Office space can be a highly attractive real estate asset class for many reasons. Mainly, due to its strong underlying fundamentals that offer space for many different types of uses that span across many different industries. Historically, office space is perceived to be the backbone of businesses and has a strong track record of producing solid returns.
In addition, the asset class can offer a spectrum of investment strategies: Core, Core-plus, Value-add, and Optimistic.
In this article, we will discuss an overview of the office asset class, the demand drivers, and considerations for making informed investment decisions.
Asset Class Overview:
Office space can come in many different sizes (think of a skyscraper in San Francisco, CA vs. a single-story creative space in Chandler, AZ. Office space is generally described by location, height, and use. It is generally split into two categories that describe its location; Central Business Districts (CBD) and Suburban. The industry also ‘grades’ properties by Class, A, B, or C based on age, quality, micro-location, amenities, etc.
The first segment is measured by its size:
- High-rise (<7 Stories)
- Mid-rise (7-25 Stories)
- Low Rise (>25 Stories)
Different types of tenants prefer different kinds of sizes. Think big law firms or financial institutions with large professional teams and prefer that wow factor of an office on the 32nd floor in Boston vs. a young tech start-up in a creative single-story space in Provo.
The next segment is by location; Central Business District (CBD Markets), and Suburban. Once again, think of the heart of San Francisco, CA versus a neighborhood in Chandler, AZ. As you can imagine Land is more restrictive (and expensive) in CBD markets which is why you’ll find all types of sizes. On the other hand, Land is typically less restrictive (and usually less expensive) in suburban areas which is why you will see properties built ‘out’ instead of ‘up’. Aside from its size and construction expense, CBD markets tend to demand higher rents than suburban locations which is why you will see more established ‘cash heavy’ companies utilizing space in CBD markets, and more small businesses in suburban locations.
The last segment is the use type. In general, when we think of office space, we typically think of professional services, finance, or tech filled with lounges, cubicles, and dedicated personal offices. On the other hand, there is medical space (picture a dental office). These different types of tenant usages have different costs associated with the type of tenant which is called ‘Tenant-Improvements’ (or TA). Tenant improvements are similar to a ‘credit allowance’ in a sense of the landlord will set an allowance for a new tenant to build out the space for their given operation. The last usage type is flex space. Flex space is a type of office space in which a percentage of the building is used for more heavy industrial uses. According to the NAIOP, at least 75% of the property’s interior must be finished as an ‘office’ (not industrial) in order to qualify as office property.
It is essential that commercial real estate investors understand the market drivers that influence occupancy, rental growth, and new construction. The biggest driver for office space is employment growth. When companies are hiring new employees, they might expand their office footprint. On the other hand, with declining job growth or a flat economy, companies may reduce their space usage. The two main tenant types are TAMI (Technology, Advertising, Media, and Information) and FIRE (Financial, Insurance, Real Estate, and Legal). How successful these types of sectors perform is the driving force for the different office segments.
A basic understanding of how user demographics, and how modern-day teams are working, will give investors a keen understanding of what types of assets are worthy of long-term, quality investment. Aside from economic shifts, which are not as easy to recognize, demographics and the modern world are.
Millennials will become the largest workforce and we know by plain example that the modern workspace is becoming more creative and less ‘cubicle’ oriented. By looking at the largest corporations like Apple, or Meta (Facebook), teams appreciate more collaborative and amenity focused; shared workspace, indoor and outdoor amenities, technology, etc. Another prime example is the shared office giant, WeWork, which designs its properties like a hip-hotel. Now, this does not fit all user types like medical, etc. but this sheds some great light on the largest workforce and what their preferences are.
The next consideration (or elephant in the room) at this time is ‘work-from-home’. We are entering the digital world 2.0 where workers have been sent home to work throughout the Pandemic and this has created (and demanded) a major shift in how the world works. Now we are in the early stages of ‘return-to-office’. This will take some time for companies to start enforcing this as they are still lingering facts from the pandemic, as well as a demanded shift flexibility.
All of these shifts have not only created changes in office design and office usage, but also location. The flexible work environment has, in some ways, leveled out the geological map as it relates to the large workforce. People are now working closer to home, and are able to enjoy their work/life balance not only in walkable metros and major CBD markets but also in secondary markets where the cost of living can be more affordable.
As investors consider asset classes as an investment, the most important factor is relevancy today and during the holding period of the investment. No matter the location, usage type, or size, relevance in a particular market that is supported by the fundamentals is the ultimate factor that should be considered while making investment decisions.