Has COVID-19 changed the commercial office investment case forever?


Having had our personal and professional lives turned upside-down, we’re now familiar with the realities of an extended period of enforced ‘hibernation’. Entire industries were shuttered and workforces stood down but the curve has been flattened. Cafes are re-opening, the kids are back at school and a tepid return to the humble office building beckons.

For commercial property investors like us, the experience of the last few months has provoked some challenging questions: Will remote working become the norm? Is this the end of the office building as we know it? How will an economic slowdown impact the cyclical office market? Will the downturn lead into a fully-fledged structural demise?

In any commercial property, the underlying investment case is linked to the asset’s current and potential utilisation. With JLL reporting that office utilisation slumped to as low as 5% during lockdown and some social media bosses allowing staff to work from home (WFH) indefinitely, these questions need addressing. The office sector faces immediate economic headwinds but also has the potential for structural change.

We believe the COVID-19-induced move to WFH is a necessary but ultimately temporary step to combat the virus. In summary, we believe it unlikely to result in any wholesale move to remote work.

The demise of the corporate office has long been forecast and yet despite email, the 9/11 terrorist attacks, Slack and Microsoft Teams, it remains a fixture of working life.

There are good reasons for this. Offices are places where jobs get done but also where trust is built, relationships are forged, and colleagues learn from one another. They are places where collective goals are achieved and celebrated.

Physical workplaces engender company culture. This is in serious risk of decay if permanent WFH became the norm. In addition, any success in remote working through the pandemic is likely a result of the strong relationships between employees cemented in the office.

Out of necessity, the concept of WFH was embraced. Everyone was happy to abide by the rules if it meant less virus transmission, and no doubt a measure of gratitude for still being employed. With a desk in the spare bedroom, a laptop and Internet connection, we did our best, marvelling at the spare time created by avoiding the daily commute.

But as the weeks turned into months the time saved was spent sleeping rather than exercising, or simply on more work as the point where work began and ended started to blur as we responded to emails while eating breakfast. And we missed the interaction with our colleagues.

COVID-19 has illuminated the desire for greater flexibility and accelerated its acceptance. Feedback from one institutional office landlord in a recent tenant survey indicated that employees wanted to WFH more often but also maintain an office presence.

The need for humans to gather and for corporate cultures to be built are answered by communal office space. We therefore think the risk of a widespread structural shift to WFH is unlikely, although the virus has revealed employees desire for greater flexibility and increased the propensity of employers to allow it.

In the short term, the requirements of social distancing may require more office space per person, plus sneeze shields, hand sanitizer stations and single direction walkways. Analysis by diversified AREIT and office landlord Mirvac Group indicated that if an existing tenant operating at a density of 1 person per 10sqm was increased to 1 per 14sqm whilst permitting 20% of staff to WFH permanently, an additional 12% of office space would be required.

As for the speed of the return, listed office landlord Dexus recently surveyed 700 tenants. It found that just under 25% planned a return by the end of May, almost 43% were expected back by June, 50% by July and above 70% by August.

These factors are likely to reverse the trend towards activity-based working, hot-desking and greater sharing of workstations, and it’s possible the need to social distance might entail the need for more space in the immediate future.

Accurately forecasting what the long-term holds is more fraught. High-tech building management systems that regulate ventilation, occupant movement and potentially even an individual’s vital health signs might be expected. More importantly, we’re confident that the office will be a feature of our working lives for decades to come.

To the issue of how an economic slow-down might impact a traditionally cyclical office market. GDP growth, business confidence and job ads have all turned negative. In the short term, subdued economic and corporate conditions will weigh heavily on the ability and willingness of corporate tenants to expand their office footprints.

Many will take stock of their existing space obligations, reconcile this with a moderated outlook for business expansion or employment cuts and decide to sub-lease part of their premises. The level of sub-lease space can be considered a “canary in the coalmine” for office market health. This measure has been steadily increasing in the Sydney CBD, albeit to date mainly due to large tenants moving around.

Our channel-checks suggest the virus has hit leasing volume and enquiry levels hard as cost-conscious corporates focus on defensive consolidation ahead of growth and expansion. Where lease negotiations are progressing, anecdotal evidence suggest tenants are requesting higher incentives, lower headline rents and pushing back on the level of fixed annual rent increases. Some are requesting shorter lease terms.

We won’t know the full story until deals are signed but, on balance, the outlook for market rent levels and asset values is negative.

Fortunately, strong market rental growth over recent years coupled with high occupancy levels across listed office portfolios is likely to provide a buffer to headline rental income, although not all listed office portfolios are created equal.

Those with relatively short lease expiry profiles, concentrations to highly priced premium grade office product and exposure to tenants under stress will suffer. Conversely, office landlords providing competitively priced, fit-for-purpose premises will be more likely to secure the cost-conscious corporate; and portfolios with strong tenant covenants and longer expiry profiles will also outperform.

With a portfolio tilted in this direction, this should be a source of comfort to AREIT Fund investors.

We also prefer AREIT management teams with a good track record in asset management and driving occupancy through difficult conditions. It’s in periods like this that capable management can really add value. Again, our portfolio is constructed with a heavy focus on such managers.

In the immediate term, the office sector probably faces declining tenant demand and downward pressure on market rents and values. The longer-term case for office buildings remains intact, albeit with some adaptation. We’re confident it will continue to be a key pillar of corporate life, a place in which culture and collaboration are fostered.

Source: APN Funds Management Ltd, Mark Mazzarella – 2 June 20