How will office valuations be affected by the decline of the five-day commute? Shopping malls could provide some answers.
Before the health crisis began, 5% or less of U.S. and European workforces worked from home. Rates are artificially high today due to stay-at-home orders: Over 50% of London workers are currently working remotely, according to the latest official count. Where this number eventually settles will be important for anyone that owns an office. Real estate consulting firm Green Street estimates that one day a week fewer in the office could reduce demand for space by 15%.
A shift toward more flexible work patterns won't hit landlords overnight. Big office moves take two to three years to plan in advance and many tenants are locked into their pre-Covid contracts for now. Big landlords are still collecting most of the rent they are owed.
Still, many companies are preparing for change. At a property conference last week, global bank Standard Chartered became the latest to announce plans to redesign its central offices for client meetings and collaborative work. The days of "rows and rows of desks" are over, it said.
The growth of e-commerce shows how technology can change real-estate prices. In late 2016, 8.3% of U.S. retail sales happened online, according to the Census Bureau. At the time, American malls were at peak valuations as investors underestimated how disruptive the trend would be. By the fourth quarter of 2020, the latest period for which data are available, the share of online sales had increased to 14%. Green Street estimates that the value of even the best U.S. shopping malls has fallen by 45% since 2016.
With offices, stock investors have spotted the potential for pain far more rapidly. The valuations of U.S.-listed office landlords such as Manhattan-focused real-estate investment trusts SL Green Realty Corp and Empire State Realty Trust are currently pricing in an average 18% decline in the price of their underlying property portfolios.
One potential reason is a higher cost of debt: Traditional lenders are acting cautiously as leases become trickier to underwrite. "Banks used to lend at 65% loan-to-value at very tight pricing. Today, they are lending 50% and pricing has gone up," says Beatrice Dupont, partner at investment management firm ARA Venn.
As has been the case in retail, office leases are getting shorter. Landlords also have to offer longer rent-free periods to attract new tenants—now up to one year on a five-year lease in Manhattan, according to Colliers data. Rents are falling more sharply in fringe office locations than in city centers , which is similar to trends previously seen at shopping malls. Office owners, who already reinvest 28% of their net operating income into keeping their properties properly fitted out, according to Green Street, will probably face higher costs as some offices need to be redesigned for new work habits.
Office landlords have a difficult few years ahead. The good news is that their shareholders are less likely to be caught off guard by real estate's latest disruption story.