Market Outlook Q4 2020
THE OFFICE WAS CHANGING
To understand the magnitude of change brought on by the COVID-19 pandemic, we must first acknowledge that significant changes had already begun over the past couple of decades. To be sure, corporations were thinking differently about office space. They had become more resistant to the historical misalignment that exists between their need for flexible, amenity rich solutions and the traditional landlord lease offering. Most notably, landlords require fixed, long term leases; whereas over the course of the lease, the occupier’s business is in constant flux. Enter the likes of WeWork and the rapid rise of flexible leasing solutions.
Similarly, during the early 2020s landlords in all US Metros began to make expensive physical changes to their assets. They waged an “amenity war” in which significant capital was invested to enhance the occupier experience within the building. High end fitness facilities, casual gathering spaces, outdoor patios and roof decks, “activated” lobbies and many other changes became part of the standard landlord playbook.
Occupiers across all industry increasingly embraced the open architecture and higher density occupancy first espoused by the tech sector. Many companies also demonstrated willingness to pay more for the finished product by leasing pre-built space. Landlords wasted no time gravitating to this model, launching a years’ long love affair with the “spec tech” prebuilt.
Meanwhile, corporations were getting more comfortable with new technologies that enabled workers to work from anywhere. However institutional bias against WFH/ remote work prevented these technologies from being fully deployed. The primary reason? Trust. Trust that the WFH/ remote employee would remain productive.
All in all, US office markets entered 2020 at a time when big changes were taking shape, portending a future where office space would be significantly different than it had been for most of the prior century. But what happened in March of 2020 accelerated and amplified these trends. The result has been no less than a wholesale reexamination of the modern office.
THE COVID-19 ACCELORATOR
Has there ever been a moment when a product used daily by hundreds of millions of people was taken away overnight? This is effectively what occurred across the US office markets beginning in March of 2020. Employers and employees were forced to quickly adapt their businesses to function without office space. To the surprise of nearly everyone, business carried on. Employees were productive, in some cases more so. Some found great relief not having to commute.
Others became healthier, filling time they otherwise wasted on long commutes with exercise and family time. Yet challenges emerged. Employees experienced burnout as they struggled to create work/life balance. Some had inadequate workspace at home. Others could not manage the constant distractions, including caring for young children or elderly parents. Still others lacked quality technology and internet connectivity. It was challenging to define, promote and maintain culture. Mentorship of young employees also suffered. But as the year progressed and the virus continued to spread, offices remained closed and companies began to think differently about their future use of office space. Here in the Bay Area, it was no surprise to see technology companies lead the way. After all, tech as an industry has done more to redefine office space than any other sector. It was tech that brought us benching, lounge spaces, fun and games at work, company chefs and much more. Now tech is leading the way in developing hybrid workplaces, embracing the distributed workforce, advocating WFH forever and other remote work policies.
Yet while Google and Facebook have a plan, it’s clear that many companies do not. To remain competitive, these companies must also determine their future workplace. They must determine how they will support their employees, employees who after nearly a year of adjusting to an “officeless” lifestyle may demand more of the same post-pandemic. No small task when you consider the magnitude of these changes and that to be effective, new workplace strategies must be custom tailored to meet the individual employee needs. One thing is certain, office space now means something different than it did in 2019.
FUTURE WORKPLACE
Out of the chaos of crisis examples of new workplace strategies have emerged. Most of these can rightly be described as hybrid solutions because they offer employees at least some flexibility to be in the office, WFH and work from other remote locations that are not home. The office space is being recast more as a center for collaboration, culture building and client facing activities. It also provides space for “head down” work for those who are not able to do so at home. There is a lot of chatter about so called “hub and spoke” workplace solutions where a company maintains a main office in the city and provides smaller, distributed remote locations near where concentrations of employees live. It’s not yet clear whether the amount of space required to implement these strategies is less than, equal to or greater than the amount of space previously leased. While difficult for many to envision their future office, it’s imperative to do so as those failing to respond to the changing landscape will be less competitive as they lose in the war for talent. Ultimately this is about attracting and keeping talent. Finding the right path forward requires proper guidance and key input from employees, HR, Workplace and Finance. Lacking a playbook for this new journey, many occupiers have chosen to hit pause and either do a short-term extension on their existing leases or simply allow the lease to expire and WFH. These are smart strategies when compared to moving forward on longer term commitments based on the model otherwise employed pre-pandemic.
THE OFFICE MARKET
In 2020 San Francisco recorded the lowest amount of new leasing on record. THE LOWEST AMOUNT OF NEW LEASING ON RECORD. For landlords, the year began with an opportunity to continue to exploit a severely constrained market characterized by over 7M sf of demand and just 4% vacancy. By June measurable demand plummeted to around 3M sf. With nearly all occupiers unable or unwilling to use their office space, sublease space surged. In fact, sublease availability quickly outpaced direct availability. Overall vacancy climbed from 4% to over 16%. Pricing for sublease spaces began dropping precipitously. Many offerings initially hit the market priced in the $80s.
By year end, sublease space was commonly available in the $40s and $50s. Meanwhile, pricing of direct space has declined but at a much slower pace. Average Class A rental rates started the year in the low $90s (a historical record high) but finished in the mid $70s. Remember, most landlords have continued to enjoy low vacancy while their tenants honor their leases and pay rent. The brunt of the pain has, thus far, been shouldered by tenants. But as the burden of vacancy begins to shift to the landlord, forcing them to compete in an oversupplied market, the pace at which direct rents fall will accelerate and landlords will fund more tenant concessions.
It’s clear the demand now returning to the market is patient. These occupiers are not forced to act based upon expiring leases. With employees already in WFH mode and ongoing uncertainty as to when the office will once again be safe for occupancy, letting the lease expire and storing FF&E is a real option. Many are using this moment to craft solutions that better match their future need; and, frankly, the market is compliant.
2021, 2022, AND BEYOND
The San Francisco Bay Area office market now affords occupiers the opportunity to exercise substantial leverage in negotiating new workplace solutions. While the uncertainty around how to proceed is real, smart companies will immediately undertake the work necessary to design their future workplace so they can implement this strategy while the market is historically soft. Those who do so will enjoy competitive advantages for years to come. Remember, Bay Area office space is unique in that the same exact product (e.g., the same office space) can cost twice as much or half as much, simply depending upon when it is acquired.
More than 2 years ago when we created TenantSee, we focused on change. We wanted to change the way tenant real estate services are conceived and delivered. It should come as no surprise that we’ve worked very hard over the past year to augment our platform with resources designed to meet the needs of this moment. Specifically, we have a service to help companies navigate the new realities of workplace. This is not a brokerage solution. It’s a consultative offering that begins with “why”; as in: Why have an office in the first place? We’ve mapped out the exact resources necessary to determine the best hybrid solutions. How much WFH? Where is your labor? What technologies do you need to measure employee engagement, to measure space usage and employee experience? How much flex do you need in your portfolio? How should your future space be designed? The output from this effort is a new Workplace Strategy which correlates workplace spending with key employee engagement drivers. We can provide an overview of our offering in a 30-minute virtual meeting. Please let us know if you would like to learn more.
As we close out 2020, I’m reminded of the words of President Abraham Lincoln, “…this, too, shall pass”. The COVID-19 pandemic won’t last forever. Office markets will cycle. They always do. Opportunities will come and go; and come again. But the way we think about and use office space is forever changed. We now have an opportunity to make it better. Better for the employees, creating more engagement, making them healthier and happier. We look forward to being part of this positive change. As always, thank you for your support and interest in our work.