Remote Work, Changing Demand Bigger Threats to Office Market Than Recession

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Who’s afraid of the big, bad bear?

As it turns out, most people — economists and real estate professionals alike are anticipating a recession in the next 12 months, driven by inflation and the Federal Reserve raising interest rates. The anticipation alone is enough to push New York City’s landlords, tenants and lenders to aggressively negotiate lease terms, take caution when underwriting loans, and just generally buckle down for what’s to come. But most expressed hope that the recession will be quick, if not completely painless. 

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The pain felt by the office market, however, is much bigger than a recession. 

“Firms are grappling with more strategic questions about how they leverage the office and how they incorporate remote working most effectively and efficiently into their model — but those are questions that transcend the risk of a recession, that transcend the short-term vagaries of a business cycle,” Sam Chandan, a professor and the director of the Center for Real Estate Finance Research at New York University’s Stern School of Business, told Commercial Observer. “We talk about a return to the office, but it’s not really about being in the office. It’s about creating opportunities for us to sit down together and engage directly.”

While a recession is likely, Chandan does not foresee an economic downturn that causes an exodus of tenants from the office market nor one that drives workers back into the city’s struggling office crop. What’s actually impacting the office market is a set of longer-term trends, including the addition of brand-new Class A space to the New York City market. An influx of such space — from Hudson Yards, to the World Trade Center, to Tishman Speyer’s The Spiral — has driven a great migration of office tenants into more modern buildings. 

“The New York real estate market has in some ways come to resemble the African bush,” Michael Cohen, Colliers’ tri-state president, said. “There’s the predator and then there’s the prey. The predator is the many new buildings, major renovations, or in some cases just the buildings south of 34th Street that offer more artistic environments. And then there’s the prey: everything that was built between 1949 and 1979 or in some cases even into the early 1980s — buildings that suffer from horrendously inefficient infrastructure, a lack of common spaces, character and a 21st-century aesthetic.” 

The data has borne out this dynamic: While office leasing activity in New York City declined 14 percent in the second quarter of 2022 compared to the previous quarter, demand for Class A space rose, according to Newmark’s second-quarter office report. Leasing velocity increased 31.5 percent for Class A space in the second quarter compared to a year prior, while leasing velocity for the city as a whole increased just 3.3 percent, according to the report. 

Of course, the sub-Saharan metaphor doesn’t end there. If new space is akin to a cheetah roaming the deserts, then perhaps the trend toward remote work is global climate change portending a catastrophic disaster for the entire desert ecosystem. Much like the desert, the labor market giving employees the leverage to stay remote has been hot, hot, hot.

But the “unsustainably hot” labor market, as Fed Chairman Jerome Powell has termed it, is already tightening. JPMorgan Chase cut hundreds of home-lending employees at the end of June. Compass, Redfin, Coinbase and Netflix have all laid off staff. While Powell has said he doesn’t want to put people out of work, he said in mid-June that the economy “really cannot have the kind of labor market we want without price stability.” With a tighter labor market, workers may head back to the office to demonstrate their commitment to work (and desire not to be culled in a round of layoffs) but firms aren’t likely to leverage a downturn to get workers back to their cubicles, Chandan said. 

Though maybe Chandan hasn’t run into Jeffrey Gural in a while.

“If a company starts laying people off, that will almost force people to come back,” Gural, chairman of landlord GFP Real Estate, said. “It is more likely [that a boss] is going to cut the people who never come to the office. I know I would.”

Employees who haven’t made a recent appearance at their desks might want to get some facetime with their bosses if the labor market begins to loosen, Craig Deitelzweig, president and CEO of landlord Marx Realty, added. 

So far, larger owners haven’t seen their tenants demanding full-time attendance in the office, said Jason Alderman, senior managing director and co-head of the New York office for landlord Hines. And work from home and a recession were “almost unrelated phenomena,” according to Franklin Wallach, executive managing director of research for Colliers in the tri-state. Companies are fundamentally reevaluating how to use space and how to do business, said Bruce Stachenfeld, a real estate attorney and founding partner at Duval & Stachenfeld. That’s not about to change with a recession. 

What Gural worried about more than the return to office was debt. Gural refinanced some of the loans on his New York City portfolio to lock in low interest rates during the pandemic. Properties overloaded with debt could be forced to sell if interest rates rise and owners need to refinance, he added.

“Those people who are over-leveraged and have loans coming due are definitely in trouble,” Gural said. “A lot of people bought buildings on the theory that interest rates will be 3 percent forever. And those of us who’ve been around knew that wasn’t the case. I think that’s going to separate the men from the boys if we have a prolonged period of interest rates being 5 percent or even 6 percent rather than 3 percent.”

Over-leveraged properties are poised to be the most at risk, said Richard Ortiz, co-founder and managing partner at the commercial lender Hudson Realty Capital. As a lender, he’s been more conservative when it comes to the assumptions he makes when underwriting office loans. Office is the most difficult type of commercial property to underwrite today, Ortiz said.

“The recession is part of it, but I think that our belief is that there has been a fundamental, systemic change in terms of how office will be utilized in the future,” he said. “That is not a short-term trend. We feel that that is going to be a longer-term trend. So, when you combine the two, we’re very conservative when we’re looking at underwriting office properties.”

Retail is also likely to feel some headwinds — particularly in those areas that became pandemic darlings. Boutique markets like the West Village and SoHo, which rode its rich residents out of a pandemic slump into new luxury-leasing highs — will likely be unable to sustain growth in rents or leasing, Ortiz said. But the Givenchy isn’t going to hit the fan, either.

“I think luxury will continue to do fine,” said Spence Mehl, a partner at RCS Real Estate Advisors. “I get more nervous about the lower income, because I think if you have a sophisticated shopper who has money, and, even if their portfolios are down 20 to 30 percent, they’re not shopping at a Ross Dress For Less or at Dollar Store.” 

Retail leasing is a notoriously slow indicator of the industry’s health, thanks to the length of time it takes to get a retail deal done, said Mehl. But he has observed a softening of consumer sales on the retail side, indicating a reason to be at least a little bit cautious — or, in his case, a little more aggressive at the negotiating table. 

Mehl said he’s been successful at getting landlords to agree to lease terms where a retailer will pay a lower flat rent fee plus a higher percentage of the sales it brings in over a threshold. That way retailers have a little more flexibility in monthly rental costs during an economic downturn, and a landlord brings in a healthy sum when business is good, Mehl said. With 52 percent of small businesses experiencing rent increases in the past six months, the practice is a smart move, though less popular with a landlord’s lenders, who prefer a consistent income, he added.

Residential rent growth for multifamily properties will also likely face a slowdown — if only because those pandemic highs are unsustainable, Ortiz said. 

With higher mortgage rates putting
single-family homeownership out of reach for more Americans, the demand for rental apartments has significantly increased, said Chandan, who testified before the U.S. House of Representatives’ Committee on Financial Services at the end of June about homeownership inequality. But those skyrocketing rents have garnered greater attention from politicians and the press alike (including this publication), making the sector more at risk for policy interventions that could constrain its growth, he added. 

The wheels of politics move slowly, though, while runaway rents have moved much faster. RXR has charged 10 to 20 percent more in rent on its portfolio of 10,000 apartments in the New York metro area —  which are 99 percent leased regardless — excluding those buildings in development, Scott Rechler, CEO and chairman of RXR, told Commercial Observer. In some units, he’s seen a 30 percent increase in rent above 2019 levels, which Rechler agrees is unsustainable, though he thinks the asset class will remain strong even as rents normalize.

Other changes might help save obsolete office buildings and solve the city’s housing shortage at the same time. Office to apartment conversions is one avenue Rechler is exploring. There are other avenues too — like the former Queens manufacturing plant RXR is converting into a 1.1 million-square-foot logistics warehouse and distribution center for Amazon.

“I’ve been doing this for a lot of years and there have been a number of economic downturns, but there is a process to them,” Rechler said. “But, ultimately, barring something systemic, you usually come out with a healthier foundation on the other side.” 

Rechler agreed that the change to the office market is a systemic change, but that, ultimately, Class A properties will survive while uncompetitive properties will be converted into something new.