Five real estate experts discuss issues surrounding the office market downturn, including how it differs from previous ones, the prospects for recovery and indicators to be on the watch for, where the office market is expected to recover first, whether the current downturn will change the way tenants lease properties even after the office market recovers, and what office building owners should focus on to make it through the rest of the recession.
How did the office market downturn come about? Would you call it a crisis?
Douglas Herzbrun: The office market has historically been the most cyclical of all of the property types, and it’s definitely living up to its reputation in this cycle. The anticipation is that of all the property types, it’s going to be the most hit over the current business cycle, both in terms of the increase in vacancy and drop in rents.
The reasons for this are the huge amount of job losses that we’re experiencing in this country and the fact that there’s a lag between when those job losses hit and when that actually impacts the demand for office space. Employers may or may not put vacant space up for subleasing, but when those leases come up for renewal, they won’t renew them. So, unfortunately, office absorption is going to lag employment, even though we are optimistic that we are getting to the end of the employment losses right now.
Russell L. Ingrum: The notion that there was an office market crash per se is a little dramatic. In 2006, 2007, no one would have told you that they believed that the conditions then would last. We were seeing markets that were trading 25 percent of the total inventory on an annual basis, and you just can’t do that for any sustained period of time. But the downturn was sneaky and it started in the debt world.
What caused the trouble is that the debt markets changed very rapidly, so that impacted office property pricing. A good 25 to 30 percent of the value correction that we’ve experienced is attributable to changes in underwriting standards and availability of debt. But the downturn wasn’t just a real estate capital market issue. It was a global issue. The other 15 to 20 percent of value loss came from increased vacancy and decreased market rents. J.
Matthew Haley: From a debt and equity standpoint, things really came to a freeze: limited activity, very few participants willing to place new money—whether debt or equity—into investments. Would I deem it a crisis in terms of fundamentals? Not yet. Within our own portfolio, we’ve seen very little change in occupancy. We’ve been fortunate. In terms of the crisis of banking, it’s getting better now with the U.S. Federal Reserve attempting to reinvigorate the securitization market. Insurance companies are providing more debt at better rates and terms than they were six months ago.
Randall M. Griffin: It’s hard to generalize about the whole country because the office market is particularly localized. We are a little different in that we are a specialty office real estate investment trust that focuses on the U.S. government, defense information technology, and data sectors, so some of my comments are probably biased toward that experience.
It’s a little bit of a misstatement to say that the office sector is in a crisis. Unlike other sectors, the office sector has held up relatively well. In the recessions of the late 1980s and 2001, we had overbuilding in the office sector. That wasn’t the case this time: the office market was relatively stable, almost underserved. It did get overheated from a pricing standpoint, but if you have a relatively stable supply, you can bounce back relatively quickly from a recession.
How is this downturn different from previous ones?
Griffin: There are a lot of people thinking that this recession will be similar to the Resolution Trust days of the late 1980s and early 1990s, but we don’t see that happening. Uniformly, real estate executives do not see the buying opportunities of the mid-1980s. Thirty cents on the dollar—that’s not going to happen. A lot of distressed properties have not come out of the pipeline from the banks: the banks aren’t being pressured to sell them, offload them, or write them down. When these properties start becoming available, the better-leased, well-located ones are going to do very well on pricing. There will be some excellent opportunities, but they’re not going to be steals.
Herzbrun: If you look at the investment side, one thing that’s different now than it was in the recession of the early 1990s is we had a substantial withdrawal of capital from real estate investment prior to the downturn in market fundamentals. Owners and potential sellers are also becoming more realistic about pricing and values earlier on in the cycle than they were in the 1990s. It’s hard to gauge pricing right now because of the dearth of transaction activity, but prices have adjusted much more quickly than they did in the early 1990s, and certainly values have. Finally, whereas many investors felt so burned in the early 1990s that they wrote off interest in real estate, today many capital sources see the repricing in the asset class as an opportunity. What do the prospects for recovery in the office market look like? What indicators are important to watch?
Herzbrun: Job slashing has been so much more severe than it was in previous recessions: companies have cut to the bone in terms of their operations. With any pickup of consumer demand and a pickup in demand from trading partners, companies will have to start ramping up their operations again— manufacturing firms, technology firms, business services firms—because they have no excess capacity within their own organizations. We see a pretty rapid ramp-up in employment growth coming out of this downturn, and that’s going to manifest itself in a fairly sharp recovery in office demand. But the negative office absorption is going to linger well into 2010. Rent performance generally lags behind that, so you’re going to continue to see vacancy rates spiking up, with probably some stabilization in 2011. You’re not going to start seeing significant rent growth until 2012, 2013, 2014.
Ingrum: When you have a shock to the financial system like we’ve had, it’s going to take some time for it to come back. Prices have reset considerably— not just in real estate, but all across the board—and people are getting comfortable with where prices are today. I envision a slow recovery—not a sharp, V-shaped recovery by any stretch, but also not a W shape in which the economy falls back down again.
There are a couple of things that I look at, and one of them is the risk premium that investors attach to various investments, such as corporate bonds. As things have stabilized, corporate bond spreads have come down considerably from where they were in January or February [2009], and when that happens, it spreads out to all of the other asset classes, including real estate.
Also, consumer spending drives between 65 and 70 percent of our economy, and my fundamental belief is that we are not a nation of savers, we are a nation of spenders. It’s not going to be a dramatic turnaround, but we are slowly backing away from the precipice to a more stable, predictable environment that will allow companies with good business plans to grow, and those without good business plans to slowly fade.
Where is the office market likely to rebound most quickly?
Haley: In the United States, Manhattan and Boston have seen more drastic reduction in rents, but that’s really driven by the fact that they reached highs that the rest of the market did not reach. Boston, although it’s a volatile market, always comes back. Manhattan is going to come back, too. We are always believers that the government will continue to expand, so we believe the Washington, D.C., market will continue to be one of the more resilient markets.
Herzbrun: The markets that are going to rebound the most quickly are ones that have a product or service that is exportable to the rest of the world. So we see New York City, for instance, as having a very sharp downturn and a pretty sharp recovery, particularly toward 2013, 2014. The same holds for a lot of technology centers, like the San Francisco Bay Area, Seattle, and Austin.
The recovery in the U.K. will probably be protracted because the U.K. is so driven by financial services. In Europe, the major market that’s probably going to have the most solid endpoint-to-endpoint performance is Paris; the French economy has stayed in relatively good shape. Hong Kong seems to have bounced back fairly quickly: the supply of office buildings has been limited there, and it’s clearly benefiting from the fact that the Chinese economy has been fairly resurgent. Despite fairly resilient demand, China has the problem of massive oversupply—particularly in Shanghai’s Pudong area and Beijing.
Ingrum: One trend to follow is the migration of the population to the southern part of the United States, especially the central part. Dallas and Houston are adding over 100,000 new residents every year, and that kind of growth is going to drive business activity. Those cities and states that either because of taxation or climate or other reasons aren’t able to retain or grow their resident base have a much more difficult road to recovery.
Is the current downturn likely to change the way tenants lease properties even after the office market recovers?
Haley: As we entered the recession, everyone wanted a very short-term lease because they didn’t know where their business was going. But that’s not going to be affecting how they look at their office space long term. Some of the smarter companies that have a good handle on where their future is going are now saying, “I’ve got a rollover next year. Let me consolidate some space. I can probably get a low rate right now.”
Griffin: Companies have been through these cycles before, and I think that they’re behaving in a similar pattern. The one thing that we are seeing as a trend that will certainly accelerate is the greening of America. That’s a grassroots phenomenon that the U.S. government is starting to mandate in its leases in 2011. But in general, in a recession, square footages per employee tend to come down, and then as we start to come out of the recession, they tend to come up. The reality is that real estate is still on the low end of the company’s costs compared to health care or salaries.
Glenn A. Shannon: Now, for the first time in my experience, prospective tenants want to see the space, and they also want to understand the capital structure of the building—who the owner is, how much debt is on the building, whether there is risk in the capital structure. They want to know that they will get the business deal and the business environment that they are bargaining for, whether that’s tenant improvements or leasing commissions or ongoing maintenance.
Companies whose tenant allowance was trapped in a bankruptcy or not released from an escrow account, or who experienced service levels deteriorating rapidly because of ownership problems, are going to be very mindful of that in future leasing commitments, and they’re going to be looking for stable, well-capitalized owners.
Ingrum: Within the tenant base, I see big companies looking to lower their operating costs through hoteling,work-at-home programs, and more job sharing. The other trend that I see is outsourcing. Offshore outsourcing gets a lot of attention, but there is also domestic outsourcing. You find big companies like IBM or Boeing hiring small companies of ten or 12 employees that excel at just one thing. Because they are so good at it, they can do it less expensively. Human resources is one example. What we’ve seen since 2000 is a huge number of these service-sector tenants leasing less than 20,000 square feet [1,900 sq m] of space in office buildings. They’re going to be using the office space that the big corporations don’t use. What should office building owners focus on to make it through the rest of the recession?
Shannon: The focus needs to be at the asset level, to maintain occupancy and to continue to provide service levels to tenants that meet their business needs. You have to continue to invest in your properties, whether that’s tenant improvements or leasing commissions or necessary capital improvements. Spend a lot of time with your tenants, talking to them about where they are in their business cycle, and make sure you’re knowledgeable about their current and future needs.
On the debt side, I think it’s about working with your lenders and very actively managing your liquidity and your capitalization. Play for duration and make sure that you’re meeting your obligations to your lenders, and that you are mindful of the future needs of the property and have a plan to provide the capital to meet those needs.
Haley: Owners need to focus on maintaining what they have—maintaining occupancy, maintaining the health of their properties, getting ahead of the issues. Talk to your tenants now. If your debt doesn’t come due for two or three years, maybe you should be talking to that lender now if you believe that debt is impaired.
There is a significant amount of equity on the sidelines from groups such as ours that are more than willing to provide fresh equity—rescue capital—to recapitalize properties. The money is not cheap and the terms are not great, but at least owners can get themselves in a position to possibly harvest some of their investment over the next three to five years.
Shannon: In the overall economy and also in the real estate world, over the period of the last ten years or so we moved away from what had been largely a relationship business, where people constructed business plans with knowledge of who they were going to be dealing with, and where business plans had contingencies built into them that recognized that these are long-term assets that are affected by capital cycles. Instead, we moved to a transactionoriented approach, with less attention paid to who your partners and your lenders were. Particularly for real estate, given the long-term nature of the assets, that’s not really a sustainable model. We’re going to move back toward a more relationship-oriented approach to how to do transactions, construct capital stacks, and build business plans for real estate assets—and that’s a good thing.
