By Robert Meulmeester
Has the dust finally settled after one of the deepest recessions in the U.S.? It seems so, as certain investors appear to believe that economic growth and disposable income will be as abundant as ever, considering that certain core office investments realized sub-5% capitalization rates.
In fact, U.S. office landlords had the first net increase in occupied space in three years in the fourth quarter of 2010, according to Reis Inc., a New York-based property-research firm.
Are we indeed back on track, and will an investment in office result in an appropriate risk-adjusted return? What can be expected in terms of future rents and values? Key observations are that the U.S. office vacancy rate was unchanged from the third quarter of 2010 at 17.6%, remaining at the highest level since 1993, as supply also increased, and during the last three years, companies have given up approximately 137.8 million s/f nationwide.
One should not forget certain basic principles. Generally, rent and value has been and will always be a function of primarily demand and supply, driven by employment, and cost of capital, driven by cost and availability of debt and equity.
Therefore, continued downward pressure on value is not unlikely, as employment growth remains sluggish and cost of capital may increase due to anticipated rising interest rates and continued constraints in availability of capital.
Notably, the drivers are not necessarily just job growth or cost of capital. It is also about how workplaces are organized. And during the last few decades, this has resulted in significantly reduced space needs on a per employee basis.
In the 1970s, American corporations typically thought they needed 500 s/f to 700 s/f per employee to build an effective office. Today’s average is a little more than 200 s/f per person, and the space allocation could hit a mere 50 s/f by 2015, according to Peter Miscovich, managing director at Jones Lang LaSalle. Office tenants who renew their leases these days often cut their space total by 10% to 30%.
The last recession accelerated the trend to reduce space due to layoffs. In addition, the future work space, typically referred to as the “New World of Work,” is designed as a flexible, highly efficient and productive way of working with an emphasis on collaborating with co-workers, partners, customers and other stake holders. Information technology is the key enabler because it makes it possible for people to work from anywhere, at any time, with anybody.
This trend aligns with a generational shift as Generation Y is entering the work force. Generation Y is the demographic cohort born between the mid-1970s to the early 2000s and is now the largest demographic group in the U.S. As generation Y has grown up with authority on the internet, social media and new forms of (online) collaboration, they embrace the “New World of Work,” through the hierarchical formality of traditional offices.
Moreover, the “New World of Work” appears to be a worldwide phenomenon with profound effects. For instance, in the Netherlands, this new work-life style may result in an additional 25 to 30% office space reduction. as reported by Martijn Van Leeuwen in Vastgoedmarkt, a Dutch property magazine. The current office vacancy rate in the Netherlands is approximately 14% and may increase to 24% by 2013 should all major office users decide to adopt such a new work-life style.
Similar to the U.S., major space rationalizations have already occurred as illustrated by the fact that work space per employee decreased to approximately 213 s/f in 2010 from 286 s/f in 2002, and may further decrease to 166 s/f within the next three years.
Interestingly, adopters are not only consultancy and technology companies, but also, the traditionally conservative banking sector.
As the recession has changed the demand for office space dramatically, the “New World of Work” change of office work-life style will certainly have a profound impact affecting rent and value going forward. This will create challenges and opportunities at the same time.
Although less space per employee will be required, a greater emphasis will be on location and the design of such new work space. Investors should prepare for such new demand requirements, and realize that it is not unlikely that certain offices may become completely redundant and will require a very different use.
Robert Meulmeester, MRICS, is partner of Cadence Capital Group, LLC.