March 1, 2024

W. Todd Henderson said the office sector correlates closely to the business cycle.
Office has morphed from a sector that once made up a third or more of real estate managers’ portfolios to one that real estate managers say they have been de-emphasizing, with the pandemic and resulting work-from-home trend curbing demand.
But real estate managers still own a sizable portion of it. The weighted average of office assets of the top 50 managers of U.S. tax-exempt institutional assets as of June 30 was 22%, Pensions & Investments’ 2022 real estate money manager survey showed. That’s down more than 4 percentage points from 2021.
The shift comes as managers are adding multifamily and industrial. Rising interest rates are making potential owners renters, and online shopping has increased demand for warehouses able to satisfy just-in-time delivery of goods.
Office made up 27% of the NCREIF Property index as of June 30 and was the only major property group with a negative appreciation in the second quarter at -0.5%. Office earned 5.8% in the year ended June 30, the lowest-performing sector reported by the index in the year ended June 30. It replaced last year’s two most underperforming sectors: hotels, now with 10.4% and retail with 7.9% for the latest year ended June 30.
“Given the current environment, real estate portfolios should underweight the office sector,” said W. Todd Henderson, New York-based head of real estate, Americas, at DWS Group. “The office sector has a very high correlation to the business cycle and the highest volatility in terms of return.”
What’s more, the sector also typically requires landlords to spend the most to attract and retain tenants per unit of income, Mr. Henderson said in an email.
“These two factors added to the demand destruction that is likely as a result of WFH (work from home) make the office sector less attractive,” he said.
Eric Adler, London-based president and CEO of PGIM Real Estate, said office historically has always been the most volatile property type. Office accounted for 21% of PGIM’s $66.2 billion in real estate assets managed for U.S. institutional tax-exempt investors, P&I’s data shows.
After the global financial crisis, real estate industry executives thought that office would emerge as a weaker asset class, Mr. Adler said. Those expectations were confirmed, with the sector not snapping back as it had in past cycles because tenant demands increased operating expenses and cut into returns, he said.
Office has been slowly losing ground since then, according to P&I data.
As of June 30, 2007, before the GFC hit in 2008, more than a third of institutional real estate managers’ portfolios was in office. The weighted average of office in the top 50 institutional real estate managers for U.S. tax-exempt investors was 36.8% and slipped to 33.1% as of June 30, 2012, P&I top real estate manager survey results show.
The pandemic has only exacerbated the trend, with hybrid work emerging as the new paradigm, Mr. Adler said.
“Right now, there’s not a lot of distress to speak of … and not a lot of transactions either,” he said.
In an environment where liquidity is low, it’s all about managing through existing assets and less about what a manager can sell and buy, he added.
At the same time, not all office properties have been impacted the same way.
Offices in the best locations and with the best amenities that are attractive places for employees to come back to work will perform the best, Mr. Adler said. Those properties that aren’t in the right location or hard to remodel are going to suffer, he added.
Scott Dennis, Dallas-based CEO of Invesco Real Estate, agrees that managers should not jettison all of the office properties in their portfolios.
Invesco owns fewer offices than it had in the past, he said. The percentage of offices in Invesco’s portfolio is trending about 20% to 25%, from about 45% in 1985, Mr. Dennis said.
“We are lucky to have some pretty good office properties in growth markets like Dallas and Atlanta,” Mr. Dennis said. Offices in those cities are doing well, he added.
“Office is not going away,” he said. “We are social animals. Has the typical 8-to-5 day in the office changed? Yes.”
There is more flexibility now and perhaps tenants need 10% to 20% less space than they did before the start of the pandemic, Mr. Dennis said. Offices could also move to a hoteling concept in which employees schedule their use of desks, cubicles and offices rather than have an assigned workspace, he said.
Many managers say they had been underweighting office for a while because they considered the property type less defensive in a downturn than other sectors.
Coming into the pandemic, the theme at Cohen & Steers Inc. was to position its “portfolios in sectors we believed would have pricing power,” said Ji Zhang, New York-based portfolio manager and vice president of Cohen & Steers Inc.
Cohen & Steers favored sectors with “shorter lease durations and healthy supply-and-demand dynamics that allow landlords to increase rents,” Ms. Zhang said.
These include self storage and industrial, sectors where “we think demand will remain strong, rents will continue going up in light of inflation, but also new supply is coming down because construction costs are going up 10% to 15%.”
Because office properties typically come with 10- to 15-year leases, Ms. Zhang said, “it’s harder to pass through higher costs.”
“We are pretty cautious on office, from an inflation standpoint and because of the secular challenges for the sector,” she said. Flexible work, Ms. Zhang said, is not only going to permanently impact demand for office space, but also the way tenants use their offices.
“Tenants want collaborative space. Owners of office space will have to spend a lot more” to provide tenants the type of work spaces they seek, she said.
Capital expenditure to maintain landlords’ positions in the market will be higher in the next 10 years than it had been historically, Ms. Zhang said.
What’s more, there is still an elevated supply of office, especially in major U.S. cities, she said.
Office occupancy levels in top U.S. markets were 44% of pre-pandemic levels in July, said Tim Coy, New York-based real estate research manager at Deloitte Services LP, referring to the firm’s recent real estate outlook. Overall, real estate investors and owners think downtown offices and suburban offices are the most attractive risk-adjusted opportunities among property types over the next 12 to 18 months, Mr. Coy said, referring to the results of a Deloitte LP real estate CFO survey taken this summer.
But there’s a “disparity between really nice office” and the rest, Mr. Coy said. “Class A is getting gobbled up quickly,” he said. Owners of Class B and Class C office buildings will have to get creative, Mr. Coy said. Otherwise, those lower quality office buildings will run the risk of becoming obsolescent or being sold at a discount, Mr. Coy said.
Michael Levy, Dallas-based CEO of Crow Holdings, said that investors should expect demand to slow across property types, not just office.
“Isn’t every CEO of every company thinking to themselves, do I really need that space?” Mr. Levy said.
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