Quick Programming Note: I’m in Hawaii this week for work (no, I’m not joking) so posting may be a bit more sporadic than usual.
One Big Thing
Green Street published an absolute banger of a report in their latest Heard on the Beach column last week which took a rather scathing view of the tail risk associated with expensive gateway office markets, even going so far as to drop a Detroit reference on SF and NYC:
Our outlook reflects a base case, but a left-tail-risk scenario for a gateway market or two warrants consideration. The two places hit hardest over the past year, New York City and the San Francisco Bay Area, are the most likely suspects. They share low WFH utilization rates, poor fiscal health, and progressive politics. It is unlikely that their future will rhyme with Detroit’s past, but parallels are found.
Successful finance and tech firms have long concentrated in New York City and the Bay Area, respectively, as auto companies did in Detroit. These places have thrived despite high costs because network effects allow for productive interactions among creative people, which, in turn, leads to high and growing income. Geoffrey West’s Scale explains that cities scale super-linearly. As a city’s population increases, income rises at a greater rate (by an additional average of 15%).
The notion of a big industry fragmenting away from its hub runs counter to urban agglomeration theory. But a reduction of institutional and cultural barriers to remote work may break the mold. The perceived benefit of clustering in the physical sense may be permanently altered if virtual connections suffice. Many firms are ready to find out. The net outflow of hedge funds from New York City accelerated in ’20 to 6% from a 2% average over the prior five years, per Hedge Fund Alert. Silicon Valley’s slice of the venture capital pie is shrinking; the cloud is now the top choice to locate a start-up. In a headquarters move less substantive than Oracle’s but chock full of symbolism, Hewlett Packard Enterprise is off to Texas. The Palo Alto garage in which HP was founded in 1939 is known as the “birthplace of Silicon Valley.”
The narrative around office can be confusing and there is no asset class that I get asked about more by non-real estate friends of late. On a personal level I am bullish on office. I was not a fan of working from home last spring and thrive in a collaborative environment with a team. I don’t think that there is anything wrong with Zoom, per se but it is a half-assed virtual alternative to a truly dynamic in-person work environment, IMHO. However, at the same time, I’m bearish on office as an asset class, which admittedly runs counter to my own personal feelings about how our team functions and collaborates best. Here’s why:
- As stated above, I am a fan of working in an office and view it as somewhat of a necessity for productivity.
- In the pre-pandemic era, the US office market was structured in such a way that accommodated nearly all US white collar workers because most employers and employees agreed with statement #1 above. For the most part, we were not overbuilt but we were also not undersupplied the way that we are in say, the housing market.
- As the pandemic has forced us to adapt, a growing number of employers and employees do not agree with statement #1 anymore. Some employees want more flexibility. Some employers want to save on leasing costs. What was once viewed as a necessity is now a mere expensive convenience even if an office environment leads to higher productivity.
- American employers proved long ago that they are more than willing to sacrifice productivity at the altar of cost savings – see the proliferation of dense and highly unproductive open office plans.
- That leaves us with a market that is supplied for the pre-pandemic era with a new reality in which office demand could drop by up to 15% per Green Street projections. We have effectively become overbuilt without actually overbuilding and it happened pretty much overnight.
- 15% is a massive number, when you consider that there are approximately 5.4 billion square feet of office in the US per Cushman and Wakefield. That is a decrease in demand of nearly 810 million sf. However, it gets even worse since that is a national average and demand has been flat or better in sunbelt and some mountain west markets.
- What that means is that there is a very high concentration in gateway markets that will act as an anchor on rents and occupancy in the coming years.
- If we overbuilt by 15% of the total market, it would take years to absorb that space. I believe that the same thing will happen in this artificially overbuilt market, dragging down occupancy and rents along the way.
I have seen a lot of chatter from office leasing brokers on Linkedin over the past few months claiming that the office sector will be fine because companies will always have a need for office space to function. IMO, this is a strawman argument because no one – with the exception of a handful of tech bros – is saying that all office is going away and becoming an obsolete asset class. Instead, the market is positioned for a world where almost all white-collar workers go to an office five days a week, which is no longer our reality. The office leasing brokers talking their own book are half right but probably not in the way that they think. They are correct that office isn’t disappearing as an asset class. However, it doesn’t need to become fully obsolete in order to cause a lot of pain for landlords, brokers and the peripheral businesses that rely on office employment, especially in CBD’s. If Green Street’s projections are correct, we are now up to 15% overbuilt in the nationwide office markets, much more so in dense, urban gateways. Proceed with caution.
What I’m Reading
Whiplash: Restaurants have been stuck in a vicious cycle of closure and reopening for almost a year now. It costs a lot of money to start up and shutdown a restaurant and this is putting even more jobs and businesses at risk than consistent policy about takeout and outdoor dining would. The Wall Street Journal
To the Moon: Opendoor price data indicates that the recent strong gains in home prices are likely to continue this year. The Business of Business
Escape Velocity: The yield curve is steepening at a rapid pace as long rates spike and short rates stay anchored thanks to accommodative fed policy. Sentiment Trader
Invasion: Californians are flooding into mountain west markets like Boise, bringing their shitty NIMBY housing policies with them. Prices are spiking and this will eventually result in an affordability crisis if it keeps up. For some reason, the majority of Californians seem to believe that their house should be the last one to be built once they settle down somewhere. We are like a virus that has destroyed its host and is now searching for a new one that we can destroy all over again. Sad. (h/t Steve Sims) NY Times
Ghost in the Machine: An army of ghost kitchens has taken over America’s restaurant scene during the pandemic. Marker
Chart of the Day
You’d never know that we had massive job losses last year by looking at a chart of foreclosures.
Source: The Daily Shot
WTF
Phony Bologna: A man was busted trying to smuggle 194 lbs of Mexican bologna over the southern US border in his car. This may sound crass but if you are going to risk getting arrested, go big and smuggle something you can actually make money on. Why risk jail time for smuggling cheap, disgusting lunch meat? NY Post
Noise Pollution: The owner of a vacant development site in San Pedro is in hot water with neighbors after blaring the theme song to Barney the Dinosaur day and night in an attempt to break up a nearby homeless encampment. Perhaps the best part of this story was buried towards the end:
“Despite Jerico’s apology, the choice of the Barney theme song was highlighted in Twitter posts. It has come to be known as a “torture song,” favored by US government agencies like the CIA for the purpose of breaking detainees; resistance. The innocuous lyrics supposedly serve to heighten the sense of “futility” for those subjected to it over and extended period.”
I take this to mean that my kids are in direct violation of the Geneva Convention when they insist on watching crap shows with awful theme songs that have a way of getting stuck in my head for hours. And then you non-parents wonder why wine consumption is through the roof during the pandemic. (h/t Chris Dorociak) The Real Deal
Basis Points – A candid look at the economy, real estate, and other things sometimes related.
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