The U.S. office market has traditionally attracted large amounts of investment capital from both institutional and private investors. This sector typically logs well in excess of $100 billion in institutional quality transactions each year.
Office is an attractive real estate asset class for a number of reasons. It has strong underlying fundamentals, a diverse base of end users that span a variety of industries, and a long track record of delivering solid returns. On average, the National Council of Real Estate Investment Fiduciaries (NCREIF) Index tells us that the average annual return for total office property (including income and appreciation) over the past 20 years is a healthy 10.3%. In addition, the office investment sector offers a spectrum of opportunities across the different investment strategies of core, core-plus, value-add and opportunistic – each of which carry inherently different risk-adjusted return scenarios that begin at single digit annualized returns on the conservative end to over 20% annualized returns on Opportunistic real estate investments are the most high risk/high reward investment opportunities, requiring major development work. Opportunistic properties tend to need significant rehabilitation or are being built from the ground up. They have the chance to reach the highest rate of return for investors, but they little to no in-place cash flow at the time of acquisition and have the... More deals. In this article, we will begin with a brief overview of the office asset class, highlight key demand drivers including the role of demographics, and conclude with a discussion on changing uses and how investors can use this information when making investment decisions.
Asset Class Overview
Office Buildings are typically defined as having at least 75% of a building’s interior space designed and finished as office space. Office buildings are usually split into two categories based on location – central business district (CBD) or suburban. The industry also “grades” properties as Class A, B or C based on criteria such as age, quality, amenities, rent and location among other factors.
CBD vs. Suburban: Throughout the U.S., office markets are generally bifurcated into two subsets a) CBD – the “Central Business District”, this is the heart of most office markets and typically possesses the largest concentration of office space and b) Suburban – lower density locations that lie outside of the urban Core commercial real estate investments are the least risky offering. They are often fully leased to quality tenets, have stabilized returns and require little to no major renovations. These properties are often in highly desirable locations in major markets and have long term leases in place with high credit tenants. These buildings are well-kept and require little to no improvements... More. Some of the differences to consider when comparing urban versus suburban properties are parking and transit. Urban properties rely more heavily on access to mass transit, while suburban properties require higher parking ratios.
Traditional vs Creative: Traditional office buildings have been the norm in the office world for decades. There is a new and growing segment of the office market that focuses on “creative” space. This sector started gaining a foothold back in the 1980s as older warehouse buildings were repurposed as “trendy” office space with interior design that highlights original brick walls, floors and open ceilings that showed exposed beams and ductwork. It was a favorite among the creative set such as ad agencies and new tech start-ups. The distinction of traditional vs. creative space is intertwined with demographics that are leading to changes in office use; a topic we discuss in greater detail below.
It is valuable for office investors to understand the demand drivers that influence occupancies, rental rate growth and new construction. The single largest driver of demand in the office sector is jobs. Traditionally, there has been strong correlation between employment growth and positive absorption of office space. The office sector typically thrives when the economy is growing and companies are expanding, as firms seek more space to accommodate the addition of new workers. Likewise, the office market struggles during periods of flat or declining job growth. In both expanding and contracting markets, the office sector is sensitive to the elastic demand of business and professional services, such as finance, insurance and real estate “FIRE” users as well as information technology employment. Those types of users have appetites for office space that can change rapidly depending on the success or demise of their business models.
There are a wide variety of companies and industries that occupy office space, and those users have vastly different criteria when it comes to choosing space to lease that best fits their needs. For some users, it is all about finding the best location that is close to customers and employees. Other companies are highly sensitive to cost and need to solve to a budget. Others still may prioritize privacy and seek isolated locations with secured access. User requirements can also include a variety of other considerations such as building services and amenities, adequate parking, state-of-the art technology, building infrastructure and the impact of the location on a company’s brand identity and image. The key point is that office buildings come in all shapes and sizes. This creates demand for different types of properties and thus different investment opportunities.
While some demand drivers such as job growth are difficult to project, demographics are absolute facts. Studying how demographics affect office demand can enable investors to draw asset-based conclusions. Millenials provide an interesting case study in this regard. This demographic will soon represent the largest segment of the workforce. Not surprisingly, their preferences are influencing office location decisions, which has landlords scrambling to better understand them. As a result, modern offices are beginning to look more like professional living rooms rather than the cube farms of decades past.
In addition to a “cool environment” millennials desire a host of on-site or nearby amenities including bike parking, locker rooms and coffee bars as well as other factors such as “green” or energy efficient buildings. If you want to see this vision in action, simply take a tour of the nearest We Work location. This company is evangelical in touting the merits of the modern workplace. Their lobbies feel less like an office building and more like that of a hip hotel. While We Work’s vision may represent one end of the office continuum that is, perhaps, too forward-looking for certain users, companies are increasingly taking cues from this model to seek out amenity rich locations in order to compete for this burgeoning generation of talent.
Changes in Office Use
With a basic grasp of how demographics factor into shifts in office design and use, it becomes easier to contemplate the alternative workplace strategies that are changing how and where people choose to work. While the mass adoption of mobile technologies has certain pundits calling for the end of office space as we know it, a more pragmatic perspective suggests that the way office space is used is changing but that it is still in demand. Working from home or the local coffee shop is not effective for every individual or every business, as the vast majority of workers still need and desire go to an office either part or full-time to do work, collaborate with colleagues and meet with clients. Therefore, demand for office space is not disappearing but evolving.
When considering this evolution, it is important to first consider the factors that affect where companies choose to locate their office. In years past, companies took a car centric approach to office requirements, which translated into demand for suburban business parks with large parking ratios and onsite amenities such as cafeterias. Now, companies increasingly want to be located in vibrant communities surrounded by compelling offsite amenities.
As companies look to answer the question of vibrancy, urbanization trends are influencing location decisions. There is more and more research to support the argument that urban centers are a magnet for commercial and residential development. Those urban hubs often feature a density of different types of real estate uses, including office, residential, retail, restaurants and entertainment. They are highly walkable, as well as linked to mass transit such as high speed bus, subway or light rail systems. All of these aspects provide a compelling argument for why a company should select it for their office location.
But, what may be surprising, is that these urban hubs are not just confined to traditional downtowns, they also are popping up in traditional suburban settings as cities adapt to changing societal demands. We are now seeing the rise of the “Walkable Suburban Village” particularly as certain metros become overly constrained by congestion. In either an urban or suburban location, the common denominator when selecting an office space is that it helps companies to attract and retain talent.
Another consideration in use changes is that certain trends have staying power, while others may be short lived. For example, “open grid” office spaces that features exposed ceilings as part of the décor have been all the rage in the past few years, which sent landlords scrambling to remove ceiling grids and deliver exposed ceiling buildouts to win deals. However, as open grid users have now lived in these environments for a few years now, some are struggling with untenable acoustics, which has led to them to turning away from this design.
CrowdStreet itself is a case study in this phenomenon. Our previous office had an open ceiling complete with exposed ductwork. Initially we were wowed by the creative look but, as our team grew, the acoustics proved overly distracting. When moving to our new location in June, we sought an office environment with an open and collaborative floor plan but one that also offered both carpet and a ceiling grid to help us manage the acoustics. Now a month into our new space, we are highly appreciative of our ceiling grid. While the jury is still out, the staying power of the open ceiling is at least now in question, which argues in favor of maintaining flexibility in the format of an office and not betting the ranch on any single trend.
As investors synthesize asset classes, markets and use types to formulate investment decisions, it is worth keeping in mind that these are the myriad factors that roll up to the overriding consideration, which is relevancy. No matter the type or location of any office asset, the bottom line is that it must be relevant today and maintain its relevancy over the course of the holding period. Understanding classifications, market subtypes, demographics and office uses are all intended to equip you with the knowledge to answer that question. Investors will find a variety of office property offerings, both urban and suburban, on the CrowdStreet Marketplace.
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