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Goodbye Offices? How Remote Working May Impact Commercial Real Estate

By Josh Barber, CFA
May 2020

The COVID-19 pandemic has forced rapid change for businesses and employees alike, including how and where people work. Historically, some companies allowed office-based employees to occasionally work from home; however, overall most people went to the office—often because of office culture and/or because technology was more readily available in the office. Recently, urbanization has increased and mixed-use projects emphasizing live-work-play elements have become popular, while large companies have made sizeable investments in office amenities to attract and retain workers.

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The views expressed are those of Diamond Hill as of June 2020 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice.

As of May 31, 2020, Diamond Hill owned Facebook, Inc. – Class A (equity). As of March 31, 2020 Diamond Hill owned Twitter, Inc. (debt).

However, the pandemic disruption has resulted in an unanticipated experiment in working from home, and many have speculated that working remotely could become the new normal. What started as short-term shift to remote working could have lasting ramifications on office buildings and the broader real estate industry.

Many things that currently seem daunting—mass transit, eating at a restaurant, going to concerts or sporting events—were utterly normal just a few months ago. It’s worth remembering that many believed people would avoid traveling, highrise office buildings and flying after September 11, yet these industries continued to grow—until the recent pandemic. Assuming straight-line trends will continue uninterrupted is often a mistake, so it’s worth taking the current remote working trend with a grain of salt. However, during the recent earnings season, companies across industries noted the surprisingly smooth transition to working remotely. Companies as diverse as Morgan Stanley and Twitter have said they envision needing less office space while allowing employees to work from home in the future.

What Does a Return to the Office Look Like?

To initially accommodate social distancing, many offices will likely need to be redesigned, creating more space for each employee, as well as larger meeting spaces and common areas, leasing roughly the same square footage for fewer employees. We believe this scenario is more likely for large companies, which will probably maintain a headquarters for a smaller number of employees than pre-COVID for client meetings and occasional gatherings of remote employees. Depending on the business model, many smaller companies may even be able to contemplate whether they need to continue leasing any office space at all. That choice may be more complex as smaller companies may operate out of only one location—meaning they would not have any office space for employee or client meetings. They could opt for less square footage, leasing an office that is more convenient location-wise for their employees.

As people return to offices, albeit in smaller numbers, landlords may have to update buildings as well. Contactless doors and elevators and better ventilation systems will likely be needed, and social distancing will need to be enforced in lobbies and elevators. If these changes can be accommodated, it will increase the appeal of updated buildings but will likely hurt older, more obsolete assets.

From a financial standpoint, office space tends to not be a major expense item relative to salaries—even for large companies—so shifting to remote working may not result in substantial cost savings. In the near term, it seems likely that companies will look to cut costs by reducing office space or be less inclined to lease new space, even when adjusting for the extra square footage needed per worker to initially enable social distancing.

Looking forward, ongoing lockdowns and strict social distancing for one to two years would create a very difficult investment environment for real estate, particularly in markets with high vacancy rates and easy new supply.

Changing Space

Some have speculated that a decline in leased office space could mimic the decline of brick-and-mortar retail, leading to lots of empty buildings and severe losses—we disagree. Retail spaces, particularly malls, are very difficult to repurpose. Typically, they need to be demolished or drastically redone to create new space, such as a community of single-family homes, offices or a new, but smaller, retail concept—meaning that the costs to repurpose these spaces are very high.

In contrast, offices can often be repurposed into apartments without enormous expense, as they tend to be well-located and have good windows, elevators, high ceilings, internet connectivity and bathrooms/HVAC systems in place. Some capital is needed to pay for the conversion, which can result in lower or flat net operating income even after the conversion, so the property yield would be lower, but not drastically so in our view. In addition, repurposing excess office space for residential use could have added benefits, helping to alleviate the housing shortage in many cities and improving pricing for the remaining office properties.

If the pandemic accelerates the decline of brick-and mortar retail, owners will likely be forced to sell off space cheaply, freeing up space in many markets that can be used for additional housing, especially affordable housing in supply-constrained markets. This would certainly attract people and help large coastal markets, which have seen rising residential rents and home prices, making the cost of living quite expensive. The new supply would probably hurt rents in the short term—but in the long term, the attraction of more affordable housing should attract more people and increase property revenues overall in those markets.

Still, REITs across most property sectors remain concentrated in the U.S.’s largest markets. If people decide to avoid very dense cities that are reliant on public transit, such as NYC, Boston and San Francisco, the shift away from large U.S. cities into smaller ones with more space and less density would create a major disruption for the property sector.

What’s Next?

The COVID-19 pandemic has raised questions about many facets of real estate. A good balance sheet is of paramount importance during any downturn, and we believe our real estate holdings have low leverage and sufficient liquidity to not only make it through the downturn but be able to grow as the economy recovers. Our office holdings own properties in dense submarkets with very little new supply where, in a worstcase scenario, some buildings can be converted into apartments or operate in markets that are dominated by government and contractor tenants or extremely large companies, such as Amazon. Our apartment holdings are concentrated in the lower-tax Sunbelt markets or have a good mix of urban and suburban apartments in the supply-constrained West Coast markets. Still, we recognize that rare events like a global pandemic are likely to have lasting consequences, and we will be closely following new trends as they emerge.

As of 2/29/20, Diamond Hill owned Morgan Stanley (debt). As of 3/31/20, Diamond Hill owned Twitter, Inc. (debt). As of 4/30/20, Diamond Hill owned Morgan Stanley (equity).

Originally published on May 29, 2020.

The views expressed are those of the research analyst as of May 2020, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.

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