Who Are The Best Investment Managers for Office Real Estate?

Office Real Estate is arguably still in disequilibrium. There are three issues that investors are contending with:

Firstly, demand has changed. Working From Home has undeniably impacted required floor space. The extent to which may not be known for several years, as fixed term leases expire, and a new hybrid working culture evolves.

These demand changes have manifested themselves differently in different cities across Europe, the U.S. and Asia Pacific. And in turn, whilst vacancy rates may have started to stabilise, it may too early to draw comfort from the numbers. But these numbers are clearly important, as they will have a causal effect on landlords ability to raise rents.

On the supply side, the issues are different. Declining profitability as a result of higher input prices may not go away soon. An issue which is compounded by both the reduced supply and increased cost of capital.

Yet despite the above, real estate asset managers seem bullish. The statistics they are producing appear to support their view that the reality and outlook is better than perceived. Whether investors assign high confidence levels to these statistics remains to be seen.

The stable historical relationship between office demand and employment growth has been challenged by hybrid working, with some estimates pointing to a 4% resultant increase in office vacancy rates. But investors attention has now turned to a different relationship. The impact of demographics on U.S. commercial real estate. The numbers are striking.

The cross-generational characteristics of the labour market is changing. Whilst the millennials over filled the work force after the Global Financial Crisis, the baby boomers were also still hard at work. Roll forward to today, we have a situation where baby boomer retirement is not being compensated by enough Generation Z labour market entrants. Added to which is a declining population not being compensated by immigration growth in the U.S., making for even tighter future labour markets.

And as the labour market tightens, employers will have to lean in to the desires of the workers that remain. Both in terms of the city in which they locate their offices, and the attractiveness of the working environment to Generation Z employees.

Identifying opportunities in U.S. Commercial Real Estate in the future, may be less about employment growth, and more about identifying assets that create an attractive working environment for Generation Z employees.

The focus on Green Rating Certifications by office real estate investors has driven the EU building stock to new levels of efficiency. Which in turn has shown a quantifiable premium for rent and asset valuations. But with approximately three quarter of EU Buildings now rated as efficient, the question is whether this Green Premium will continue to be a differentiating factor.

According to real estate investment manager research inside RFPnetworks, the answer may depend on rating concentration by location and building value.

It has taken 2 years for restaurant and flight activity in the U.S. to return to their pre-pandemic levels. The same cannot be said of offices. As of end 1H22 office utility rates are still at less than 50% of their March 2020 levels. Investors are clearly concerned that this may suggest a structural long term change in the demand for CRE. But are these concerns well founded? Or an opportunity?

Investors are looking at different data points to arrive at their projections.

Default rates for CRE Loans have not risen. But this can be explained by the ability of firms to finance the long term leases that they signed before the pandemic.

Higher vacancy rates also give a skewed picture. Whilst newly completed projects in 1H22 remain unfilled, that does not mean that tenants are vacating existing premises or downsizing en masse.

Conclusions can also be drawn from rent growth, which seems to have levelled off. And an increase in sub-letting where tenants are off-loading unused space.

It seems that a long-term structural change in the demand for CRE may be taking shape, alongside the the shift to hybrid working arrangements. The question is how long it will take for this to play out, and what are the options for repurposing any oversupply in CRE. We may end up working from home, in a home that was previously an office.

Across Europe's top 25 markets, 5.6 million square metres of commercial office space was let in 1H22. This was above the long term average trend for first half reporting and represents an increase of 41% on 1H21.

Read all Real Estate Investment Manager research and statistics inside RFPnetworks.

One empirical observation that attracts professional investors to the real estate market is landlords ability to raise rent above inflation. But this assumes that vacancy rates are low and tenants are prepared to pay. How does that rationale translate to the office market, two years into COVID?

With clear data insights on office utilisation lacking, drawing conclusions from non-traditional data can share some light on how the new hybrid working model is, and will potentially impact vacancy rates.

Useful trends can be extracted from Google workplace mobility data, Bloomberg's Pret a Manger Index, and the INRIX Global Traffic Index.

What these sources suggest is that the negative impact on office from partial WFH, combined with 20-40% less office utilisation than pre-COVID, may not be compensated by the expected increase in office employment needed to offset the current increase in vacancy rates. If lower office attendance gets absorbed by a shift to hot-desking, and firms aim to reduce their office footprint, the inflation hedging ability of office may deteriorate.

Fortunately, the magnitude of this risk for office real estate investors will vary from city to city, region to region, country to country, tenant to tenant, and industry to industry.

In other words, the assets and the asset managers that investors select going forward, may be very different. At least, the managers we see getting traction inside RFPnetworks are not the ones who usually get all the footfall.