The Day After Tomorrow

by Frédéric van der Planken

CEO Whitewood

The real estate market in years to come

Week 7 since the world as we know it, came to a dramatic change. Home work became the norm, digital interaction is the only form of social connectivity, video calls with crying children or barking dogs in the background, are common place and widely accepted.

In what follows, I’ll try to convey Whitewood’s view on three main points, bearing in mind that we are for the most part an office player:

  • What will COVID-19 do to office rents, yields and availability?
  • What will the future office (have to) look like?
  • Where do we see the main threats and potential opportunities?

What’s next? Will it be a sharp V-curve as the most optimistic future tellers tend to state or will it be a long and elaborate U-curve or even a L curve? I for one, am afraid that the latter two or the most likely scenarios. This however does not necessarily mean that the real estate market will drop back into 2008-2012 modus across the different markets.

For one, the abundance of available funds are at an all-time record high, which is substantially different than during the GFC. Leverage is nowhere nearly as high and even over the past year, with lending policies softening and trend of LTV ratios rising, the overall use of external capital is much more controlled than it was.

On top of that, the ECB has agreed with the different lending banks that they are allowed to concede interest payment holidays to lenders without the loan automatically being treated as being “in default” (as opposed to interest rate renegotiation, where the latter would be the case, requiring the bank to post more capital against such defaulting loan). With the interest rates on loans as low as they are (remember the ECB base rate back in 2008 was 250-300bps higher than in 2019), having your interest payment increase in the next period, isn’t necessarily that costly. The real question will hence be: will tenants be able to pay the rent? Will we go into a long recession, with ultimately companies failing and hence vacancy rates increasing? Time will tell but the subsequent effect of a slowing economy on defaulting loans, banks having to increase their capital ratio’s against such defaulting loans and the spiral effect that it causes as we have seen during the GFC, will not be as abrupt on most real estate asset classes. Retail and leisure being the notable exception, clearly, but offices, family homes, logistics and the like, will probably have a much more soft landing, which will allow investment and asset managers to take the required measures.

The abundance of capital out there will still require that money needs to find a safe place to be invested in. Real Estate still being an underweighted asset class in most (European) portfolio allocations, will uphold the need for transactions, so it is our opinion that the market will not fall a cliff as steeply as it has back in 2008.

First and foremost, home work is here to stay. In a recent survey of CNN and an article in Forbes on April 10th, 74% of CEO’s are convinced that 5 – 10% of the workforce will permanently work from home. This is not just driven by health concerns, but this crisis has shown, imperatively, that for some employees, working from home is not just a viable alternative, but a cost effective one at that, both in money as in time and hence quality of life.

Now, don’t start sending in your lease termination notices just yet and reduce your office space to the absolute minimum. Yahoo for instance was one of the pioneers in open-plan office space, with desk sharing and an ever increasing density. Since then they have taken a u-turn on that policy and have encouraged employees to start working from the office again. The lack of (social) interaction between mainly team members has proven so counterproductive that it actually increased the overall cost to the company vs the savings they could make on decreased office space.

Other studies have shown that pure open space itself and more “forced” interaction between different teams for instance (joint coffee areas, desk sharing across the floors with a complete absence of dedicated seating, not even for teams as a whole), have proven less productive in the longer run. It diminishes productivity as numerous studies have pointed out, due to back ground noise, actual more limited interaction between team members etc, as they might be forced to sit further away from each other with different teams in between.

Cost control and productivity were until recently the main concerns for office managers, CFO’s and increasingly HR officers, who interacted more and more with the first two. Health is now a third (and incredibly important) factor that will play a role in deciding on how the office needs to be organized. One trend that can’t continue for that last specific reason, is the continuous increase of density that we have seen over past years, with especially co-workers going down to even 1 person every 5 sqm.

We applaud the work that Cushman & Wakefield Design and Build have done on this topic in their memo called “the Six Feet Office” in correlation with the 1.5m social distancing policy that we have now grown accustomed to. In its report, C&W Design and Build, propose a set of simple, but efficient rules in (re-)organizing your work floor, to allow team members, colleagues and visitors to uphold the social safe distance at all times. Different use of furniture and materials, signage and a set of behaviour recommendations are at the base of their report and will determine what the office of the future might look like. Cleary super dense office floors are out, as one of the results.

In our opinion, we will see two countering tendencies, where the one will soften the impact of the other. Yes, home work will increase vs pre-March 2020 levels. Video meetings were not as widely spread yet, but the reality of the COVID-19 measures that needed to be adopted, have forced the use of video as a valid alternative for (some) meetings. Even the most tech adverse companies, have now understood that notably recurring update meetings don’t always require physical presence. Having people come to a meeting room, often from other floors or even other office locations, for just one meeting, is costly and inefficient. To justify such meetings, they usually have a much longer “small talk” part and run out much more than their video-equivalent. In the months and years to come, the right balance between physical meetings and digital ones, will become part of corporate culture adopted by different businesses alike. We will therefore see a shift in space requirements with probably similar tendencies for companies in similar industries, which might be different from companies in other industries. In any case, adopting digital meetings and accepting home work as a viable alternative, will lower the requirement for office space and could increase vacancy and/or put downward pressure on rents.

The second tendency however will result in the opposite. The Six Feet office or similar measures that will become widely implemented with a view on the Health component of the HR officers’ and Office managers’ reflections, will actually increase the need for space. In Belgium for instance, companies installing partitioning walls, have reported a substantial hike in their order books, indicating a return to more closed off offices, which clearly require more area than the open plan equivalent.

This increase in space requirement per office worker, mainly for Health reasons, will probably cushion the lowering requirements following out of the home work tendency; Hence, we don’t see an immediate pressure on rent or upward push on vacancy as a result.

Savvy asset managers will pick up different ways to assist HR Officers and CFO’s in their decisions on office space. Quality, even more than before, will become key, mainly in the implementation of technology throughout the buildings. In an article in the Guardian of April 13th, Oliver Wainwright pointed out that diseases often changed our architecture. “It was cholera that influenced the modern street grid, as 19th-century epidemics prompted the introduction of sewage systems that required the roads above them to be wider and straighter, along with new zoning laws to prevent overcrowding.” This is clearly not a cry for government lead, (over-)regulation, but high-end, qualitative implementation of technology and state of the art technical installations will assist in diminishing health risks. Contactless doors, badge readers, infrared flushing or even complete automated toilets (with contactless moving toilet seats for instance) are but a few of the technical measures that can be taken in modern buildings. Improving ones technical installations can also be done in a cost efficient way, as pointed out by a recent study of CES Engineering in Brussels. Re-cycling air out of the office, was already abandoned as much a possible, but installing high-end filters in the current installation and periodical cleaning of the shafts and air conduits, may for instance become a part of any good property and facility managers program.

“It is the Economy, stupid”. Therein lies the curve ball. What will the impact be on companies as a whole? With the economy set to slow down or even drop into a wide spread, long term recession; of course the impact will be important. So even though we don’t expect that the current tendency of increased home work or the decreasing density of office plans, will influence neither rent nor vacancy, as they counter each other out, the overall economic impact of this crisis will. As no one can state with absolute certainty what its impact will be and how the governmental bailout plans will counter or worsen such impact for that matter, the threat to the market is clear. The real test will be next winter, to see if the COVID-19 pandemic was a “one-off-event” or a seasonal recurring one. This will in likelihood determine the U or L-shape of the future market. Note that we do not believe in the V-shape curve and hence steep recovery, even though we would welcome such recovery!

Whatever the shape may be, the key will be to continue the trend in providing investors and tenants alike with the highest possible quality for the investment they are looking for through pro-active management initiatives. Now more than ever, only active managers will assure savvy investments. Banks should be cautious on what they are lending on, yes, but new developments putting smart technology at the core of their projects to better cope with the occupational concerns of tenants, are and remain in our opinion the smart bet and the real opportunity in the years to come.