Peak Office
In the 1990 Pulitzer Prize-winning book by Daniel Yergin "The Prize" – so called because the swashbuckling American oil executive Everette Lee DeGolyer who toured the Middle East in the early part of the 20th century and believed it to be "the greatest prize in history" – is a comprehensive historical account of the global oil industry, tracing its evolution from its early beginnings in the 19th century to the present day. The book addresses the "Peak Oil" theory which suggested that global oil production will reach a maximum point, or "peak," after which it will gradually decline due to the depletion of easily accessible oil reserves. Like the apparent munificence of oil, there is an estimated one billion buildings in the world - and around 100,000 office buildings - which will more than double by 2050 to 2.6 billion as the global population approaches ten billion. A city the size of Paris is built every week. Have we reached “Peak Office”?
There are widespread concerns, even from the White House, that commercial real estate is past a cyclical peak. A White House adviser told senators he is keeping an eye on commercial real estate, amid concerns about the banking sector and its real estate debt holdings. "This issue is very much on the watchlist," Jared Bernstein, a member of the White House Council of Economic Advisers, told the Senate Committee on Banking, Housing and Urban Affairs this week during a confirmation hearing over his appointment as chair of the council, Bloomberg reported. "It’s something we’re tracking carefully,” he said.
Much of the concern is focussed on offices, with quite a queue of commenters predicting that we have seen ‘peak office’. J.P. Morgan has predicted that if office occupancies do not recover from their pandemic-era slump, approximately 21% of CMBS loans associated with office properties could default, with a loss rate of 8.6% for loan holders. This could result in $38bn in losses for the banking sector and $16bn for life insurance companies. If office occupancies shrink permanently by 20 or 30 percentage points, J.P. Morgan estimates default rates would increase to 28% and 35%, respectively.
The California State Teachers' Retirement System (Calstrs), which has been investing in real estate to diversify from stocks and bonds, is now expecting write-downs in the value of assets in its $52bn property portfolio. Calstrs' chief investment officer, Christopher Ailman, told the Financial Times that he was now bracing for write-downs in the value of assets in its property portfolio “Office real estate is probably down about 20% in value, just based on the rise of interest rates. Our real estate consultants spoke to the board last month and said that they felt that real estate was going to have a negative year or two.” The CEO of State Street, Ron O’Hanley, also told the Financial Times that the US custody bank’s biggest concern was “what happens with commercial real estate, particularly offices”.
A survey conducted by Goldman Sachs Asset Management in February found that three times as many life insurance companies, which hold approximately 15% of the $4.5 trillion in U.S. CRE debt, are looking to reduce their office lending in 2023 as last year. Wells Fargo announced in its Q1 2023 earnings report that it has increased its reserves by $643 million to cover potential loan losses. The increase in reserves is primarily for commercial real estate loans, specifically those associated with office assets. At the end of Q1, the bank had $725m in nonaccrual office loans, which is an increase from $186m at the end of 2022. Nonaccrual loans indicate that the borrower has not made any payments for over 90 days. Half of the bank's total nonaccrual CRE loans are related to office assets, up from 25% in the previous year.
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Office demand may not be quite as past its peak as many have thought though. In an Harvard Business Review survey last year, respondents cut days on site by 30% or more, but the survey data suggested cuts in office space of 1% to 2% on average only, implying big reductions in density, not space. Indeed, J.P. Morgan Chase instructed managing directors to work in the office five days a week, according to an internal memo seen by Bloomberg. The memo, written by the bank's operating committee, emphasized that leaders play a crucial role in running the business, meeting with clients, teaching and advising employees, and being available for feedback and meetings. The memo also stated that while most employees are keeping to their agreed hybrid work arrangements at the bank, there are a number of employees who are not “meeting their in-office attendance expectations, and that must change”.
Another sign that office demand may not be waning is that US, companies are bringing back relocation benefits. According to hiring platform Indeed.com, job postings that mention relocation benefits have surged by nearly 75% as of February 2023 compared to the previous year. These benefits can range from a lump sum of a few thousand dollars to full-service packages that cover everything from packing and shipping household items to several months of paid rent in corporate housing. This trend highlights how much companies value having their employees back in the office, and are willing to invest in their relocation to make it happen.
The result will be demand focussed on higher quality stock, as M&G Real Estate Head of Investment Strategy Jose Pellicer said at MIPIM, peak office means a future focused on “quality not quantity”. The process might be brutal and some office buildings and locations might not survive. Office buildings should be torn down as demand isn't going to bounce back, Kyle Bass told Bloomberg. Converting office space to apartments isn't practical either, he said. "It's one asset class that just has to get redone, and redone meaning demolished," Bass said.
Environmental laws will accelerate these changes, and as OPEC can explain, restricting supply will boost pricing. Fitch Ratings predict that new UK energy efficiency regulations will actually curb longer-term valuation risks to core London offices from hybrid working and that it is older offices in outlying locations that face the greater risk of becoming stranded assets. BNP Paribas Real Estate estimates that up to 24% of inner London commercial stock could become unlettable from the legislation which has just kicked in. However, for compliant offices, they believe the removal of properties from the letting market can help offset the continuing demand shock from the shift to hybrid working since the pandemic.
Some are sensing an opportunity. Amundi has targeted €1bn of investment with a net zero property fund which targets a 60% commitment to the office sector, and already currently allocates 63% to the segment. It will focus on assets within central business districts that are geared towards tenant wellbeing. Barings has closed on its first major high-yield U.S. fund since 2016, and it has done better than anticipated. The fund, which will target “specialized office space,” raised $680m, well over the $500m target Barings set for the vehicle when it launched in 2021, Green Street reported. Barings expressed confidence in its chosen subsectors of real estate, in spite of overall concerns in the office market. They emphasized that it the vehicle is targeting a specific type of property bucking the trends: office space leased to life sciences and tech tenants. "At Barings, we believe there is strong relative value for the highest quality office assets that attract high-calibre life science and technology tenants, who continue to drive advancements in healthcare and global economic growth," Barings Head of U.S. Real Estate Equity Acquisitions and Portfolio Management Joe Gorin said in a statement. "The leasing performance of this specialized subset of office has substantially outperformed the overall office market since the beginning of the pandemic." Pellicer said that M&G, which has £34bn of real estate assets under management, would continue to invest in the London office market. “We have made a big bet on investing in better quality but fewer offices. Our criteria going forwards is to invest in office spaces that have been designed to allow people to meet and collaborate and they must also be on the path to net zero,” he said.
While there was once a fear of peak oil supply, the current concern is that we may soon experience peak oil demand due to the rise of electric vehicles and net-zero policies. However, projections on the future of oil demand remain uncertain and heavily depend on the state of the global economy in the coming years. For offices, we can also expect ongoing debates on the trajectory for demand, but the focus on quality and sustainability are clear: and investors are starting to take heed. In fact, Yergin doesn't even reference “peak oil” until the penultimate chapter of his magnum opus The Prize. But if you substitute the word ‘oil’ for ‘offices’, it sums up the unsolved argument for both industries. "In each case, new territories, new horizons, and new technologies banished the fears [of running out of oil] within a few years; and indeed, in each case, shortage gave way to surplus. But is this time different? That is a contentious question which arouses strong passions. It is also a question that appropriately requires thoughtful, careful analysis, for the stakes are very high.”