Office Sector: Survive Until 2025
Green Street recently hosted a webinar with Scott Rechler, CEO and Chairman of RXR Realty (a large private investor/operator), as part of its Industry Leaders series. Mr. Rechler is a highly respected executive and provides thoughtful commentary on several important topics. The conversation primarily focused on his views/outlook for New York office fundamentals and capital markets.
A transcript of the discussion and replay are available on our website. Key takeaways:
- Rechler was forthcoming when speaking about the weak near-term prospects for the office sector given the uncertainty associated with remote work and a potential recession. That said, he remains positive on the long-term outlook for New York given the city’s diversified talent pool and status as the financial hub of the world.
- Rechler believes that hybrid work is here to stay and will have some minor negative impact on office demand; however, he noted that return to office mandates and rising office utilization are potential bright spots that suggest tenants still value the office as a crucial place to do business. While hotdesking gained headlines with Google’s recent announcement, Mr. Rechler does not see this gaining too much popularity. As such, he attributes most of the slowdown in office leasing activity to economic concerns rather than entrenched work from home trends.
- The uncertain economic climate and layoff waves have weighed on office demand recently and Mr. Rechler expects this to continue for some time. While this initially started last year in the tech sector, he noted that financial services may be the next industry to ease on office leasing activity given recent events in the banking sector. Overall, he thinks we’re in the early innings of a recession which will take time for the office sector to work its way through, though the sector should recover over time.
- While the sector is challenged, the tenant flight to quality is being reinforced by hybrid work trends, which has allowed higher quality assets to generate more than their fair share of leasing activity. That said, net effective rents for this product still remain pressured as large concession packages are being offered to induce tenancy.
- There is no price discovery in office capital markets creating a lack of clarity around where valuations are for office assets. However, Mr. Rechler was open in saying that valuations that existed before the rise in rates won’t be the same today given the new interest rate regime. He paralleled the current environment to the early ‘90s when the commercial real estate industry went through a valuation paradigm shift. This revaluation period saw a series of restructurings and workouts and Mr. Rechler fears the industry is at that same moment. Once the dust settles, he believes high-quality, well-located assets will revert back to a more normalized range.
- Debt financing continues to be very thin for office assets, and this is likely to be exacerbated by the recent issues that have recently unfolded in the banking sector. The financing environment is even challenging for fully leased office assets with long lease terms and credit tenants. The lenders that are relatively involved are existing lenders that realize they must participate in a refinancing and partner with the existing owners. Most other lenders are hesitant to provide capital given the significant uncertainty around office demand and where valuations will ultimately settle. In many instances, the swift rise in interest rates will result in a re-equitization of capital structures, an environment he thinks will play out through ’25.
- Office conversions have become a popular topic given the weak demand backdrop for office properties. That said, conversions are difficult in practice for several reasons. First, the starting basis for a conversion in New York likely needs to be in the $250/s.f. range (read: much lower New York office values would generally be needed) when a property is fully vacated to make sense from an economic perspective. The next issue is related to zoning, which is a problem today, but the city of New York seems to be willing to ease rules on this front. Third, not every office building has the physical characteristics that lends itself to a conversion. Buildings with smaller floor plates tend to be more conducive to office-to-residential conversions than those with larger floor plates.
- Sustainability is becoming increasingly important for the commercial real estate industry, particularly in New York where Local Law 97 is set to enforce fines on landlords for not meeting certain carbon emission thresholds. While the regulation has gained popularity amongst politicians, Mr. Rechler wouldn’t be surprised if there’s a relaxation of certain carbon emissions targets given limited alternative energy sources and an ambitious timeline. On the investor side of things, Mr. Rechler mentioned that certain institutions require a higher standard for sustainability.
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