June 10, 2024

Retail tactics to rebuild offices, part two: investor takeaways

This article is the second half of a two-part series from Director of Brokerage Neal Swanson exploring the changing landscape of office investments and why “tenant mix”—historically a retail investment strategy—should no longer be a term reserved for shopping centers.

In part one: creative activation, I shared some recent examples of office properties that have found new life through diversifying their tenant mix.

The five key takeaways at the end of this article offer cues from retail to help community-minded investors think through ways they can reposition office assets as active community participants.

But first, I want to offer some important context—because to fully grasp the significance of property activation, we have to understand why the pandemic has impacted office so disproportionately in the first place. Let’s dive in.

Silos and micro-communities

Office tenancy has evolved in an opposite direction from that of retail. Today’s office buildings have been optimized to meet the needs of a specific set of similar professional service providers (such as law firms and financial advisors) who have historically benefited from being physically near one another.

The benefits of grouping similar industries led to clusters of office buildings forming near transportation hubs to create what are known as “central business districts” in the downtowns of cities across the United States. With the introduction of air conditioning and steel construction, office spaces could be stacked on top of each other, and office skyscrapers were built to house an even greater concentration of similar services.

Office towers in central business districts were typically Class-A properties: well-constructed, well-located and brimming with professional service tenants that created stable net income for owners. They quickly became one of the strongest and safest investment classes.

This approach worked well for cities, tenants and owners for decades. But the pandemic revealed some of its unsustainable features and demonstrated that what’s great for investors isn’t always great for communities. Here are two deficiencies of the pre-2020 economy that are specific to the central business district model:

  1. Central business districts have confined micro-communities of professionals to the same physical space, even after the advent of the internet made this arrangement unnecessary. While some businesses have taken advantage of the opportunity to operate from remote campuses —Microsoft, for example, which famously moved its offices out of Seattle and into a suburb—many others have been content to stay in their trophy office buildings. As a result, institutional money has continued to favor these assets as relatively safe investments with strong returns, and property owners have continued the status quo of filling office spaces with homogenous office tenants.
  2. Central business districts have taken for granted that certain community resources will be provided by other types of property owners. Pre-COVID, a variety of ownerships ran services, businesses and restaurants that depended on the physical presence of professionals downtown—lunch and happy hour spots, markets and retail stores that thrive on professional foot traffic. And, assuming the presence of these services, professional services have stayed siloed in office-only structures, owned by office-only investors.

The sky is falling! (But not on everyone)

We’ve all seen headlines like these: Commercial foreclosures spike amid office market collapse, or: Empty office tower sells at near 90% discount. But some data points tell a different story.

For example, the newest office buildings with the best tenants in N.Y.C., Chicago and L.A. haven’t seen much of a dip in performance at all. At most, they’re experiencing a 10% change in vacancy or rent. Similarly, according to CompStak data, the largest law firms, financial advisors and other professional service firms continue to lease and renew office space at nearly pre-pandemic rates.

Even here in Portland, for every office asset we see in foreclosure (or up for auction), plenty of others seem to be doing just fine. This seems contradictory, but the explanation is simple: Even though offices have been devoid of people-traffic since 2020, the institutional money behind many of these big trophy assets is enjoying relative stability.

In other words, the tenants are still paying rent, but the actual people have left. And since the people have left, the businesses that surrounded our city’s office buildings—many of which are locally owned—have suffered tremendous losses or closed altogether. 

What makes a property an asset?

An office building’s financial performance doesn’t tell us much about whether it’s performing in other measures—most notably, is it an asset to the community, or is it a detriment? While these properties still contribute heavily to a city’s tax base through property taxes, that’s only one piece of the pie that makes for a vibrant community.

A trophy office might be leased by the best firms and advisors, and at the same time be surrounded by closed-up small businesses. Grouped-together properties that are performing financially may only be performing for themselves; not active, alive, or contributing to solutions in any way, and no longer an asset to their community for any reason other than tax revenue.

All of this begs some hard questions for property owners. Because buildings aren’t the true actors here—you are.

5 tenant mix takeaways for office owners

If you want to develop the assets in your portfolio into truly valuable assets for your community, consider the strategies below. (They’re based on the examples I shared in part one, so if you haven’t read those stories, please do that first.)

  1. Think long-term. Due to lending restrictions, not all owners have equal flexibility when it comes to offering reduced rent to attract good tenants. But even those who do have this freedom might worry they can’t afford it. Consider that a dip in overall revenue may be temporary. In the case of the ground-floor gym tenant, this owner now has a quality gym to offer as an asset to those who work within the building, which means they can charge more in the long run for renewals and new vacancies in the remainder of the building. That adds up to more than the rent reduction in just one space.
  2. Prioritize sustainable, whole-community interaction. Professional micro-communities provide some clear benefits to office tenants, but they also miss out on opportunities to engage the larger community. Physically bringing outsiders in—for example, to use gym space or visit a vet office—can increase the sustainability of your investment.
  3. Anticipate future challenges (and solve for them). The owner in Example 2 did their homework, and they correctly predicted the demand for a veterinarian in the community. This has resulted in financial success—even more quickly than they anticipated—for the practice, the surrounding community and the landlord.
  4. Consider evolving neighborhood dynamics. The same owner also understood that while leasing to another financial tenant would be a safe investment, the community’s needs had changed. Instead, they creatively sought out a tenant that would provide people and pet traffic to activate the property within the community, providing a valuable asset to the neighborhood that could last for many years.
  5. Expect “thinking outside the cubicle” to be messy—and worth it. Drawing up plans and getting city approval to convert offices for education zoning was a complicated and even risky process for Harrison Square’s owners. But the results of mixed office and school tenancy have been incredible.

Maintaining status quo is a pretty safe investment strategy… until it isn’t. The office market didn’t collapse out of nowhere; it was built on the assumption that we’re not all better together—that designing for one type of tenant is enough, and that communities don’t really need to function interdependently. The pandemic has shown us just how costly this assumption was. Investing meaningfully in a city—not just owning some of its square footage—requires more thoughtful consideration and sometimes more risk, but the returns, both tangible and intangible, can also be much more significant.

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