What Should We Do with All of this Office Space?

Greg Campion: From Wall Street economists to local taxi drivers, there's one topic these days that everyone's talking about. What are we going to do with all of this office space? It's no secret that the office segment of commercial real estate markets is facing some unprecedented challenges, from new post COVID work habits to fall out from some of the fastest interest rate hikes in history. What does this all mean? And can there still be opportunities amidst all this volatility?

Dags Chen: The office segment is facing some very serious challenges, both structural and cyclical. It's going to take a long time to work through. There's definitely going to be material repricing of assets along the way, but we don't subscribe to the theory that office is dead. We're investing in office properties that are positioned to offer tenants exactly the type of specialized space they need. And we are pretty sure this will be a key driver of returns in the years ahead.

Greg Campion: That was Dags Chen, head of US Real Estate Research at Barings. And this is Streaming Income, a podcast from Barings. I'm your host, Greg Campion coming up on today's show, what should we do with all of this office space? All right, Dags Chen, welcome to Streaming Income.

Dags Chen: Great to be here.

Greg Campion: Excited to have you here. It is an incredibly timely topic that we are talking about, and that is what is going on with the office segment of the commercial real estate market. It's something that everybody is talking about today. Everybody's got an opinion about. You've got a particularly informed opinion. So I'm very excited to host you here talking about this today. So why don't we start out by just trying to get our arms around how big this problem is for real estate market, for the economy. Tell me about how you and the team are even starting to get your arms around sizing up the problem that vacant office space represents today.

Dags Chen: Certainly. Well, we're thinking about it in three ways. The first is the space market. That's the physical office market. The second is equity values, and the third would be debt values. In terms of thinking about it from a space market perspective, there's an estimated four and a half to 5 billion square feet of office space in the us, and that includes all types of office.

Greg Campion: Okay.

Dags Chen: About an estimated 25% of that office space, so about a quarter of the office space, as it stands, we would classify, and I think anyone who works in an office would classify that as functionally obsolescent, meaning you don't want to work there. There's practically, for all intents and purposes, no one on site. And the value of that structure is probably worth the value of the underlying land, if that much, because you consider demise costs to just raise the structure.

Greg Campion: So that's a big number, 25% of the US office market potentially obsolete today.

Dags Chen: Yes, as we're sitting here. Then you factor in another 20% will be functionally obsolescent over the next five to 10 years if it doesn't receive major capital expenditure, if there's not a major upgrade to the premises. So there's another 20% on top of that 25% that is at risk of becoming functionally obsolescent. So almost half of the office space in the US from our perspective. And granted, there's a lot of assumptions that you have to make if you want to bracket this problem at this point in time, but roughly half faces some kind of danger of obsolescence.

Greg Campion: So that's a pretty massive number when you just think about the space alone. And I take your point that when you're trying to get your arms around something as large as the US office market, there's a lot of assumptions that go in there. You're talking about all different kinds of space. But even if that is directionally correct, that is still a really big number to be considering. Now, you mentioned space is one consideration, equity valuations and debt valuations are the other considerations. So how are you thinking about valuations from a high level?

Dags Chen: Yeah. So in terms of equity valuations, I will point to the public office REIT market is that values have declined since peak, which is around the end of 2021, the beginning of 2022. Revalues have declined by about 50%. And the unlevered property values, because REITs are companies that own real estate, so there's a component of revaluations that is not necessarily real estate, but property values on an unlevered basis are down around 25 to 30%, with some thinking that it could be down even further. So you can multiply that by whatever amount you would think the office market is valued at currently. It could be anywhere from half a trillion to over a trillion dollars worth of value destruction that has just taken place in the last, call it 18 to 24 months.

Greg Campion: Yeah. Wow. Okay. Again, some pretty big numbers. So these are some fairly dire stats that you're throwing out there just in terms of the potential space obsolescence, and also the sort of retreat in equity valuations that we've already seen. Okay. So it's hard to conceptualize sometimes, big numbers like this, but I think we can all agree that this is a major problem, obviously not only for the real estate space and investors in the real estate space, but obviously for the economy, and more broadly for banks especially, et cetera. So it's no surprise that this is on the cover of magazines everywhere. It's on the headlines on CNBC everywhere. So thank you for helping us at least start to figure out the size of this problem. Now, let's talk about how this works its way through the system. To me, and maybe this is just my simplistic way of thinking, there's kind of two ways. One is a repricing of assets, and two is a repurposing of assets. And so let's talk about those. On the repricing side. It sounds like that is really underway already, and we've already seen a pretty material devaluation. Tell me what's the next step there and kind of who's most at risk in terms of further deterioration and property values?

Dags Chen: Well, the most at risk are going to be those who bought most recently and those who are most leveraged. So those are certainly the ones who are facing the greatest valuation. Risk. Valuation is a really interesting area right now for office. We can all recognize that the office of today, especially if it was built even a decade ago, is worth less than the office of yesterday, just by virtue of being in a higher interest rate environment. Now, the process by which values are adjusted, and I think many of the listeners will recognize that property values are determined primarily through appraisal, that's effectively or essentially an expert opinion of value, especially when a property has not transacted. And so changes or inflections in valuation trends take place slowly, in part because there isn't a lot of transactions during periods of inflection. Buyers and sellers both kind of effectively freeze, right? Buyers wanting to gain the largest discount and sellers wanting to preserve the most value possible. Eventually, there's capitulation. And this time, it should certainly be on the part of sellers. But that process is very much ongoing. And when we look back on the history of real estate downturns, we see that they take a while to transpire. They take a while to bottom out. If we were to use history as our guide and look at the NPI, which I think our listeners will understand as the inaudible Property Index and kind of a proxy for high quality or institutional quality leased office properties, if you look back historically, it takes anywhere from six to 10 quarters. Perhaps tens a little bit long, but it takes, let's call it two years for property values to stabilize. I think that happens a little more quickly, but mind you we're only about two, perhaps three quarters into this right now. So we have a while to go if history is our guide. At the same time, we have a lot of" cash" on the sidelines. There's a lot of dry powder out there that's directed a or allocated to commercial real estate. So that may change the timing, but certainly we're looking at a very extended period of time. And as we've discussed, you and I, there are going to be opportunities to purchase heavily discounted assets that you can then remake into a next generation office property, one that firms and tenants will want to be in. There's going to be opportunities that happen between now and the eventual recovery of the office market, but on a market wide basis, we're certainly a long ways off from any type of even stabilization, but certainly recovery.

Greg Campion: Yeah. Yeah. That's a great point. It's not as if we need to hit the bottom of the cycle, and then come all the way back up before there are really interesting investment opportunities. So we talked about repricing. Let's talk about repurposing, which I think you're alluding to here. So there's a lot of talk about this, right? And there's a lot of conversation about we've got too much office space in this market, in that market. What can we do with it? Can we convert it to residential? Can we convert it to another purpose? I'm sure it's very idiosyncratic and dependent on different situations and different cities and locations and assets and all that kind of stuff, but talk to me about just how you're feeling about that generally, and how realistic you think it is for legacy office space. Let's say properties that were constructed or haven't been updated since the sixties, seventies, eighties, nineties, how realistic are conversions? And what could they be converted into you?

Dags Chen: Certainly the office to resi conversions are very popular to talk about or to theorize about. But in terms of execution, incredibly difficult, at least over the near term, let's call it the next two to three years. I don't really see that being a significant solution to the issues that we're facing right now. The office to resi conversions, aside from being structurally difficult, I think many people can appreciate that there's plenty of buildings that really don't lend themselves well to becoming apartments. But also from a regulatory standpoint, it's also challenging. I heard an anecdote from a Bay Area developer who reminded the audience at a conference I was at, that residential buildings in San Francisco, for example, are subject to more intense seismic requirements than office buildings are. So there are going to be those types of considerations. Now, perhaps it's simply easier to do that in places that are more lightly regulated. I'm thinking Texas, for example, perhaps Dallas, where structural vacancy perennially just runs higher even before the pandemic, before this transition to hybrid work. We may see a higher incidence of office to residential or office to something else conversion. Office to hotel is another possibility, office to industrial. But that's really going to be for suburban office assets.

Greg Campion: So office to residential, lots of challenges, not that it won't be done or can't be done, but lots of challenges associated with that. What else could office be repurposed into that you think is realistic, potential solutions here?

Dags Chen: Here's the thing, and here's how the repositioning is related to the valuation question. It's in that once office values have reached a point where developers feel they have the ability to perhaps be experimental, to make mistakes and not lose money right away on the purchase of an obsolete office asset, that's going to affect the equation. That's going to affect the conversion of office to something else. Likewise, something that may stave off some of that is perhaps the intervention of the public sector where there's some type of incentive financing or tax wise related to rehabbing older office properties, and we're seeing glimpses of this. I think there's going to be more to come. The New York Economic Development Corporation recently put out a program that was designed exactly to do this, to attract investors to upgrade older office space in Manhattan.

Greg Campion: Yeah, makes a ton of sense. Obviously, the amount of tax revenue that's driven by the employers taking up space in these buildings and the owners of the assets themselves is very substantial, so I think they're all very incentivized to have buildings in use. So I think that's a great point, that this is not all happening in a vacuum. You have policymakers who are all seeing this happen and potentially have levers to pull that can affect the equation and maybe lead to conversions or updates that maybe can happen sooner than otherwise. So if we zoom out a little bit and we go back and kind of look at this situation over, so you've painted a picture that we've got a big problem on our hands in terms of office vacancies. There's different ways to work through it, through repricing of assets, potentially through repurposing, et cetera. Even though these are probably the toughest market conditions, maybe you've seen in your career so far, at least for the office, there are still opportunities, aren't there? So tell me just high level where the Barings team is looking for opportunities today, finding opportunities today, even in the office market.

Dags Chen: The scale of the problem means that there are going to be opportunities, and we are seeing them. Albeit on a infrequent basis or cadence, but we are seeing them where there are sellers that are distressed. Perhaps they're distressed because of a timing issue, because of broken capital structure around that property, and they need to sell in this environment. There is certainly the opportunity to pick up good viable assets. And it's not to say these are the one Vanderbilts of the world. That said, there's going to be a lot of office properties that are viable locationally, viable because they're in an area with a high concentration of tech related employment. In areas where there's a highly skilled, highly educated workforce. We can step into those opportunities just as we've done already. We see this current environment as simply an expansion of the opportunity set.

Greg Campion: And actually, Barings and Greatland Realty Partners, I believe just announced the acquisition of a 510,000 square foot office space close to Boston. Would that be an example of what you're talking about here?

Dags Chen: It is a great example of what we're looking for at this moment. So this is an office property that is leased to institutional quality tenants with decent lease durations. It is in a market with a high exposure to tech, employment, science, technology, education, math, those types of employment, and it's within a broader metro area with high educational attainment. There's the potential for conversion to lab space because there's a high concentration of biotech tenants in this area. It is one of the leading, if not leading markets for life science in terms of scope and size. So this is a perfect example of an opportunity that we're seeing, but also seeking. This wasn't broadly marketed, but this came to us specifically because of the relationships that we have within the market within the greater Boston Cambridge area.

Greg Campion: That makes sense, and I think that's really encouraging to see, because I think it's easy to get caught up sometimes in the headlines. And even in our discussion, when you look at some of those high level numbers, things can and do look pretty dire, but it's encouraging for me to see examples like this where, okay, here are situations and assets that come to market that are very attractive from a structural long- term perspective and tick a lot of those boxes that you and the team would look for long- term investments. And so it's not that transactions have completely evaporated. There are still interesting opportunities out there, and I think that you and the team are really well placed to find some of those and source those for our investors. Okay. I have one final thought for you here, or a question for you to finish out. And this is that, in my experience anyhow, I think what I've seen in my career thus far is that it's the crises that you don't see coming that are the ones that really end up biting, right? And so I would agree when we were going through the GFC, I think things were pretty high flying in 2007. Maybe there were a few people that saw the writing on the wall, but largely, it was good times in the market. Same thing, kind of 1999. Sure, some people were sounding the alarm bells, but by and large, it was kind of good times in the market and in the media's representation of it, certainly. Today, I'm looking at a magazine right here that says, commercial real estate is getting scary, is the headline on Bloomberg Business Week. And this is not an outlier. It's everywhere. And so my question to you is, is there some way that the fact that this is so widely known, widely expected to be a major problem, is there some potential upside to that in that it's not a total surprise, this crisis coming to bite real estate in the broader economy?

Dags Chen: That is a great question. And to your point, it's a great example. We've all heard that adage that we should buy, investors should buy when there's" blood in the streets." Well, arguably from an office standpoint, there's a lot of blood in the streets. But there is a lot of hesitation right now, as there should be. It is difficult to buy during these times where uncertainty is so elevated. It may feel, in some instances, that people will never return to the office, but we understand that we have offices for a reason. Here we are. We're doing this podcast from an office. We could have done it from our homes over Zoom or Teams or whatever. But we're here because, and we all recognize this, being in an office together offers many benefits, a lot of which are difficult to quantify. That said, it's very easy to beat on office right now. And I oftentimes have to remind myself in the midst of quoting or identifying the scale in the scope of the problem, to not forget that this is also a great opportunity. The sentiment is certainly turned against this property sector. And we all know. We've seen it. It happens almost every time. When sentiment is so dark and so patently against something, there is opportunity because people aren't taking time to understand the nuances. We are. We're digging in deep. What are the properties? What are the precise locations that we think are going to do well, that are going to offer those opportunities to create that next generation office space experience that tenants are going to demand and are willing to pay a premium for? That's something that tends to get overlooked in the discussion, is that tenants have a proclivity to really spend up for space that they want to be in. And perhaps that's because they're spending less overall on space, but they think of office no longer as necessarily just an area for people to get work done in, but they see it as a means to foster collaboration for talent retention, to help with culture building within their firm. So there's a lot of points that we can spotlight that are going to be good for office and office investors. You do have to be very careful in this environment. But people, both buyers, sellers, lenders, they understand that right now. And this is why we think you could obtain significant discounts that could not be available in a short period of time. We understand that the capital market trends and space fundamentals, those don't necessarily follow the same cyclical timing. So if you understand the difference, if you understand perhaps there's an opportunity that's within the capital markets as opposed to the space markets, and you could take advantage of that, sufficiently de- risked, then that's certainly a window that we're looking to transact in. But there's going to be the need for a lot of selectivity, A lot of caution right now,. And part of what I'm tasked with and I think about day to day is, how do we identify those spots, those precise locations? There's a reason for office distress at this point. And I would say by and large, you don't necessarily want to buy just simply distressed office, but office in the right locations attracting the right tenancy, certainly we're very interested in that.

Greg Campion: I think you've just managed to do it. You've managed to end this podcast on a note of optimism, albeit cautious optimism. So in a space that's very challenged right now, I think you give some reason to believe that there is reason for optimism. So I appreciate that. I know that you and the team are putting pen to paper all the time on these topics. And so we'll link to some of your latest pieces, and I would encourage everyone to go to barings. com to see Dags and team, all the research that they put out. But Dags, this has been great. Thanks for giving us a window into this market that is so very topical right now. And we'll look forward to getting you back on the podcast again soon.

Dags Chen: Thank you, Greg. It's been a great discussion.

Greg Campion: Thanks for listening to episode number 10 of season eight of Streaming Income. If you'd like to stay up to date on our latest thoughts on asset classes ranging from high yield and private credit to real estate and emerging markets, make sure to follow us and leave a review on your favorite podcast platform. We're on Apple Podcasts, Spotify, YouTube, and more. We publish a new episode every other week, and if you have specific feedback, you can email us @ podcastatbarings. com. That's podcast P- A- R- I-N_G- S. com. Thanks again for listening and see you next time.