The Great Reset

Ever consider how odd it is that “great” is the adjective of choice for some of our most challenging times?  The Great Depression, The Great Recession, etc.  Reflexively, when I think about what’s happening in the office market, the reset that’s playing out all over the world, the first adjective that comes to mind is “great”.  Sorry about that.

Let’s also talk about “reset” for a moment.  It feels a bit flimsy.  Despite being a delicate word choice, it does convey the basic concept.  Both sides of the market are resetting.  This is the kind of reset where things end up being different than they were, not where we go back to a familiar place and start again.  It’s more like a reshaping.  We are certain that when the dust settles, the markets will look different.

How?  The catalyst is changing demand.  Demand for office space is changing in three important ways:

1. It’s getting smaller

2. It’s afraid of commitment

3. It’s way more likely to “swipe left”

The net effect of these changes is a substantial uptick in vacant office space.  This, in turn, causes changes to supply as investors compete to fill their buildings.  Key changes we’re beginning to see (and which will accelerate) include:

1. Newer, better amenities

2. Flexible leasing options

3. More concessions and lower rent

While this Great Reset thus affects both the product and the consumer, the economic outcome is vastly different for each.  In many markets, the occupier (consumer) will enjoy plentiful options, significantly lower costs, a better product and more flexibility - - - so it’s a net positive.  Yet the product side (building owners) faces significant challenges.  Take the San Francisco market, as an example. Many investors bought assets at pricing that no longer makes sense given market fundamentals.  And while the math is bad even without having to invest fresh capital to make the asset competitive, many must do so to be relevant in a 25%+ vacant market.  This puts the entire investment thesis in question.  Do you double down on the investment, take your pain and hope the market will recover such that you can at least break even (and how realistic is that); or, do you cut your losses now and sell?  We think many will sell at steep losses.  Why steep losses? Because whereas the seller bought the asset at a time when average rents were $85/sf, vacancy was <7%, demand was strong, debt was cheap and plentiful and rents were increasing 3%-5%+ year over year, the new buyer is investing when average rents are in the $60s and declining, vacancy is >25%, demand is way down, debt is expensive and hard to get and near-term rents are projected to decrease year over year for the foreseeable future.  This is precisely why, for many assets, values will decline by 25% or more.  The product reset is a modification to the physical offering (more amenities, etc.), a modification of the financial structure (debt and equity), and a modification of the types of leases being offered (flex, etc.).  The Great Reset has begun but don’t expect it to proceed smoothly.  The consumer has so far proceeded with extreme caution and investors are rarely quick to take losses.  But proceed it shall.