Put simply, good investments follow popular opinion and appeal. The value of an asset usually depends on its popularity. If many people start liking something, it will tend to cost more. While this is the basic tenet of supply-and-demand economics, it has broader implications for office space.
There’s a realignment in the value and desire for office space that is following demographic trends. As workers migrate into secondary markets and away from big cities at a faster rate than in years prior, there will be a lack of supply to meet the demand. Therefore, office space in smaller cities should become more appealing to commercial real estate investors and the mortgage brokers who work with them. This is the story of the outpost economy.
The pandemic is accelerating a trend toward a more spread-out economy in which employees no longer need to be concentrated around major cities. The advantage has shifted to smaller cities that have lower costs and a high quality of life. Smaller regional hubs are taking shape and the office is being decentralized. Companies are opening smaller branches closer to where their workers or potential workers have moved.
The shift means that companies are expanding outward — in essence, they are chasing employees rather than employees moving closer to the big city in search of a career. Studies suggest that this trend started developing well before the pandemic struck in March 2020.
According to a Marcus & Millichap report from last year, numerous smaller markets were gaining population at much faster rates than the national average. For example, Austin and Orlando had five-year population gains between 2015 and 2019 of 13.5% and 11.7%, respectively, whereas the national average was 3%. So, the pandemic was not the root cause of this realignment, but it certainly has sped up the process.
Smaller regional hubs are taking shape and the office is being decentralized. Companies are opening smaller branches closer to where their workers or potential workers have moved.
Although considerable uncertainty remains in regard to office-space demand as companies formalize their work-from-home policies, it seems clear that some office assets will fare better than others in the immediate aftermath of the pandemic. Big-city office properties — and especially space in skyscrapers — will likely struggle longer with vacancies and reduced leasing activity, and thus will see values drop.
Meanwhile, smaller-city office properties should benefit from two general trends. First, with the emergence of COVID-19, more companies have been willing to allow their employees to live where they want. As a result of this new flexibility, people are moving away from big cities. Second, many companies still see value in the office in terms of creativity, community and collaboration, meaning that they are likely to buy or lease space in these smaller communities.
During the pandemic, office-market fundamentals have been hurt across the board, although assets in major cities such as New York, San Francisco, Chicago and Los Angeles have been hit particularly hard. In first-quarter 2021, the U.S. office vacancy rate hit 16.4%, up from 13% a year earlier, according to Cushman & Wakefield. CBRE economists noted last year, however, that the “largest, most dense office markets have been disproportionately impacted” and predicted that offices located in suburbs would recover faster than their central business district counterparts.
As the outpost economy continues to unfold, more office development in secondary markets should be expected. Real estate demand will reflect the oldest phrase in the book: “location, location, location.” But a favored location is likely to mean that the property is in a secondary market that has a high quality of life and a relatively low cost of living.
As the outpost economy takes shape, the shift in where people want and choose to work will become a defining factor in real estate evaluations.
According to an Upwork survey conducted in October 2020, some 14 million to 23 million Americans were planning to move as a result of their ability to work remotely. About 42% of people working from home were interested in moving more than four hours away from their current home while another 13% planned to move at least two hours away from their current home.
Thus, more than half of respondents were planning to move beyond daily or weekly commuting distances. This suggests that the shift is not simply one of people moving from big cities to nearby suburbs. Rather, people also are moving away from the suburbs of a big city.
Commercial mortgage brokers should keep this in mind when looking for clients. Office-property investors are still searching for healthy long-term assets. Although savvy investors won’t be in a panic to sell downtown office properties, others will tend to search for properties outside of the largest cities in the U.S.
It should be emphasized, however, that surveys suggest that the traditional office is far from dead. A global CBRE survey from September 2020 indicated that 81% of companies anticipated that their workforce would use an office, even if workers were given more options to work from home. Companies predicted that only 11% of their employees would be exclusively remote, while 39% were expected to be primarily office-based. Another 42% would form a so-called “distributed workforce,” splitting their time between the office and home. A separate 2020 CBRE survey of 10,000 employees found that 67% desired a balance of office and remote work as their preferred choice.
By comparing these findings with the Upwork survey, it can be assumed that a considerable number of people plan to return to the office in some capacity but have either already moved outside of major cities or are planning to move. This suggests that the demand for office space in these smaller markets will increase.
According to Marcus & Millichap, the pandemic will likely reverse an office-development trend that has lasted for more than a decade. Companies have preferred dense buildings located near public transportation, but Marcus & Millichap expects a new focus on lower-density space in smaller markets or suburban locations accessible by car.
More generally, given the migration into certain secondary cities, the Marcus & Millichap study noted that investment capital was chasing multifamily, industrial and office properties in these smaller markets long before the pandemic struck. In 2019, roughly 60% of transactions priced above $1 million were completed in smaller markets, compared with only 40% in the year 2000.
In a more dispersed economy, white-collar workers have the flexibility to work where they want. One option is to lower their personal expenses by moving to cities with a lower cost of living. Traditional blue-collar cities, such as Buffalo and St. Louis, may witness a renaissance and an influx of office workers there.
Cities can sell themselves as places that are revitalized and ready for a remote-centric workforce. If enough workers go to these cities, companies will begin to realize that the masses have spoken and they will want to establish offshoots of their main office in these new hubs. The result is that businesses will follow workers, which is a complete 180-degree shift from past generations.
As the outpost economy takes shape, the shift in where people want and choose to work will become a defining factor in real estate evaluations. There is still a considerable amount of uncertainty in how companies will adjust their work-from-home policies. Commercial real estate values across the country could fluctuate for some time (and considerably more than usual) until there is more certainty. Savvy investors who are heavily invested in office buildings in major cities should consider diversifying into properties in secondary markets where the growth is likely to come.
Remote work used to be an exception to the rule. And while many workers may continue to work exclusively from home, it’s likely that many companies will require their workers to come into the office for at least part of the week. Given the reality of the new outpost economy, this bodes well for office properties located in smaller cities and communities. ●