Market Impact From COVID-19
In order to understand the impact of COVID-19 on the Commercial real estate market, we need to look at how it will impact tenants. There will be three tenant outcomes due to COVID-19: Shrink, Growth, and Death. Reflecting on the causes and results of these three groups, we draw conclusions of potential market outcomes. However, we can take steps today to mitigate a market downturn. Landlords and Tenants need to work together to understand net space requirements, tenants need tools to understand their space needs, and landlords need data at a building level to inform their leasing strategy.
When grouping tenant outcomes, we find it helpful to use the categories of shrink, growth, and death. These three represent the most likely final results: tenants will need less space, more space, or go bankrupt / abandon their space. First, we’ll talk about why this happens, focusing on characteristic sub-groups. Then we’ll dive into the result on the office market: supply changes, pricing impact, and strategic implications.
We expect many tenants to reduce their office space use. The steep economic decline seen in many industries will force businesses to cut back on staff - Ritual recently let go of half their employees. Industries most at risk include: High-contact Services (hair salons), low demand industries (travel, restaurants). However, companies may shrink due to effective investments in technology. As employees adapt to working from home, office requirements will drop dramatically. These industries include: banking, consulting, and other professional services. These companies have invested in maintaining operations virtually; when the market begins to open, this investment will create a barrier to return to their former operations.
Shrinking tenants will look to sublet their extra space. They will struggle to understand how much extra they have, and they will market this space as-built. They will also be willing to charge below their current rent level, in this way subsidizing their overall rent cost.
We expect fewer tenants to expand their office space use. Those that do will do so for two reasons: increased safety requirements, and high growth. Some industries will do well during COVID: delivery services, virtual work enablers (Zoom is a notable example). These industries will need to hire more employees and therefore need more office space. However, even those companies that are cutting back may need more office space. A lot of ideas are being explored on how to make office spaces safer. Safe Six is becoming a goalpost for a potential design standard. For the past few years, densification has been the objective of office space, meaning that many offices may need to double or triple their space to conform to safe six.
Growing tenants will look for additional, flexible space in the short term to fill their needs. They will prefer flexible units as these provide a way to unite all their space needs into one unit at lease maturity. It’s important to note that many growth companies are growing because of safety constraints not financial gains, so they will be looking for a quick and cheap way to expand.
Unfortunately, there will be companies that cannot survive the prolonged economic downturn. These companies will die. We are seeing the prelude to this event, as many companies ask for rent abatements from their landlords. The inability to tell which of these requests are necessary and could save the company has prevented landlords from taking them seriously. Unfortunately, this may cause more companies to die than necessary.
Dying tenants leave behind a fully furnished unit. We expect landlords to market these spaces as-built, attempting to lease them at market rents with furniture as a bonus.
With these three outcomes in mind, we can make reasonable assumptions of what will happen.
More shrink than growth: We think there will be more efficiency generated during this crisis, leading to more employees working from home. We also think that a return to work will be slow and in waves, caused in part by the financial damage many companies are experiencing. This will result in more shrinking companies in the short to mid term than growth companies. This will increase vacancy rates as companies die.
Market rate: We expect market rents to drop. This is due to the surplus of sublease units coming onto the market and the demand for space being predominantly sublease spaces. Since subleasing in theory has no bottom price, tenants will try to outbid each other to subsidize their rent costs. Landlords will find themselves competing with their tenants for clients. Landlords will be unable to profitably match sublease rates leading to lower net revenues and potentially losses.
We Can Prevent This:
Imagine if we could:
Understand which tenants were dying and could save them.
Understand which tenants were shrinking and could find them sub-tenants.
Understand which tenants were growing and could find them extra space.
Then, across a building or portfolio, many of these sublease opportunities would cancel out with the growth requirements of other companies. Furthermore, there would be more tenants in the building who survive, keeping vacancy lower.
For tenants: Subleases would be found and filled faster, for higher rents than in the market.
For Landlords: More total tenants, and higher average rent. Will not need to compete with subleases when marketing whole unit as-builts.
For the Market: Less sublease space goes onto the market, market rents stabilize at a higher price.
How We Can Get There:
Changing Attitudes: In the past, landlords did not need to be worried about tenant subleases. There was enough demand in the market, with vacancy at all-time lows, that there was no competition. Landlords now need to take an active role in identifying the changing needs of their tenants.
Understanding the need: Tenants need a tool that will support them in understanding how their office space needs have changed. They need to be able to use current safety standards, layout their space, and understand the potential space options.
Data Driven Decisions: Landlords and Tenants need accurate and timely data to make decisions. For Tenants, this means understanding the costs and impact of changing their office. For landlords, this means having an understanding of the net demand for space across a building or portfolio, and proactively mitigating the impact of high expected vacancy.
Together, we can create a better future for all CRE stakeholders.