Revolutionizing Office Demand: Investor be prepared

02/24/2011 11:16

Has the dust finally settled after one of the deepest recessions in the U.S.? It seems so as certain investors appear to believe that economic growth and disposable income will be as abundant as ever considering that certain core office investments realize sub-5 percent capitalization rates. In fact, U.S. office landlords had the first net increase in occupied space in three years in the fourth quarter of 2010, according to Reis Inc., a New York-based property-research firm. Are we indeed back on track and will an investment in office result in an appropriate risk adjusted return? What can be expected in terms of future rents and values? Key observations are that the U.S. office vacancy rate was unchanged from the third quarter of 2010 at 17.6 percent, remaining at the highest level since 1993, as supply also increased, and moreover, during the last three years, companies have given up approximately 137.8 million square feet nationwide. Obviously, one should not forget certain basic principles. Generally, rent and value has been and will always be a function of primarily demand and supply, driven by employment, and cost of capital, driven by cost and availability of debt and equity. Therefore, continued downward pressure on value is not unlikely as employment growth remains sluggish and cost of capital may increase due to anticipated rising interest rates and continued constraints in availability of capital. Notably, the drivers are not necessarily just job growth or cost of capital. It is also about how workplaces are organized. During the last few decades, this has resulted in significantly reduced space needs on a per employee basis. In the 1970s, American corporations typically thought they needed 500 to 700 square feet per employee to build an effective office. Today's average is a little more than 200 square feet per person, and the space allocation could hit a mere 50 square feet by 2015, according to Mr. Peter Miscovich, Managing Director at Jones Lang LaSalle. Office tenants who renew their leases these days often cut their space total by 10 to 30 percent. Obviously, the last recession certainly accelerated the trend to reduce space due to layoffs. In addition, the future work space, typically referred to as the “New World of Work”, is designed by our advanced connectivity through the modern information technology, resulting in a flexible, highly efficient and productive way of working with an emphasis on collaborating with co-workers, partners, customers and other stake holders. The information technology is the key enabler because it makes it possible for people to work from anywhere, at any time, with anybody. Think about work life balance and working flexible hours where the job is not 9 to 5 but depending on what it is that needs to be done along with managing a household. Think about the increasing need for reducing carbon footprint and reduce wasteful commuting or other travel time and expenses. Also, think about the reducing need for space for libraries and archives. Who needs those as we move more and more into a more virtual and paperless environment. Certain revolutionizing “New World of Work” practices comprise the encouragement to have meetings standing up, the freedom to work from either a lounge chair or perhaps a bar stool located within a common area. The underlying thought is to create an easily accessible environment that invites and stimulates people to perform different types of work in the most effective and pleasurable way. Workspaces will have to optimally facilitate such types of activity, whether those are meetings, brainstorm sessions, telephone and video conferences or chats, and also include space to relax, play and have some fun. This trend aligns with a generational shift as Generation Y is entering the work force. Generation Y is the demographic cohort born between the mid-1970s to the early 2000s and is now the largest demographic group in the U.S. As generation Y has grown up with the authority on the internet, social media and new forms of (online) collaboration, they embrace the “New World of Work” vis-à-vis the hierarchical formality of traditional offices. Moreover, the “New World of Work” appears to be a worldwide paradigm with profound effects. For instance, in the Netherlands, this new work-life style may result in an additional 25 to 30 percent office space reduction as reported by Mr. Martijn Van Leeuwen in Vastgoedmarkt, a Dutch property magazine. The current office vacancy rate in the Netherlands is approximately 14 percent and may increase to 24 percent by 2013 should all major office users decide to adopt such a new work-life style. Similar to the U.S., major space rationalizations have already occurred as illustrated by the fact that work space per employee decreased to approximately 213 square feet in 2010 from 286 square feet in 2002, and may further decrease to 166 square feet within the next three years. Interestingly, adopters are not only consultancy and technology companies, but also, the traditionally conservative banking sector. As the recession has changed the demand for office space dramatically, the “New World of Work” change of office work-life style will certainly have a profound impact affecting rent and value going forward. This will create challenges and opportunities at the same time. Although less space per employee will be required, a greater emphasis will be on location and the design of such new work space. Investors should prepare for such new demand requirements, and realize that it is not unlikely that certain offices may become completely redundant and will require a very different use. - Robert J. Meulmeester MRICS Robert Meulmeester MRICS Robert J. Meulmeester MRICS and Partner, Cadence Capital Group, LLC has over 13 years of experience in real estate investment and divestment strategy advisory, financial structuring and capital placement, due diligence, feasibility studies, and valuation. Prior to joining Cadence Capital Group, Mr. Meulmeester worked in senior real estate advisory roles for Deloitte & Touche and Arthur Andersen in offices in Amsterdam, Brussels, and New York, where he served various Fortune 1,000 companies globally. Mr. Meulmeester is an adjunct professor of Real Estate Finance at the Schack Institute of Real Estate at New York University, a member of the Urban Land Institute, New York District Council, and a Member of the Royal Institute of Chartered Surveyors, New York Chapter. Mr. Meulmeester holds a Masters in Economics from the University of Amsterdam in the Netherlands.