Vice-President, Chief Economist and Strategist
Slow-Motion Office Wreck?
As we look back on the wild year that was 2022, office workers returning to in-person work (mostly in a hybrid format) marks a key milestone in the transition to a post-pandemic world. Days in the office might feel a lot like the old normal, but the fact that many of us are in only a few days a week means that this is still very much a new normal. Research on working arrangements in the US suggests the share of paid full days worked from home has settled around the 30% mark in 2022. That is about half of where it was in the spring of 2020 but well above the estimated 5% pre-pandemic.
This means that the situation is far from settled for the commercial real estate market, and by extension, for the stock of capital that corporate offices represent. Nothing surprising given commercial real estate’s reputation for being a “long game,” with leases lasting a decade not being uncommon in the industry. In principle, this gives most corporations some time to assess what the hybrid world entails for their office space needs. That said, cost pressures from inflation, wages and interest rates are leading some companies to look at redundancies, and one obvious solution jumps at executives any time they roam those deserted offices floors.
Since 2000, the availability rate for offices has never been as high at the national level. Calgary, Edmonton and Montreal had the highest availability rates as of the third quarter. Across North America, the tech sector is among those that have been reducing office use most aggressively. The sector has been more prone to adopt full-time telework arrangements—notably recent startups pulling together talent spread out globally—but has also seen layoffs this year. In a recession scenario where more sectors experience layoffs, we may see further pressure on office space availability, especially as some of those leases will gradually be up for renewal.
From the lens of an economist, it raises a number of issues. Effectively, the pandemic and its lockdowns have ushered in another case of technological disruption. True, the ability to remote work has existed for well over two decades. In some sectors like business consulting, hybrid work was common well before the pandemic hit. With some significant investment in connectivity capacity during the initial lockdowns, businesses were able to broaden this capability across their office workers in a matter of weeks.
But as with any case of technological disruption, old capital is made obsolete and loses its value. One example is how ride-share services have upended the traditional taxi industry across the world. In New York City, the value of a taxi medallion—the certificate required to operate a yellow cab—went from above US$1M in 2014 to just over US$100K this year, leaving many drivers mired in debt. In the case of offices, some significant square footage is now unnecessary in a paradigm where people show up only part of the week. A survey by Colliers suggests that 60% of businesses will require between 50% and 70% of their current office space within three years.
Just like honking yellow cabs continue to roam the streets of New York, the emptied physical space will not be going anywhere soon. However, compared to yellow cab medallions, the question of how much those assets will be worth is more complicated. Office real estate is segmented into classes depending on their quality. Currently, demand for Class A (e.g., newer offices, well-ventilated, equipped with modern amenities and optimized for collaborative work) remains strong across markets. The more dated Class C buildings in less desirable locations are the ones that may experience increased vacancies as well as downward pressures on rent and property values. The markdowns could be significant. Recent empirical research for New York suggests that offices may end up losing 39% of their pre-pandemic value on a permanent basis.
Some are even speculating that office space might turn out to be a stranded asset. This seems rather pessimistic, as owners will be looking into adaptive reuse of the space to mitigate the blow. This process has happened time and again in the history of most cities’ industrial neighbourhoods, although it can span over many decades. In the current context, the repurposing of abandoned offices invariably brings up housing, given its short supply. If somehow the excess stock of office space could be converted into housing, it would be a win-win. As Canada is looking to step up the pace of immigration to soon reach 500k per year, there’s little doubt that all ideas to unlock desperately needed housing supply must be considered. And repurposing idle offices into housing would bring the added benefit of limiting urban sprawl and reducing carbon emissions.
Unfortunately, these common sense arguments bump into the complexities of office real estate. First, these structures have been designed and configured for the specific needs of corporate offices, not residential units. The location of elevators, plumbing architecture, heating and cooling fixtures, exposure to natural light, balconies—these are just a few of the amenities that are designed differently in a residential building. Second, and especially in the case of older office buildings, they may also need deeper retrofits to adhere to modern norms pertaining to ventilation, energy efficiency or fire safety, entailing significant costs. Third, it may be that such conversions require specialized expertise within the construction industry, and it’s safe to assume that this expertise is in short supply currently.
Given the costs (including those of materials and labour) and the risks, new residential units sold in freshly converted office buildings would need to be able to fetch a high enough price to make conversions a profitable endeavour. It’s not unreasonable to expect that only the most affluent might be able to afford the minimum asking price (or the rent) on these units. That would hardly improve housing affordability for middle- and low-income households. If the goal is to specifically convert offices into affordable housing, it might not be attainable absent significant government involvement.
Even if the converted units were affordable, there is the question of whether central business districts are attractive for typical households. This means making sure they are equipped with schools, daycares, hospitals, public facilities and retail spaces. These public investments would be needed precisely when the depreciation of properties is likely to put pressure on municipalities’ tax receipts, meaning that federal and provincial involvement would be heavily solicited.
Bottom line: We are back in the office, but office real estate will no longer be the same. This has major impacts. The investors who have piled into the asset class when interest rates were low know that very well. And it might get worse before it gets better.
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