The world has been upended by an adaptation. A rare virus has adapted in a way that allowed it to attach itself to a new victim, humans. This molecular mutation goes to show how small, often unseen changes can cause ripples that can turn into waves powerful enough to send us seeking the shelter of our homes and the entire global economy into a freefall.
Every living thing owes its biological makeup to the result of millions of years of these types of incremental changes that made it better able to cope with its environment, changing as it might be. The same thing can be said for organizations as they can for organisms as it can for organizations. Businesses have been mutating since the advent of modern capitalism, building upon adaptations that prove advantageous. We don’t call it mutation, opting instead to give it more aspirational labels like innovation, but the process is the same: try new things, continue as long as they work, then try something new, and start all over.
Adaptation isn’t linear, it’s cyclical. Any advantage is ultimately eroded by new environmental changes and increasingly well adapted competition. Biologists call this the Red Queen hypothesis, a theory that proposes that a species must constantly adapt in order to be able to compete. It is a reference to the race scene from Lewis Carroll’s Through the Looking-Glass (of Alice in Wonderland fame) where the Queen has set the rules so that you can only move if you keep running faster.
Up until now, one of the organizations that had not done much mutating (because it didn’t need to quite frankly) was the relationship between commercial landlord and tenant. Historically investors put money into commercial real estate to generate “passive” income. Management companies for many commercial properties were designed to do little more than collect rent and maintain the building. Now, though, many landlords and property managers are rethinking this arrangement. Faced with tenants unable or unwilling to pay rent while their businesses are closed or their teams are working from home, the property industry is in a state of upheaval that is paving the way for an important adaptation.
The WFH adaptation
Some mutations happen quickly. In the biological world, they call this saltation. The term comes from the Latin word saltus meaning “leap” and explains a large mutational change from one generation to the next. This is the best way to describe what offices had to do at the inception of the outbreak. No one could have guessed how quickly and completely “non-essential” work would not be permitted to be done at an office. But this non-essential work still needed to get done so, from one week to the next almost every business in the world had to find a way to operate without the use of their workspace. For most people that meant working from home. This left financial districts and office parks desolate, and it forced companies to think about their now seemingly wasted office lease expense.
A few months ago, when the world first started to react to this deadly new strain of the coronavirus I reached out to Peter Miscovich and Sundar Nagarajan, the heads of the consulting practice for one of the world’s biggest commercial property managers, JLL. I wanted to know how businesses were reacting to the news that many of us would be forced to take our offices to our homes for the foreseeable future. Since the lockdowns were first announced the two had been spending almost all of their time in meetings with their large corporate occupier clients, helping them understand how to best allocate resources as they closed down their offices.
“Today we have organizations during the COVID-19 pandemic that are spending millions of dollars on real estate that is under-utilized. Near empty buildings with very low occupancy over the long-term will become a challenge in terms of energy consumption, financial resources and management time,” Miscovich told me. “We must try to find ways to help companies navigate uncertainty and risk, and to rethink their workplace strategies and long-term portfolio strategies. We must help organizations discover new ways of working, turning workplace inefficiency and waste into more positive financial outcomes. In turn, this will support the funding of employees’ salaries and benefits and help many organizations survive this challenging economic downturn.” They explained that where they were once seen as a real estate advisor, their roles were now changing to help clients understand their entire business through a real estate lens.
We must help organizations discover new ways of working, turning workplace inefficiency and waste into more positive financial outcomes. In turn, this will support the funding of employees’ salaries and benefits and help many organizations survive this challenging economic downturn.
Peter Miscovich, JLL
Both Miscovich and Nagarajan said that they had been expecting a shift to distributed teams and an increase in work-from-home for a long time. The pandemic had only accelerated that change, shrinking the time it took industries to adapt to the new way that we organize our work from years to months. They also stressed that while cost-cutting was a goal, it shouldn’t be the main one, “right now business continuity should be on the top of every organizations’ mind,” said Nagarajan. He said that rethinking offices was an important step, but one that should be done once things start to settle down and we have a better understanding of when the pandemic will be over.
After the initial fears had subsided and business started reoccupying their offices, I followed back up with the two to see how they were continuing to help clients understand their businesses from a property perspective. They told me that the lessons that they had learned in certain parts of the world that were able to open up first, like most Asian markets, were helping them inform the areas that were still in the midst of the shutdown. “What is happening now versus when we last spoke in April,” Miscovich said, “is that many companies have gotten through the shock phase. We now understand that we are experiencing an elongated COVID-19 journey with most companies engaged in the development and modeling of multiple long-term scenarios.” They told me that they were telling their clients that this represented an opportunity to reimagine their entire operating model.
I couldn’t help but ask them the question it seems the entire world is asking right now: How much office space will companies need in this new work-from-home environment? I didn’t expect for them to have a definitive answer, there are obviously specifics about the industry, the company, and the space that would need to be factored into that calculation. I wanted to ask the question because it has other important questions embedded into it. Namely, do companies have less of a need for office space? And, would JLL, a provider of space, advise companies to reduce their office footprint even if that meant less need for them to manage it?
What Nagarajan said next surprised me, “Without exception, none of my clients are reducing their envelopes yet.” He explained that this shock had taught a lot of large companies, their typical clientele, that excess capacity was needed to increase the organizations’ resiliency.
Miscovich added additional context, “many organizations discovered what happens when you run a company ‘too lean’ with little consideration for long-term resiliency. For example, our medical supply chains for PPE [personal protective equipment] were run this way historically and it hindered our ability as a country to provide the necessary supplies during the early phases of the COVID-19 pandemic. Given the increase in space needed for social distancing and the unknown timeframe of when we will have a vaccine, our clients are not reducing space in the immediate near-term.”
Rather than jumping to the unverified conclusion that less space was needed for office work, as I had done by asking that loaded question, they were helping companies with scenario modeling. By analyzing different outcomes and timelines, they are able to help businesses create a list of different options for each. They did not rule out the possibility that less space might be needed for some of the companies that they advise. But they stressed that it was important to understand the specifics of what kind of space is needed and why as well as just how much. They have already seen a lot of opportunity for traditional long term lease space to be turned into flexible suites. “We have recently recommended to a global client to increase their coworking space by 100 percent for the long-term—beyond 2021,” Miscovich said.
While it is still impossible to know how the world will emerge from the tsunami created by the COVID-19 virus’s adaptation, we all have a sense that it will never go back to the way we were just a few short (but long) months ago. This is what makes this change even more different than the others that humans have endured up until now. While there seems to be less existential dread now than when we first learned about this mutation of the coronavirus, the uncertainty seems to have a much longer time horizon. No longer do we have hopes of a quick V-shaped recovery. Even the lasting immunity of a vaccine is in doubt. Short term uncertainty causes businesses to retreat and wait out the storm. Long term uncertainty causes businesses to experiment. Waiting out the storm isn’t a good option if the storm never breaks. “In the past, when you had a flood or business interruption, resiliency was just getting back to normal,” Nagarajan said. “In this situation, resiliency is more about how to adapt. What do you want to become? Our goal is to help people emerge stronger.”
The center of a new shopping world
Most genetic mutation happens slowly. Small changes every generation can amount to big variances over time. The mutation rate for any organism depends on how often it reproduces, on how many chances there are for mutation to take place. For businesses, this doesn’t happen through reproduction; it happens through destruction. Every failed business is a lesson learned by the market and an open patch of daylight that allows new ideas to germinate. If these new businesses can get past the sprout stage, they might be able to replace the failed business with a better adapted one.
Brick and mortar retail has been going through a long period of rapid destruction and rebirth. Local “mom and pop” retailers have already had to compete, and often lose, to large mega-stores like Walmart and online shopping platforms like Amazon. Now, they have to figure out a way to stay afloat in a world where every shopping trip carries with it the risk of infection.
Through all this adversity, retailers have started a symbiotic relationship with their landlords. I spoke with one of the landlords who has adopted a uniquely collaborative approach to his relationship with tenants. Alex Zikakis is CEO and President of the real estate investment and development company Capstone Advisors. He came into the real estate industry during the savings and loan crisis in the 90s. He saw how bad things could get when commercial property defaults happen en masse. “At the time, there was a lot of unfounded speculation on property values, people were buying properties just for the tax benefits,” he told me. But he draws a distinction about what happened then and what is happening now. While the saving and loan crisis was a way for the property industry to learn a lesson about the dangers of overleveraging, the COVID crisis doesn’t have that same kind of lessons to be learned. “The pain being felt now isn’t anyone’s fault. This is a health crisis that no one could have predicted that is harming the most vulnerable part of our economy, small businesses,” said Zikakis.
Even before the pandemic, Zikakis saw the impact that the internet was having on the way we shop, so he hired a small business consultant to work with any of his tenants that wanted the help. The consultant provides expert advice on almost every aspect of small business ownership, from point of sale systems to inventory management to predict the next new popular trends for many of the local businesses in his centers. One of the biggest impacts that the advisor has been able to make is helping companies improve their online profile along with their physical one. “Social media following and search ranking is so important to a local business, we have to do everything we can to help them compete,” he said. “We found that consistency is really important for both of these, so we have regular educational sessions to help tenants continue to stay on the top of people’s search rankings and media feeds,” Zikakis said.
Social media following and search ranking is so important to a local business, we have to do everything we can to help them compete.
Alex Zikakis, Capstone Advisors
To insulate his shopping centers from the destruction to retailers that he predicted a shift to online shopping would bring, Zikakis focused his leasing effort on service-based businesses like dry cleaners, salons, and healthcare. This turned out to be a great move…until the pandemic hit. “When the outbreak started, I knew it was going to cause a lot of pain for many tenants because their businesses, by definition, needed in-person visits,” he said. Rather than waiting for the rent relief request to come to him, he sent out a note as soon as the stay at home orders were issued telling tenants that they would get a rent abatement for the month of April. “I think it is because of this early acknowledgment that renters would need some help that our rent collections have been much higher than the rest of the industry,” he said, even citing instances where tenants told him that they would rather not defer rent payments even when he had given them permission to do so.
Investment by any other name
In a way, the efforts that Zikakis has made to help his tenants survive in these challenging times for retail can be seen as an investment in local business. The hope is that these investments will result in a return of a less turnover, less vacancy, and a happier client base. Other retail landlords are making investments in some of their larger tenants as well, some of them in an even more direct way. Brookfield has devoted $5 billion to invest in a Retail Revitalization Program that will function under their private equity arm to inject capital into companies with locations in their major markets.
Money is tight right now so the access to this capital could keep retailers out of bankruptcy court, but it isn’t the only benefit to the arrangement. Private equity firms also bring with them their business expertise often helping their portfolio companies streamline their operations and restructure their debt. Just having the backing of a company like Brookfield could have a positive effect on how a brand is treated by investors, vendors, and partners.
What private equity companies are to established businesses, venture capital firms are to startups. By bringing early stage capital, a network of advisors, and name recognition to a company, venture funds hope to cultivate (and therefore participate in) the growth of the next big thing. The majority of venture investment goes into technology companies since they have the most potential for exponential growth and are often valued at a multiple many times higher than their revenue. Now, though, some venture firms see promise in helping retail brands grow from pop-up shops to anchor tenants.
One of the venture firms pioneering this push into retail is Fifth Wall. They have invested in technology companies on behalf of some of the biggest players in real estate since their inception four years ago and have recently closed a $100 million Retail Fund. I spoke with one of the firm’s founders, Brendan Wallace about this move. “The premise of the fund is that landlords, whether they like it or not, are in the investing business,” he said. “You are underwriting risk and giving credit to tenants whether you like it or not.” He spoke to the exposure of consumer choice, thanks to online shopping (and now the growth of side hussle consumer goods on sites like Etsy due to the quarantine). “Now, a mall or shopping center is not just a place to buy goods, but a place to discover them. That means that the retail real estate industry has to curate new ideas and up-and-coming brands. The problem is that the financial characteristics are so insecure for these new, often digitally-native products that it creates much more skin in it for landlords.”
…landlords, whether they like it or not, are in the investing business.
Brendan Wallace, Fifth Wall
Wallace thinks soon retail landlords will start to resemble venture funds in a lot of ways. “Now you see Brookfield and Simon working together to rescue brands, and while this is a defensive move to inject capital into companies within their markets, it is an example of retail landlords assuming a role more akin to a venture investor in order to provide assistance to their portfolio,” he said. A better idea, in his mind, is to have landlords work together to not only invest in brands, but give them access to consumer behavior data, distribution networks, and retail expertise that can help them change and grow, not merely survive.
The new space race
The pandemic has accelerated the digital migration of our culture and our economy. It has changed the role that our buildings play in the way we work and shop. There will always be a need for a physical space when it comes to running a business or selling a product but that need might look very different going forward. The changes that we have made in the face of the COVID-19 virus have been dramatic. Some of them might be permanent and some might become a distant memory once we have a vaccine and we no longer live in a state of fear of contagion.
The difficulty for the business world right now is understanding this migration. Will work-from-home become a mainstay for companies, or will we eventually need the collaboration and serendipitous interaction that comes from having teams in the same room as each other? Will we eventually just go online for all of our purchases, or will we always want to try out the products we purchase or be introduced to the ones that we didn’t know existed? These are not billion but trillion dollar questions, and getting the answer right will make the difference between the companies that come out of the pandemic stronger and the ones that will become another casualty statistic in the growing list of bankruptcies.
Landlords and property managers obviously have an interest in a continued demand for office and retail space. For that reason most in commercial real estate have been trying to determine how much demand there will be in the short and long term. But maybe we shouldn’t be focusing on how much space businesses will need and instead help them get ahead by providing a better understanding of what kind of space they need.
The commercial real estate industry is undergoing a necessary mutation. What was once an adversarial relationship between tenants and landlords is now becoming a collaborative one. If successful this could give businesses, and by extension their landlords, a competitive advantage against their peers. Eventually, for both the natural and business world, the Red Queen hypothesis applies. Any advantages that come from the changes brought on by the “retail apocalypse” and the “WFH experiment” and this “unprecedented pandemic” will eventually get undermined by new changes to the competition or the ecosystem. As the Queen explains in Carroll’s tale, “Now, here, you see, it takes all the running you can do, to keep in the same place.” As discouraging as it might sound, for many businesses, staying in the same place is their best case scenario, and they will need all of the advice they can get to do so.