By Taylor Williams
Office owners have spent the last two-plus years undertaking every creative measure they can fathom — and afford — to get tenants and their employees to legitimately want to come back to their buildings. From investing in upgrades to physical amenities to hiring hospitality-minded professionals for property activation to offering personalized incentives, nothing has been out of bounds when it comes to recouping occupancy.
Enough time has now passed such that owners can judge the extent to which their ideas and initiatives have worked. Of course, the goalposts for what defines success in the office sector have shifted radically during that time. Profit margins and forecasts have shrunk as 60 to 70 percent occupancy three to four days a week now starts to look pretty good, all other factors being held equal. It’s simply a different world.
“We are never going back to pre-pandemic ways,” says Ami Figg, senior leasing specialist at Houston-based Hartman. “What COVID-19 has done for the office market is equivalent to what September 11 did for the travel industry. There will always be a need for traditional office space, but it’s changed forever, so it’s upon us as landlord and tenant reps to educate and provide clients with what the new market is generating and demanding.”
In Figg’s view, another major way in which the market has shifted involves an emphasis on steady occupancy over optimized cash flow.
“We never want to lose a tenant over rates and have an empty space for six months, which is why it’s important to get in on the front end with tenants and develop relationships, understand their concerns and figure out how we can address them,” she explains. “We’d rather reduce the rate and increase occupancy than keep rates unattainably high just to appease investors, and investors tend to support those decisions.”
Thinking Differently
After 24 months and change, the trappings of the new practices that define leasing and occupying office buildings are on full display. The shifts in tenant behavior — flights to high-quality buildings, sporadic onsite work schedules — are plainly visible to any office building visitor and have been extensively documented in the mainstream media.
On the landlord side, many owners are displaying newfound flexibility as they come to grips with new realities, primarily that aggregate demand for office space will likely never return to pre-pandemic levels.
“Whether it’s a new deal or a renewal, we see landlords getting more competitive on all lease terms than they did a few years ago, simply because there are fewer deals out there,” says Robbie Baty, who serves as the office tenant representation leader in Cushman & Wakefield’s Dallas office. “Whether it’s discounted rent, more tenant improvement (TI) dollars, added termination options or additional parking, landlords are going to reach further for tenants rather than hold out for companies that can pay more like they did in the past.”
Last fall, Baty’s team represented staffing and recruitment agency Phaidon International in its lease of 26,687 square feet at The Centrum in the Oak Lawn area of Dallas, which is known for its abundance of shops, restaurants and entertainment outlets. In addition to those features, the Class A building offers expansive ceiling heights that maximize the flow of natural light into workspaces, another means of boosting tenant morale while onsite. All of these factors played into Phaidon’s site selection decision.
Armed with a mindset that reflects flexibility and new ways of thinking, many owners and their broker representatives are finding that being able to showcase buildings that exude vibrancy is key to leasing efforts.
Much like prospective college students want to see happy, energetic people and atmospheres during their campus visits, so too do tenants on tours of office buildings.
Utilizing the activity of in-place tenants to attract new users is not necessarily a novel strategy that is completely traceable to COVID-19. It’s merely a tactic whose efficacy has been enhanced by the new office environment. Regardless of whether people come into the office voluntarily or against their will, sources say that drab, isolated office buildings that are devoid of human activity and buzz will make people feel dispirited.
“Zombie buildings just don’t perform well on leasing tours,” says Tyler Garrett, executive managing director at JLL’s Houston office. “When tenants walk into a lobby and it’s quiet and empty, it’s just not a great thing. Tenant reps are also going to be hesitant to put a decent-size user in a building that’s sparsely occupied. So buildings that do have a lot of employees who are back in the office full-time are easier to sell on leasing tours versus those that are quiet.”
JLL recently secured a 22,000-square-foot office lease renewal in Houston’s Memorial City district, which boasts strong retail/restaurant and multifamily components. These uses generate foot traffic independently of the office component, which contributes to the general sense of hustle and bustle throughout the development.
Some tenants, however, still take an old-school approach to office site selection and assess many of the traditional draws.
Beyond time-tested attributes like access to public transportation and walkability to surrounding retail, restaurant and entertainment options, there’s still value in making certain aspects of the buildings sparkle and pop.
“When it comes to leveraging existing occupancy to attract new tenants, it’s something of a chicken-or-the-egg question,” notes Lucas Patterson, executive vice president of operations at Bright Realty, an office developer based in metro Dallas. “You have to have occupancy in order to demonstrate the vibrancy of a building, but it’s equally important to be able to show the qualities that make a building well-run — lighting, parking, access, cleanliness.”
“All of those features breed comfort and activity among tenants and visitors,” Patterson continues. “And that’s very important in today’s environment, because if you’re asking people to come into the office, you don’t want the experience of the building itself to be a factor in why people don’t want to work there.”
Most traditional office-using companies whose employees need little more than an internet connection to do their jobs are giving those people options on how often they come into work. Some hybrid work routines are more stringent than others, and the notion that a full-blown recession could trigger stronger returns to buildings as employees lose leverage remains a well-subscribed belief.
“Flight to quality is still there, especially for the large corporate users in tech, finance and legal as they compete for talent,” says Ryan McManigal, founding partner at Dallas-based investment firm OliveMill Holdings. “Some of those companies are right-sizing their head counts. Companies are still looking for best-in-class office space to help build culture and increase productivity. Meanwhile, some employees are coming back to the office to make sure their bosses have seen them and that they aren’t on the chopping block.”
OliveMill Holdings is currently underway on a multimillion-dollar capital improvement program at 2801 North Central Expressway, a 240,000-square-foot building that formerly served as the headquarters for marketing agency The Richards Group. OliveMill Holdings, which will rebrand the building as One West Village, sees the building’s location along a major artery and proximity to other existing uses as factors that can be leveraged.
“As we’re trying to lease the building up, we can work in the flexible growth needs of certain tenants,” says McManigal. “Some groups are experimenting with flexible leases as they take newer, nicer spaces, but they also want fairly robust TI packages, and those are often competing forces. If we had an asset with some tenancy in place, we’d be doing spec suites to allow tenants to move in quickly and maybe do shorter-term leases.”
Financial Complications
Of course, just as it has done to all financial strategies across the spectrum of commercial real estate, the Federal Reserve’s aggressive spate of interest rate hikes in its bid to curtail inflation has complicated things.
When short-term rates rise by more than 450 basis points in less than a year and owners have loans nearing maturity or coming up for refinancing, the decision to consciously trade occupancy for top-tier rents becomes a more difficult sell.
Or so you would think. Sources say that despite now playing under vastly different financial circumstances, many owners are sticking to the new operating philosophy.
“At least for now, runups in rates aren’t precluding landlords from doing deals at discounted rents just because they’ve now got higher interest payments” says Figg. “Instead, they’re looking for creative solutions like offering caps on controllable expenses. This is especially true for larger tenants that would likely take more of a hit from noncontrollable expenses like interest rates in subsequent years of their lease term.”
This trend is owed mostly to the fact that the overall supply of available office space exceeds demand, and expectations for rent growth can only realistically be taken so far. Against that backdrop, it’s better to keep the cash flowing than to sit on your hands and wait for deals that may never materialize.
Yet there are exceptions to the rule, mainly because no two owners’ financial situations are identical.
“The extent of the impacts of interest rate hikes depends on the landlord’s goal,” says Garrett. “Landlords that want to do a value-add deal at a low basis today then exit in five or seven years are going to try to push face rates. If they’re in the middle of a long-term hold, landlords will prefer to strike deals at lower rates with less concessions due to the cost of that capital.”
Beyond the scope of individual deals, office owners and brokers are also assessing interest rate impacts in terms of greater supply and demand.
“Buildings that are already under construction will be completed, but there will be a significant lag in new construction, which really began last year,” says Baty. “If it’s not under construction and hasn’t been for six or nine months, it may not get built, so you’ll likely see a gap of two to three years in which there’s not much new office construction, with the exception of single-tenant build-to-suit projects.”
Rate hikes are hardly the only source of financial drama. According to data from New York City-based data analytics firm Trepp, there is $79 billion in commercial loans backed by office properties that are coming due in 2023 — about 30 percent of the total volume of commercial debt that fits that description. This figure represents the highest amount among the major commercial food groups, with multifamily coming in second at $64.2 billion in loans maturing this year.
Those loans are maturing at a time in which the underlying faith in the U.S. banking system as a whole is being sorely tested following the collapses of major institutions like Silicon Valley Bank and Signature Bank.
Sources say that while it’s still too early to apply definitive conclusions from those events to the office market as a whole. Yet the undeniable fact remains that the sector is hardly a favorite among commercial lenders right now.
This article originally appeared in the April 2023 issue of Texas Real Estate Business magazine.