Will Social Distancing Lower Demand for Office Space in Northeast?
The outbreak of the COVID-19 virus has led to an economic crisis that is forcing office users across the region to make tough choices to continue their operations. While New York has been the epicenter of the virus, reporting nearly a third of the more than 1 million confirmed cases in the entire country, companies across the region have been forced to furlough employees and reassess their short-term needs for space.
The nature of traditional office work was already changing before the virus, as mobile technology has allowed more flexible collaboration from home and co-working offices. Lessons learned from the virus, including the need for social distancing, will carry into whatever market conditions follow. Some companies may desire larger office spaces to allow wider distances between employees, while other may forgo physical space in favor of the mobile model.
As a result of the health crisis, office brokers are working to help their landlord and tenant clients find common ground as they tentatively move forward with leasing agreements. Northeast Real Estate Business recently caught up with three veteran brokers to gain their insights into how the virus has impacted their office markets.
Below are edited responses from Joshua Levering, senior vice president at NAI James Hanson’s New Jersey office; Ina Sargen, senior vice president at Colliers International’s Pennsylvania office; and Alan Cafiero, senior vice president of investments at Marcus & Millichap’s New Jersey office.
Northeast Real Estate Business: What concerns are you fielding from your office-owning clients right now and how are you counseling them on those issues?
Joshua Levering: Most importantly, office owners want to know when we will get back to some semblance of normalcy. They are worried about the trends of rightsizing and working from home that could accelerate after the COVID-19 crisis and have deep ripple effects on the office market. Although I don’t have a crystal ball and it is hard to give an exact answer to when this will be over, I think we will see a return to “normalcy” in the next six to 12 months.
Ina Sargen: It’s a combination of factors. There is so much uncertainty, but a lot of it is just dialogue. The biggest thing we are trying to do is stay engaged with any deal that we had in progress going into this situation. We are trying to counsel people that if they can, they should keep things moving forward because we do believe that when things open up again, there’s going to be some pent-up demand. Tenants looking for new space need to be first in line for leasing, and developers need to get into the municipalities for plan review early.
Alan Cafiero: The obvious concern is that tenants are mandated to be shut down, and so they are having trouble paying rent. But every tenant has to be approached on a case-by-case basis. In some cases, I’m seeing pure rent deferrals, whereby the tenant will pay partial rent but has to repay it over a certain period.
We are also seeing some abatement of rent in exchange for more lease term. In that case, the tenant would only be required to pay partial rent for a prescribed period of time, but in return would have to extend its lease. Some tenants on this plan are extending their leases anywhere from five to 15 years.
NREB: Do you expect any significant short-term dips in occupancy, which in turn lead to little or no rent growth? If so, when and under what conditions do you expect occupancy levels to rise again?
Levering: While I don’t expect to see any short-term dips in overall occupancy, we can see that rent growth will be flat for at least the next six months. Due to longer-term financial issues and changes in the corporate work culture, tenants will have to carefully review the intricacies of new or renewal deals over the next couple of years to make sure their spaces still work for their businesses.
Sargen: The occupancy dips could potentially come if you’re in a building that has a lot of tenant rollover. Some tenants are unable to make long-term decisions or even keep their business going. Because of the nature of the long-term leases in office space, the market is not going to be as prone to those big drops.
Philadelphia’s office market was fundamentally strong going into this situation. The central business district had just under 90 percent occupancy and the suburbs were about 85 percent occupancy overall. Everybody was seeing rent growth, so it wasn’t as if things were starting to turn down. It’s like a car that was moving down the highway really well but suddenly hit a wall. The car can be repaired, but it might take a while to get back the confidence to drive again.
Cafiero: Some tenants will go out of business. If they were teetering before, this could be the knockout punch. But New Jersey is a funny place — almost every town has a different story. Markets like Parsippany and Piscataway will probably take a while to bounce back, but Jersey City might be in a better position.
NREB: To what extent do you expect the COVID-19 virus to upend or delay the closing of larger office leases, move-ins and relocations that have been announced in your market?
Levering: Since most of the larger office leases that were in progress prior to COVID-19 outbreak were quite complex, multi-year processes, they will continue to progress during this short-term disruption. The recent shutdown of non-essential construction in New Jersey will inevitably cause slowdowns for tenants in the midst of buildouts, but much of that will be short-term in nature and should not stop these types of deals from advancing.
Sargen: The bigger deals involve companies that are better prepared to weather a downturn. Some of it is a domino effect. Let’s say you are a large tenant and there’s a building under construction that you were going to move into. If that construction is halted, your move-in will be halted and you’ll have to consult with your current landlord about an extension or another plan. In moving past this, the larger companies are trying to make the right strategic decisions. Small businesses are more of an issue, and those deals might have more fluctuation.
Cafiero: For some leases, it’ll just be a delay. Most everyone is forced to work from home now, and some companies might realize they don’t need as large of a space. Some tenants might downsize by several thousand square feet and just have some of their people continue to work remotely. But most people I have spoken with can’t wait to get back to the office.
NREB: In what ways was the office sector strong before the outbreak of the virus, and what lessons can the sector take away from this virus that will make it stronger in the future?
Levering: Throughout our market, the redevelopment of functionally obsolete office space and buildings was humming along before COVID-19. With the emphasis on quality following COVID-19 that I am expecting, it will be even more difficult to lease the poorer quality office product in the market.
However, with an increasing emphasis on working from home, I can see companies looking to decentralize their office space allotments similar to the hub-and-spoke model we have seen with the industrial market. Instead of one large headquarters
office in Manhattan, companies could look to spread smaller, regional offices closer to their employees to increase employee retention.
Sargen: Things were chugging along well in Philadelphia and nationally. But the thing about Philadelphia is we have never been a market like San Francisco that is just on fire with skyrocketing rents and big demand from tech companies. We don’t have those peaks, but we also don’t have those valleys. It’s a diversified market, so that bodes well for us coming out of this. Occupancy and rental rates were strong going into this [pandemic].
One thing we talk about with owners is whether companies will realize that they need less space after this event. Is this like a successful, but unintended experiment, where some companies might actually want their employees to work from home more often? Maybe, but I also think workers will miss the collaborative environment of the office and having people around them. There had been a trend of more density per square foot [prior to this pandemic]. Now, attempting to avoid the future spread or return of diseases, tenants are looking at their layout and might want to increase the space between workers. So, in that sense, the demand for office space might actually increase.
Cafiero: Medical office was strong before the COVID-19 outbreak. Those properties tend to have low vacancy and low turnover, especially if located near a hospital. On the general office front in New Jersey, there were very few low-vacancy markets [before the pandemic hit.] It might take a while to get back to where it was, but ultimately, I think office will remain strong, especially on the medical side.