Commercial real estate has always been an easy bet for investors. Performance is predictable, and a good commercial building’s low-risk profile can help diversify almost any investment portfolio. Values go up when times are good, and foreclosures are a last resort for banks when times get tough. Traditionally, the office is the most attractive asset class within commercial real estate as a whole, typically making up 30-40 percent of real estate assets in any given portfolio. But lately, the office hasn’t been a top performer.
Overall, institutional real estate delivered a 5.33 percent return in the first quarter of 2022 across five asset classes: office, hotel, industrial, multifamily and retail. However, returns within those classes varied. Industrial topped the leaderboard with a 10.94 percent return to kick off the year. Office came in last, only yielding 1.6 percent for investors, continuing its lagging performance from last year.
Office buildings aren’t going anywhere, but they are having an identity crisis in the eyes of investors and the companies that call them home. According to one study, 69 percent of companies have permanently closed an office since the start of the pandemic. In the last month, Facebook, Bose, and Tesla are just a few of the companies that have either paused construction on planned offices or decided to condense their office footprint.
Hybrid work has forced changes to individual workplaces and how much space a company leases, but not necessarily the buildings. So what has to change about the buildings themselves and the business model of the office? These buildings can take a cue from the investors who back them. It’s time to diversify, rethinking how a building makes money and why someone would want to go there.
One of the big reasons why office buildings are a safe investment is the standard lease term. There aren’t many other industries that have guaranteed revenue streams for ten or fifteen years with a single signature.
But the standard lease terms aren’t so attractive to many potential tenants who are still trying to figure out their long-term real estate plays. Why should they be forced into a lease they may not need next year? Some want to see if people will go back to the office if they have one to offer, with the ability to cancel as easily as they would a Netflix subscription. Many don’t even need an office full-time, only thinking about space once or twice a year for team gatherings.
Flex space existed prior to the pandemic. But if an office building has flex space, it’s probably less than 10 percent of the total square footage. Flexible offices are typically viewed as a risk to occupancy rates over time given the turnover of tenants and are typically not included in traditional value calculations. That mindset has to change. The multifamily asset class can be a source of inspiration, building a revenue model based on multiple lease terms with the comfort of knowing that most tenants move from lease to lease rather than exiting the market.
What type of flex space is right for your building?
“Institutional investors are embracing the positive impact that flex space can have on building valuation and performance. Asset owners and the capital markets are following their lead,” explained Melissa Schilo, Vice President of Account Management for Flex by JLL. “More than 30 percent of the office will be flex by 2030, including unmonetized amenity space for all tenants to enjoy from exciting food and beverage to full-scale event centers.”
Schilo hints at another opportunity for office buildings to diversify by offering more than just office space, taking a cue from mixed-use properties that offer retail, restaurants, fitness, office, and housing at one address. Beyond adding to topline revenue, this gives office buildings a purpose after 5:00 pm, on the weekends and holidays. Easy access to these services also attracts more people back to the office because it means they can do more than just go to work if they brave the commute. You aren’t going to out-amenity the convenience of working from home, but buildings can give people an experience they can’t get somewhere else.
Many newer office buildings are already designed for well-rounded experiences. Perhaps that’s why buildings built in the last 10 years have a 96.7 percent occupancy rate in comparison to an 85.2 percent rate for older buildings. This 11+ point delta is the highest it’s been in recent years. Think of Hudson Yards in Manhattan as an extreme example of this. Not only does it combine offices with retail, restaurants, and fitness offerings, but it also gives people something to do even if they don’t live or work there. From the Vessel, a climbable public art installation at its center, to the Edge, the tallest observation deck in the Western Hemisphere.
Asset owners are also looking up to their rooftops specifically to generate additional revenue. Even though 5G upgrades have been for years, telecommunication companies and cellular networks are still on the hunt for more than 800,000 sites across the country in order to make 5G a reality. In addition, formerly regional telecoms like U.S. Cellular and Dish are expanding their territories, bringing more competition to the rooftop market. Leasing roof space for antennas and other network equipment has little cost to owners, meaning rooftop revenue has an outsized impact on net operating income. And what’s better than that?
These efforts won’t just add to revenue or valuation. They will push office buildings to become more resilient and better positioned to respond to what companies want from their offices (once they figure it out) while also giving the space a purpose beyond a place for people to work. Other asset classes can’t pivot as the office can. Good locations plus relatively blank canvases enable office buildings to reinvent themselves easily, and that flexibility will continue to make them a good bet for investors.