How Will Older Office Buildings Compete in the New Workplace?
Aging CBD Office Stock Face Dual Threat from Changing Tenant Needs, Competition from New, More Flexible Development
Office properties in core CBD markets have delivered above-average returns for investors over the past two decades and remain a favored asset class today. However, with more than half the existing Class A office space in the CBDs of Boston, Chicago, Los Angeles, New York, San Francisco and Washington, DC built before 1980, the increasing age and relative inefficiency of these properties present big challenges and risks for owners and investors as businesses increasingly re-evaluate and re-engineer their office requirements to meet leaner 21st-century workplace needs.
“There is a coming crisis in these leading CBDs: the changing occupier requirements can no longer be adequately supported by the majority of the current inventory,” noted Cushman & Wakefield Managing Director Rick Cleveland in a new report, “Supply Side Risk in the New Age of Work.”
Even older buildings that have undergone renovation since their initial construction often are not suited to handle the demands for more productive and flexible work environments and higher employee densities by today’s high-end office users.
One of the largest and most prosperous U.S. office landlords, Boston Properties, Inc. (NYSE: BXP), has a clear view of the challenges to office economics, as both a developer of new buildings and landlord over existing tenant rosters of financial services, technology and life science companies.
BXP Director and President Douglas T. Linde, has frequently cited tenant densification, increased productivity and new supply have become the heaviest drags on a stronger recovery in the office sector.
“In one way or another, businesses are finding ways to fit more people into less space. Organizations are moving from offices and cubes to trading desks, and offices and cubes are getting smaller, and traditional support functions are either being eliminated or consolidated,” Linde said at a recent conference.
New office construction is being delivered in all major markets, with BXP developing major projects in Boston, New York City and San Francisco. The new deliveries are creating a churning effect as tenants seek buildings offering smaller, more efficient floorplates, that are capable of supporting advanced technologies and offer energy cost savings and sustainability features.
“In many cases, we have major large tenants that are moving into new [developments], and they’re creating negative absorption,” Linde said.
Linde said he expects non-traditional office tenants to absorb a portion of the older supply being vacated by companies moving into the new buildings. However, some older building will be relegated to Class “B-ish quality or lower quality, and it’s going to be less attractive to tenants that are trying to become more efficient.”
The net result is a slower office recovery than previous cycles. While conditions in the older office buildings will eventually improve, “it’s not going to be the same kind of spike that you have in rents that we saw in 2005 to 2007, because there is this torrent of cost compression that is out there,” Linde said.
Companies Trimming Space Requirements
Since the economic recovery began, corporate real estate departments have had ample time to re-assess their space utilization. Companies are shrinking their per-employee square foot requirements while demanding more collaborative space and flexible floor plates from landlords. Many companies are prepared to sacrifice the holy grail of real estate, the CBD location, in pursuit of newer space in an evolving “outer ring” submarket that better suits their needs.
Citing a survey of major U.S. corporations conducted this year by architecture/design firm Gensler, Cushman & Wakefield’s Cleveland noted that many U.S. workers struggle to work effectively, even as more than 95% of surveyed companies believe that workplace design has a direct impact on employee productivity.
“Reducing and controlling cost through higher density is not only a trend that is here to stay, but is arguably the one factor that will have the most impact on the physical asset,” Cleveland said.
According to a recent CoreNet Global survey of corporate real estate executives, more than three-quarters of respondents project that the average will drop from the 2010 average of about 225 square feet to 150 square feet or less by 2018.
Large Manhattan landlords are seeing this stinginess for leasing space first-hand. Despite a recent increase in technology and creative tenants, owners have yet to experience a widespread spike in demand due to their lean space needs and penchance for subleasing space, according to Heidi Learner, chief economist for tenant presentation firm Studley.
Companies such as Tumblr, Tremor Video, Yodle and 10gen are occupying space at far higher densities than financial services, law firms and other traditional Midtown tenants, according to Learner, lead author of a Studley report on the Manhattan tech boom.
“An ingrained culture of collaboration creates the need for offices without walls that often have a large number of people working in open floor plans and close quarters, which has led to communal seating arrangements such as benching. Flexible work schedules may make it less likely that all employees are in the office at the same time,” Learner added.
“When these firms lease direct space, the lower allocation of square feet per employee is an added negative for landlords … increased efficiency will decrease demand for office space over the long term if this trend continues.”
A prime example of this diminished need for larger space in micro-blogging platform Tumblr, acquired this year by Yahoo! for $1.1 billion. The company is using just 154 square feet per employee for its headquarters offices at 35 East 21st Street in Midtown South.
However, Tumblr’s quarters might feel a bit spacious compared with the 98 square feet per employee expected to utilized by Paperless Post, an online stationary e-commerce firm leasing 12,500 square feet at 115 Broadway.
According to the CoreNet survey, more than 53% predicted average office space usage will for to 100 square feet or less by 2018.
CBDs Losing Cachet to Emerging Tech Centers?
Owners of older core CBD assets are also fighting on another front — competition from up-and-coming submarkets such as the aforementioned Midtown South in New York. A rising number of smaller and mid-size tech and creative firms are migrating to submarkets in other cities, such the Seaport District in Boston and SOMA (South of Market) in San Francisco.
Cities and the private sector are investing in infrastructure and other redevelopment in these districts, clearing the way for shiny new transit-oriented projects where employees can live, walk to work and play.
Traditional CBDs in the top cities will likely continue to outperform the broader office market, Cleveland said. However, many owners or prospective buyers may be lulled into making unrealistic assumptions about leasing income and necessary capital improvements.
“Owners of assets in more traditional core submarkets must consider how their buildings will compete in this environment and account for this in their lease-up and underwriting,” Cleveland said. “Workplace strategies centered on cost, efficiency and productivity are not passing fads, but rather part of a larger movement towards a more strategic and analytical approach to occupancy.”
New strategies often include a transition away from large personal offices to more open and collaborative environments, and even more recently, to striking a balance between collaboration and the need for employees to perform focused work.
Older buildings can have less flexible floor plans and lose nearly 20% of usable space when accounting for interior vertical columns, hallways and other features. Owners must consider this potential space loss when making projections about leasing and rent.
Finally, even well-located traditional locations could lose out as companies become much more in tune with what their employees want. Organizations have spent considerable time and effort determining their optimal space and have multiple site choices in most markets, and owners must be prepared to offer discounts to tenants on uncompetitive space, even in well-located buildings.
“Expect occupiers to be reluctant to compromise on the design of their space and ask for considerable allowances. Be aware of the underlying trends in tenant demand and what the various segments of the markets are seeking,” advises Cleveland.
Source: CoStar Randyl Drummer October 8th, 2013