The market for office space is undergoing a profound shift
Who will win and who will lose?
I’ve spent the past couple of weeks talking with investors about Tandem, a business I’ve been building to help hybrid teams split office space (you can read more about us here).
One of the first questions that’s come up is: how do we know this hybrid thing represents an actual shift in the market, rather than just a moment in time?
Why this isn’t a typical economic cycle
I’ve written lots on why hybrid is such a shift (here, here, and here). As I’ve shared, most experts predict a 30%+ drop in aggregate demand for office space, with a return to supply/demand equilibrium by 2030 in the very best of cases.
Real estate, while less volatile than say, publicly traded stocks, goes through cycles like any asset class.
There is a difference, however, between an economic cycle and a change in demand preferences.
Economic cycles are momentary and typically caused by shocks unrelated to the good being sold.
A war or pandemic might cause a recession, and that recession will cause demand to fall for goods and services broadly. Sometimes the impact is felt for many years (it took six years for office prices to stabilize after the ‘08 crisis, even though the recession had little to do with office real estate). But wars and pandemics do not alter how much consumers want those goods and services, they just change their ability to buy them right now.
But some demand shocks happen for reasons intrinsic to the good or service: preferences among buyers have changed.
When demand falls for a good, like it has for office space in the last year, to assume it’s just another economic cycle without questioning the underlying causes of the fall is naïve. Imagine having run a company that sold fax machines when email just became a thing and saying “don’t worry — our sales regularly go up and down and this is just another swing.” You’d be called crazy.
Take a look at this piece in the WSJ this week - Vacant Offices Are Piling Up in Silicon Valley:
But such return-to-office policies haven’t stopped the firms from slashing their office footprints—a trend that can be seen playing out in the sublease market, where a record 7.6 million square feet of office space is available in Silicon Valley, up from 2.7 million in 2019, according to CoStar.
“Tech companies have done their research,” says Nigel Hughes, a CoStar senior market analyst, “and they’re starting to let space go.”
Even as tech companies pull back their workers with mandatory 2 or 3-day a week in-office policies, they are STILL slashing space.
For all the reasons I’ve written about, from here on out companies just won’t need as much as space as they needed before. Hybrid is here to stay — it is not a momentary economic event but rather a change in demand preferences.
A tectonic market shift is underway
What all this got me thinking about this week was how exactly these demand preferences will change.
Assume the following to be true:
Because of hybrid, firms will use less office space for the same number of employees. Even accounting for the small, relatively niche group of people who have become and will remain fully remote, the total amount of office space needed per person in the U.S. will drop.
Daily usage of space will become much more variable (see ‘The office flywheel’).
As a result, managing, coordinating, and forecasting office use will become much more complex.
Therefore, demand preferences will change in ways that are more nuanced than simply a drop in quantity.
U.S. firms spend more than $350B a year on office rent. That is by no means a small market. A change in demand preferences will create winners and losers on a massive scale — arguably, there are few other markets of this size that are changing this much right now.
Who will win and who will lose?
So, what will that change look like? Who will win and who will lose?
Probably a lot more to come on this topic, but I think the place to start is by going straight to the buyers of the good and trying to predict as best as possible how they might change.
My first prediction is that the office lease will shift from an infrequently-thought-about, essentially capital expense to a regular operational one.
Let me unpack that.
Office leases are generally accounted for as operational expenses. You don’t own the underlying asset; you pay rent on it to use it each month (I should note there are exceptions, and sometimes leases, especially very long ones, will appear as liabilities on the balance sheet just like a loan would).
But most leases today, including those accounted for as operational expenses, get treated internally as if they’re capital expenses. Someone sitting under the CFO signs the lease and shoves it away. In fact, the lease itself is often ‘administered’ by a third-party corporate services team at a major brokerage house. For all intents and purposes, the lease is “out of sight, out of mind” until the expiration comes around.
However, if space is now a tool — that is, it can be used in different ways at different times to produce different outcomes (for example, you may want to use physical space to improve team ideation and creative work) — the way you manage and account for space should change too. You’d expect the management and oversight to be a LOT more hands-on.
We’re already seeing a shift in who within a firm manages real estate — increasingly, real estate is moving from a cost center underneath the CFO to an important function within the firm’s talent and human resources group.
The change in ‘who’ might be able to point us in the direction of ‘what:’:
How will internal real estate teams be held to account differently? By what metrics and standards will success be based on? (Office utilization? Creative output? Team morale and employee retention?)
How will this translate to changed ways-of-working, including how real estate teams acquire and administer office space?
What gaps will be left unserved in the market by these changed ways-of-working? Who will come in to fill them, and how?
If you work on an internal real estate team at a large firm, I’d love to talk with you.
good stuff, Rafi!