December 30, 2021
As companies have begun to reevaluate their longer-term space needs, headlines have focused on those that have abandoned their office expansion projects or slashed their space needs. That’s led to speculation by some that “the office is dead.”
Our research suggests that the office is not going away, it’s evolving—with many companies choosing to shift to some form of a hybrid work schedule for at least part of their workforce.
Whatever happens, there will be implications for investors. “The return to work that is underway is likely to result in a new office normal that will vary regionally and by industry sector,” said Vanguard senior credit analyst Mark Lahoda. “Newer, trophy-quality and Class A properties with modern amenities are likely to fare better than older, Class B and C properties in need of renovation—you want an attractive workplace where people feel safe and want to come back to. When evaluating potential investments, underwriting assumptions and required risk premiums need to be adjusted to reflect these differences.”
A hybrid work model may not dramatically reduce demand for office space, and it could even increase it. A survey conducted by real estate services firm CBRE in April 2021 showed that only 9% of companies anticipated making a significant decrease in office space. Pre-pandemic building usage helps explain that low percentage; office buildings were rarely 100% occupied on any given day—60% was generally the norm. Social distancing may also lead companies to reverse the trend in space usage per employee, which had fallen significantly in recent decades—from about 200 square feet per employee in the 1980s and 1990s to 125 square feet today, according to the July 9, 2020, Moody’s report The Future of Office Will Be an Odyssey Not Exodus, With Uneven Credit Implications. Companies’ need for flexible space for collaboration and in-person meetings should also support the demand for office space.
We have modeled our outlook for office property values in primary markets using baseline, downside, and upside scenarios, as shown in the figure below. In our baseline scenario, property values would decrease modestly, by 3%, while under our downside scenario, property values would fall by 12%. In our upside scenario, property values would increase by 10% by 2024.
Notes: The primary markets include the top 30 U.S. metro areas by population. Projections are as of December 16, 2021.
Overall, we are constructive on commercial mortgage-backed securities (CMBS) fundamentals as the economy continues to reopen. Also, single-asset single-borrower (SASB) CMBS deals allow for more targeted exposure to specific sectors, including the office sector, which at times can offer attractive relative value opportunities to conduit CMBS.
Office REITs also have advantages to offer investors in the current environment. They tend to hold higher-end property portfolios (Class A buildings) and have a diversified tenant base. Many office REITs are involved in property development, which allows them to be more responsive to changes in demand. During the pandemic, several office REITs have increased their focus on the life sciences office sector, which experienced a rapid increase in demand for lab space because of expanding research efforts to combat COVID-19.
“Investing in office space may be more complex than in the past,” said Vanguard senior credit analyst Erick Miller. “This should give active managers with deep fundamental analysis capabilities more opportunities for outperformance.”
This is an abridged version of research published recently by Vanguard Fixed Income Group.
* Includes funds advised by Wellington Management Company LLP.
Note: Data are as of September 30, 2021.
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