Owning office properties in a post-COVID working environment is profitable when the right factors align

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With the combined movement toward working remotely pre-COVID compounded by the work-from-home mandates during the pandemic, some markets in office real estate have seen negative absorption for the last few years. A few of those negative absorption figures are even understated since large companies that own their own vast office buildings do not report vacant office space. With many companies looking for solutions to their mismatch between shrinking headcount and fixed office space, can office real estate still produce out-sized returns for investors?

Stabilized vs Opportunistic

In the midst of this systemic change to the office market, some pockets of investing groups have purchased office space opportunistically, coupling expectations of higher returns with, at times, higher risk. For example, purchased with lower occupancy but for a reasonable price, these investments can enjoy significant upside with similar risk as their more replete counterparts. Some of these lower occupancy opportunities may achieve even lower risk by getting tenants to sign a letter of intent/lease even before the building is purchased.

If events go sideways, however, these opportunities could tilt the other way: lower occupancy properties may not absorb tenants as projected, non-traditional location investments may resist the intended growth in the non-traditional area, or value-add office opportunistic choices may fail to reach the amenities demanded during a stronger than expected migrative "flight to quality".

However, stabilized A class office buildings in many markets have resisted losses via high occupancy and competitive rental rates. Purchasing a stabilized, high occupancy building comes with its own risks of tenant loss while being stuck with a high fixed loan payment. Withal, at times, stabilized properties are stabilized for a reason, whether it be location, quality, price, etc., and can offer a good return/risk profile.

The Salt Lake City County metro area, for example, not only saw positive absorption for the year end but also increased rates, particularly for Class A properties, according to Newmark's 4Q21 report.

New Development

Developers of Class A+ office buildings historically enjoy high demand and no material change to that pattern has emerged in recent years. However, in areas of aggressive development in the office space, owners have faced additional supply pressures on price and vacancy, especially in areas or industries where remote working has blossomed. Coinciding developments suffer leasing risk that especially should not be overlooked.

Growth Markets - Utah

Investors and partners that keep abreast of the surrounding market data, e.g. employment rates, population growth, and housing starts, will have better chances of making good investments. Office real estate is a cyclical asset class inextricably tied to the economic health of the surrounding area, and, to a lesser degree, to the country as a whole.

Areas of flat or negative growth around the COVID era, either due to strict health mandates, lax theft and vandalism law enforcement, or other forces, have borne lower occupancy and rental rates in select office markets. Regions of positive growth around the COVID era have endured the pandemic well, with bolstered economies and office real estate health. Utah, for example, recovered quickly with a year over year drop of employment of only -0.2%, one of the lowest in the nation. By 4Q21, the state’s unemployment rate dropped to 4.3%. By US News, Utah is ranked the #1 in the nation for best economy and #2 for best state position for economic recovery.

Tenant Growth and Preferences for On-site

Starting from country economic health and growth rates and zooming down to state growth, local area growth, and then finally to the current tenant company growth and health in a target office building reveals a deep understanding of the risk level of a particular office property. With only a cursory inquiry, a potential investor can learn the tenant roll and begin research into each major tenant’s future prospects of growth and sustainability.

Uncovering revenue figures and growth metrics may be a challenge for private companies. In those cases, calling the company directly and having a candid discussion around your group’s potential purchase of the building and that company’s office space plans could provide priceless and useful insight.

Historically, analyzing the tenant’s company was one the final levels of risk analysis, but in our new era, a perfectly healthy and growing company may still reduce their office footprint if they incline toward remote work spaces. The careful investor group must now also educate themselves on each major tenant’s workspace preferences and plans, for both short and long term. This information may also be supplied with a direct and frank call with each major tenant HQ. These preferences can change depending on personnel changes in the desk of the decision makers, so, when possible, investors should strive to learn what they can about personal preferences of each potential decision maker when it comes to remote work.

Wrap-Up

Office is facing challenges as an asset class, but most markets that will suffer have indicators- some have already been showing growing pains for the last few years, even before COVID. By highlighting the lower risk of stabilized, Class A office, in areas of strong growth, an investing group can minimize the risk while still pursuing out-sized returns. Additionally, a seasoned manager will be served by looking at the yearly trends of vacancy rates, rental rates, and net absorption of the area before COVID. Finally, the manager may benefit from direct investigation of each potential tenant and learn their company growth prospects, remote preferences, and rental plans.