Green Street



Headwinds in Office Real Estate: A Sector in Transition

A transformation is underway in the office sector. Danny Ismail, lead analyst for Green Street’s office sector research, explains how two trends – densification and rising capital expenditures – are underestimated by market participants. The net effect is a tempered outlook for returns in the sector. Danny also interviews Lisa Picard, CEO and President of EQ Office, a Blackstone portfolio company that is mapping a strategy to take advantage of the changes underway.

Densification: A Huge Secular Change

For the office sector, one of the biggest headwinds for operating fundamentals this cycle has been densification, or increased utilization of office space. The new normal is closer working quarters. This means a company that signed a lease in 2010 now likely uses 15-20% fewer square feet by packing employees into a smaller space. Densification can be considered a type of shadow inventory that is having an outsized impact on fundamentals in most major office markets.

In New York City, WeWork is now the largest office tenant. WeWork tends to operate more densely than traditional office companies. While New York has experienced elevated supply growth relative to recent history, it is the shadow supply from densification and office reconfiguration that is having a bigger impact. As a result, New York reported flat net rent growth over the last year, and likely will not see healthy net rent growth over the next few years as job growth gets offset by tenants taking less space.

The bottom line is that densification creates a meaningful drag on office fundamentals that isn’t visible in traditional inventory growth statistics – and that means it can be overlooked by commercial real estate executives. In effect, markets need more employment growth to compensate for the increased utilization.

Rising Costs of Capital Expenditures

One of Green Street’s core beliefs is that both the public and private market underestimate the true cost of owning commercial real estate for a full cycle. In the office business, the trends toward densification, open office configurations, and flex-office arrangements require sizable investment. At the same time, construction costs are rising. As a result, capital expenditures (cap-ex) for the office sector is on the rise.


Green Street divides cap-ex into two categories: leasing costs and maintenance costs. Leasing costs are incurred whenever tenants move or renew their leases. Owners need to clear out the spaces and reconfigure them for new tenants or provide capital for renewing tenants to refresh their existing space. Maintenance costs are expenses required of owners just to maintain buildings and keep them competitive.

One would assume that re-tenanting costs or tenant concessions, which reflect tenant pricing power, would decline in a healthy economy with fairly low unemployment. In reality, the opposite has been true. Costs to re-tenant have been higher over the past few years than they were at the beginning of the cycle. Pricing power continues to favor tenants, and that trend does not appear to be reversing any time soon.

Green Street has analyzed actual capital expenditures made by private and public companies over the past 30 years. The data show that office real estate has by far the most onerous capital expenditure needs of all sectors – even more than hotels. Green Street estimates that office owners need to reserve as much as one-third of their net operating income in capital expenditures to get close to market-like returns.

Weak Outlook for Office Sector Returns

Low nominal cap rates, high and increasing amounts of cap-ex, and low expected fundamental growth together paint an anemic picture for future office returns overall. Relative to other property sectors, Green Street expects weak returns for the office sector in the coming years. This outlook is in spite of a reasonably healthy U.S. economy as measured by unemployment, consumption, the fiscal and tax stimulus, job growth, and venture capital investment.

REIT investors seem especially negative about New York as office REITs investing there have been trading at some of the highest discounts to their underlying asset values since the Great Recession. Essentially, REIT investors are saying commercial real estate values are too high. Historically, REIT investors have gotten this right. Large premiums in the public markets have generally been predictive of property appreciation in the private markets, and large discounts have been predictive of property deprecation.

U.S. Office REIT Premiums/Discounts to Private Property Values*


This linkage has broken down somewhat in recent years. REIT investors have been bearish on New York for a while, but while property appreciation has slowed, values have not declined. There are still healthy bids for New York assets in the private market, with skinny cap rates and some big trades. Although the public market is saying that commercial real estate valuations are too high in New York, the private market disagrees for now. Given the amount of debt on the sidelines waiting to be put to work, Green Street does not expect values to change much in the immediate future.

West Coast and Sun Belt Markets Shine

Green Street West LA Spotlight


Green Street’s favorite markets include the West Coast gateway markets of San Francisco, West Los Angeles, and Seattle, where tech-related job growth has been a significant driver of commercial real estate returns this cycle. These West Coast markets are expected to have some of the best growth in fundamentals over the next few years. They benefit from steep barriers to new supply. In San Francisco, Proposition M places an artificial limitation on the amount of new office space that can be constructed in the city each year. West L.A. is a very difficult market in which to build new commercial properties due to terrible traffic and deeply-held nimbyism. Sun Belt markets such as Atlanta, Austin, Nashville, and Charlotte should also outperform, since they are bolstered by strong demographic trends and expansion plans on the part of major employers.

Office Real Estate Transformation and Blackstone’s EQ Office

Green Street Office Conference Call with Lisa Picard, EQ Office


Some companies are facing the monumental changes in the office sector head-on. Green Street recently interviewed Lisa Picard, CEO of EQ Office during a conference call for clients. Picard discussed how disruption and change in the office sector will remain a constant, and that office owners and operators who adapt to address tenant needs will benefit.

EQ Office is one of the nation’s largest office landlords, with close to 50 million square feet across the United States. EQ Office, formerly known as Equity Office Properties, was a public REIT prior to being purchased by Blackstone in 2007. Picard, who became CEO two years ago, described EQ Office as migrating from the mindset of a B2B business to that of a B2C customer approach with the aim to create workplaces that attract, retain, and – most importantly – inspire the talent to help businesses compete.

“Replacing talent is enormously expensive, and creating an environment that actually promotes lifestyle, promotes the culture of the organization, and fosters productive, effective work” is absolutely critical, Picard said. “The pressures placed on businesses everywhere are definitely demanding a different product.”

According to Picard, companies like WeWork, Convene, and Industrious are resonating with the marketplace because they provide a different product that solves tenant needs with shorter terms, flexible structures, and real energy in the office space. “The market sees this product as absolutely critical to business strategy,” she said.

Picard says office owners commonly pitch the efficiency of space, but tenants today are looking for value and effectiveness. Furthermore, the mobility of companies has increased, lease terms have gotten shorter, and. retention rates have dropped. To retain tenants, landlords must do more than offer new paint and carpet. Companies are realizing that they must essentially recast the space they are in to attract the next workforce. In response, real estate owners and operators need to step up their operational game and be laser focused on the customers' needs. Otherwise, those customers are going to vote with their feet when those shortened lease terms expire.

Businesses are concentrating on how they can have a more agile strategy, one that can morph and work with customer pain points. Take Amazon, for example. The company grew rapidly by creating “remarkable value focused on solving customer pain points,” Picard says. “Our industry is no different.”

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