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The triple whammy for office real estate

Zoom into the “where we are” map on Automattic’s website, and you’ll search in vain for an “our headquarters” icon. The large but low-profile tech company behind WordPress and a host of other open source software has people working for it from Ghana to Greece, from San Diego to Seville. But its 2,031 staff, in 96 countries, all work remotely — and always have done.

Plenty of companies, since the start of the Covid-19 pandemic, have rethought their use of offices. Many now espouse “hybrid working”, with staff splitting their working lives between home and office, even if few have yet gone the whole hog and become what Automattic calls a wholly “distributed company”.

It is impossible to predict what the lasting legacy of Covid will be on working patterns, but few bosses would dispute that it will mean less time in headquarters buildings for most big company office workers.

Unfortunately for those who own office property, that seemingly inevitable decline in office demand is set to coincide with a looming downturn in the perennial cycle of commercial property — one that could feasibly prove sharper even than the seismic crash of 2007-8.

When the global financial crisis began to hit 15 years ago, the bubble in real estate assets was one of the biggest and one of the quickest to burst. Capital values in the London office market, a landmark global property sector, slumped by 25 per cent.

Property markets have long been notoriously cyclical but the upturn of recent years has been just as dramatic as that crash, thanks to persistently cheap financing and a desperate search for investment returns. Both factors were the result of ultra-low central bank rates, deployed first to fan the post-2008 recovery, then to stave off a catastrophic downturn when Covid was unleashed on the world.

But as night follows day, bust in real estate markets follows boom. And with the Federal Reserve, the Bank of England and the European Central Bank all now in tightening mode, real estate agents acknowledge the good times are over. It is only a question now of how bad it gets. CBRE last month spoke of a “marked slowdown everywhere” thanks to the speed of interest rate rises, which had “taken us all by surprise”. 

A third, ostensibly benign, force is at work too. Efforts by governments and the investment industry to boost the green credentials of large offices have cut the carbon footprints of the best newbuilds drastically. But for investors there is an unwelcome side-effect: large swaths of the world’s existing office space falls short of new greener standards thanks to brown energy, inefficient heating and lighting, bad insulation and poor provision for green commuting. Experts expect this category of property to lose the most value in the downturn.

How bad will it get? Interest rates are not generally expected to get close to the historic highs when the Fed funds rate, which sets the bar for US borrowers, was in the 10-20 per cent range. In the UK, even radical economists are only forecasting a rise to 7 per cent.

But optimists on the future of the office may be clinging to an unrealistically rosy scenario. They point, in particular, to a limited impact on office leases since Covid first hit two and half years ago.

That demand picture gives false hope: leases are typically long-term without easy break clauses, meaning that only now is an initial trickle of non-renewals turning into something more worrying. Three-quarters of New York leases, for example, have not come up for renewal in the past two and a half years, a recent SSRN study found.

Recent analysis suggests that thanks to the extent of overheating for the past decade, and the pressures now being felt, the outlook for the office real estate market is actually pretty bleak.

That SSRN paper concluded that the value of US office real estate could decline long-term by 28 per cent, or nearly $500bn. In Europe, Bank of America analysts recently warned of a 12 per cent likely decline in office values over 18 months, and major property groups, including Brookfield and BNP Paribas, have themselves signalled concern about a sharp sell-off (presumably with an eye on potential bargains).

This cycle, like any, will of course turn. And anecdotal evidence suggests that as well as ultra-green buildings, those in city centres, rather than business fringes, may fare best, as employers recognise the desire of workforces for human contact in a vibrant setting. Even Automattic’s “distributed” workforce meets up in person once a year — albeit not in an office.

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