Level Setting the ‘Flight to Quality’
Reasonable. With landlords willing to wheel and deal, sign short-term leases and offer all kinds of incentives, businesses could realize opportunities to be in quality office spaces much more easily than in the past.
In a recent research report from Cushman & Wakefield, the firm cited an “unprecedented imbalance of supply and demand,” and said some 330 million square feet of commercial office space would be vacant by the end of the decade.
As one might expect, the statement has caused quite the hullabaloo in the market and several publications have directly referenced the report, which was bolder on the future of office than most of the other major brokerage houses.
Truth be told, flight to quality is simply a misleading phrase. There is just too much quality commercial office space for all of it to see a full and speedy rebound. The Cushman & Wakefield report breaks the market down into three buckets, with only 15% of the office product in the market projected to garner a significant premium over the rest.
Oxford Economics’ Cities and Regions Senior Economist Barbara Denham works in New York, thus far the epicenter of the return-to-office story. In her lower Manhattan office, she told Allison+Partners it’s “eerily quiet most days.” And though she agrees flight to quality is more a generalized concept, she mentioned something people don’t too often associate with real estate fundamentals: happenstance.
“When it comes to maintaining a successful building, luck is almost as important as location,” Denham said. “The timing of leases is pretty random. Consider how rents in the late 1980s were as high as they were some 20 years later – and in nominal terms. Also, consider how low vacancy rates were in late 1999-2000, again with spikes in rents. And with 10 to 15-year leases, these decisions have a lasting impact on a property's worth.”
Regardless, the flight to quality is a crowded space, according to Bill Boyd, an executive vice president at commercial brokerage Kidder Mathews, who has been in the office leasing game for more than 40 years.
“Not only are the historic professional service office users, like legal and financial institutions, still leasing the available quality office space but second tier users, like insurance, marketing and even social services, are now able to pursue quality office environments as quality office space becomes more affordable,” he said. “Older or non-institutional office space will be pressured to lower their own rents as superior buildings compete for tenants that once were relegated to the more affordable buildings.”
But even for quality assets, concessions are more prevalent. From increased rent abatement to the more extreme tactic of prior occupancy. What it means is ostensibly having the tenant move in months ahead of the lease commencing. This allows the landlord to only offer a certain amount of free rent but add a few more months on the backend. For the tenant, this takes a nine-month free rent offer and turns it into as much as a full calendar year.
Another pervasive narrative around the commercial office sector is the idea of conversion, most notably to residential spaces. This makes perfect sense, as it takes an asset class that has seen a decrease in demand and increasing supply of an asset class that has nearly insatiable demand. That said, there’s been a lot more talk than action on this topic.
“I think many owners are hoping that others will convert to residential, so that inventory will drop,” Denham said. “Of course, most modern buildings won't qualify as a good candidate for conversion, but many older ones do. Owners don't want to incur the expense even if the long-term payoff suggests they should. Some of these are the ‘cream’ and owners know this, but they should still convert yet won't. City planners should buy out some owners to tear down the buildings to create small parks and sunshine. Owners might then rethink their conversion decisions.”
Boyd puts the state of the market much more succinctly.
“It’s an office space game of musical chairs, and when the music stops, the lesser quality office space may be left without a chair,” he said.
Elliot Golan is a senior vice president and senior leader in the Allison+Partners Real Estate Practice and has spent more than a decade as an industry watcher. Prior to joining the agency, he led public relations and communications at a publicly traded global real estate services firm and served as Managing Editor of Bisnow, one of the country’s largest real estate news and events platforms.
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