

4 The Impact of Work From Home on Commercial Property Values and the Property Tax in U.S. Cities, Institute on Taxation and Economic Policy, 11/04/2021

Balloon Balance: a lump sum principal balance owed that is paid at the end of a loan term, often as part of interest-only commercial mortgages.

Real Estate Investment Trust (REIT): companies that own or finance income-producing real estate across a range of property sectors. Listed REITs have characteristics of both the income potential of bonds and growth potential of stocks.

REIT Net Asset Value (NAV): in real estate investing, the total value of a real asset, minus any outstanding debts and the costs of any other fixed or planned capital expenses.

Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.

AAI000186 01/31/2024

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