BiggerNews November: Was The “Office Apocalypse” All Hype?

David:
This is the BiggerPockets Podcast show 682.

Kevin:
So there’s this cowork… I mean, the world more calls it flex office and I think that’s more the appropriate term because when you hear coworking, you think more of the hot desk version of WeWork. But flex office is actually a subtype of office that’s tracked as a subtype of office in places like the UK for a long time, for the last 20 years now. Actually, started in 2003, I think Cushman & Wakefield started tracking flex office as actually property type.

David:
What’s going on everyone? This is David Greene, your host of the BiggerPockets Real Estate Podcast here today with one of my favorite co-host, the Amazing Data Deli, Dave Meyer with another bigger news episode. Dave, how are you today?

Dave:
I’m all right, man. I was actually kind of sick, but I was so excited to have this conversation that I rallied to talk about this very important topic and get a chance to hang out with everyone here.

David:
It’s one of the things I love about you is I too have been rallying after BP Con. I’ve been pretty sick, but-

Dave:
Really?

David:
… the show must go on. Oh yeah.

Dave:
At BP we’ve been talking about there’s like a BP flu going around, like everyone, right? It’s just a hangover for sure.

David:
It hit me very hard.

Dave:
It was a lot. It’s intense and it was super fun, but it’s a pull forward on all of your energy and I was just feeling drained for a few days after.

David:
And I don’t sleep well if I’m out of town. So I was getting maybe three, four hours of sleep at night. And then you combine that with the traveling in the airports, all the hands you’re shaking, all the hugs and the pictures you’re taking, it was a recipe for getting sick. But still, if I had to go back, I’ll do it again.

Dave:
I’ll do it again next week.

David:
There you go. Well, you’re in Amsterdam, you know how to party. This is not going to scare you. Speaking of parties, on today’s show we interview a very impressive guest, Kevin Fagan, one of the senior analysts at Moody’s Analytics who loves commercial real estate and also has a background in architecture. So he’s coming from a very well rounded position.
Why should we be listening to this, you ask? Well, commercial real estate is one of the juggernauts in the space of the overall impact that real estate has. And this space is changing. Much like residential real estate had the entire analysis of these properties change when short term rentals started to take effect and as medium term rentals become more popular, we’re seeing that changing how properties are valued, the same is true of commercial space. The industry is changing in. We want to be ahead of how those changes come. It’s always better to know where you’re going to get there first than to see what everybody else did and try to play catch up.
So today’s episode is very fascinating. We have a pretty impressive guest. Dave, I got to say, I thought this was one of your better performances. What exactly were you doing that allowed you to come up with such good questions?

Dave:
I don’t know man. It’s just when someone starts talking data, I just get laser-focused in on what they’re talking about and I like to follow it. But thank you, I appreciate that. But honestly like you said, I don’t really invest in office space. I mean, I don’t at all. I do own a couple REITs in the space, but I own residential real estate. But I still really like this topic because I think what’s going on in the corporate world and what’s going on in office space has driven a lot of changes in the economy as a whole, and subsequently, residential real estate, right? When work from home really started taking over during the pandemic, people started moving to the suburbs and we started seeing residential homes grow faster in the suburbs than in urban landfill, which was a totally big change from what had been happening post great recession. We saw the cities grow a lot faster than the suburbs.
Sort of my assumption going into this conversation was like, that’s going to continue. But I think Kevin shared some really interesting data and insights about what’s happening in the office space. And if you’re interested in office investing, it’s going to be super interesting. You’ll really love this. But even if you’re a residential investor like me, and I think David you’re primarily only a residential, you learn a lot about this that can really inform your investing strategy that you’ll think you’ll get a lot of nuggets from this.

David:
Yeah, that’s exactly right. I don’t like the investing approach that says, “Let me just see what else everyone else is doing and copy it.” That’s lazy and you end up losing money because usually by the time that you hear about the latest trend, everybody else has already run it up, right?

Dave:
True.

David:
The better way to invest is, where are things going? How can I see where it’s going to evolve and how can I get ahead of that? Imagine if you were one of the very first people to get into the short term rental space. You crushed that, you made a ton of money, you have this amazing list of reviews on Airbnb. It’s very hard for someone coming in like me now to catch up with somebody who got into this 10 years ago. The same is true of all real estate. And so I’m excited for how things are evolving in the commercial space and we’re going to talk about that.
But before we do, today’s quick tip is, as we’re wrapping up an interesting year in real estate, 2023 is new territory for sure. Inflation as well as days on market and interest rates are all up. Make sure you’re tuning in weekly to hear the stories and the tactics that we are working on right now to keep you informed. We love that you are listening to all of our content. We want to prime you for where you can make the biggest impact. And that is staying real time with what is happening here on this podcast and On the Market podcast as well. I’ve said it before, I will say it again. Real estate is evolving at a faster pace than it ever has before, which means you need information more than you ever needed it before. We are committed to bringing it to you. So make sure you prioritize that. Dave, any last words before we bring in Kevin?

Dave:
I’ll just say I love that point because honestly, I like when it’s kind of the situation where everything’s changing quickly. Because if you are informed, you have a big advantage. And so I like being informed and I like that other people are not going to spend the time or dedicate themselves to understanding the market and how to take advantage of it. It’s more for me and you, man. It’s more for everyone who’s listening and staying informed. So I love that quick tip.

David:
Change is bad for the lazy and change is good for the prepared.

Dave:
Exactly.

David:
All right, let’s bring in Kevin.
Welcome Kevin Fagan to the BiggerPockets Podcast. Kevin has quite the impressive resume here. He’s a senior director and head of CRE economic analysis at Moody’s Analytics. He has degrees from the University of Texas in… What did you get your major in there, Kevin?

Kevin:
Architectural Engineering.

David:
Architectural Engineering. You’ve worked in that field for a while and actually designed buildings in California, is that right?

Kevin:
That’s right, yep. About a decade of that.

David:
A decade of that and then you said, “Okay, I’ve had enough of this. I’m going to own my own real estate.” And you built a portfolio. So can you give us a brief rundown of what makes up your portfolio today?

Kevin:
Well it’s relatively small. It’s kind of more of a side thing. But we have hotel, some Airbnbs, multifamily, mobile home parks, and might be branching out in some other stuff soon.

David:
Yeah, that doesn’t sound small at all, but thank you for being humble. So you’re here to talk with us today about commercial real estate and office space in particular. Dave Meyer, you got to be freaking out over there with giddiness. How are you feeling right now?

Dave:
I’m excited. I love talking about commercial real estate. I feel like in BiggerPockets in general, we talk a lot about commercial real estate in the context of large multifamily investments. Sometimes a lot of our listeners are interested in self storage, but honestly we don’t talk a lot about office or retail or industrial real estate and it’s this whole other side of the real estate investing world that I personally think our listeners should know about. And so we’re super excited to have you on here today, Kevin.

Kevin:
Happy to be here.

Dave:
Great. I think it would help if you could tell us a little bit about just the state of play for office. What has been going on since the pandemic? Everyone knows that work from home sort of shook up the corporate world a little bit. So can you just give us some background on what’s happened over the last few years?

Kevin:
Yeah, sure, happy to. Yeah, I think the office market is really where most of the attention has been out of all the different property types. I mean, through the pandemic, the ones that got hit the hardest were office. I mean, excuse me, retail and hotel. That story kind of got played out pretty quickly because you just knew that retail was going to come back, and it did. Actually, it came back very nicely outside of malls anyway. It came back very nicely with retail sales rebounding. Hotel is now the highest ADRs, average daily rates we’ve seen historically ever right now on average nationally for hotels.
And so that’s more of a kind of typical situation going on there. The mall conversation is a secular change, but generally that’s just typical real estate. But for office now we have this either assumed or big concern about a secular change. Like, how do we analyze this asset class might actually be completely different going forward than it was. Real estate has always a story kind of asset class. So you get guys that have been in the industry for 40, 50 years and “This is how I’ve always done it.” Now this is a real change where you might have to think about it differently.
So I sat most of the pandemic on the rating agency side of Moody’s. My role there was a kind of head of CRE research. So everything that we rate that touches real estate banks and REITs and CMBS, what do we do for things where office is backing that? Because all you’re really worried about on the credit side is what’s the worst case scenario?
And so I mean we rolled up our sleeves and did hundreds and hundreds of different articles, studies, discussions with different players in the space like real corporate tenant consultants, and really found that the story is way more nuanced than office is dead. I mean, those headlines you kept seeing as like, “Will people want to go back to the office?” Blah, blah, blah. Dah, dah, dah. It’s a very complicated story and remote working is 40 years old back with IBM in 1983 and the government actually doing a lot of telework plans over the last few decades. It’s not a new story. We really found that it’s very nuanced how remote working actually translates into more or less office demand.
The ideal state of things is not full remote working for all kinds of very obvious reasons and some less obvious, but bottom line is that we did not see a mass exodus of all corporate office tenants out of office during the pandemic, and we don’t expect that to happen going forward either. The data has really not continued to show that that’s not the case. If you look at it the last three or four cycles, this has actually been one of the most benign cycles for the office sector despite all of this worry right now. So we’re watching it in a bunch of different ways, but bottom line is that the apocalypse has not arrived yet but we have a ton of ways to watch and see if it’s on its way.

Dave:
You said this is one of the most benign times in office space. Is that compared to 2008? One of my first jobs at real estate was cold calling offices and trying to get them to sign new leases with a… I worked for a tenant rep agency. Vacancy rates back, this was back in 2009, were insane back then it was like 30% in downtown Denver, higher in some places in Denver. Are vacancy rates that high now or how do they compare to the last downturn?

Kevin:
Yeah, so sticking to occupancies vacancy rates, right now office vacancy rates average nationally, the occupancy rate is about 82%-ish. So vacancy rate, we just hit 18.5 this last quarter. It’s been that low before. Occupancy rate was 82 in the worst of the financial crisis. It was 83 in the worst of the tech boom bust. And then in the early ’90s it was about 81%. But kind of peak-to-trough, we only saw about a 2% decline in occupancy rates this time. The last time it was a 5% decline. The time before that was 9. The time before that it was 12. So we saw these big kind of busts before. We didn’t really see it this time. It was already relatively low coming off the financial crisis and it didn’t drop dramatically.
A lot of sub-leasing going on which is somewhat new. But sub-leasing means that somebody is actually taking the sublease and there is actually a lease on the property. My point is that we just really didn’t see that dramatic kind of very procyclical behavior of the office market that we do in other. Because basically, because of remote working, companies were able to stay going. They didn’t have to do the same kind of layoffs that they did in prior crises. And so they kept the lease, maybe they did a sublease but they still kept the lease. So just in general, that bust that happened over the last couple years did not cause a bust in the office market like it typically does.

Dave:
And is the same thing true with pricing? Generally in terms of leases, are they still pretty stable from where they were prior to the pandemic?

Kevin:
Yeah. So effective rents, effective means basically just taking into account concessions and tenant improvement packages that tenants will typically get to move into a space. So effective rents decline just shy of 2% this time, 12% in the GFC, the global financial crisis, and then 27% in the tech bust. So again, just a relatively minor adjustment in rent. And we’ve seen in many markets now particularly the Sunbelt where we’ve seen office rents have been right now there’s this big dispersion of office rents going on where definitely laggard markets like New York and San Francisco but then a lot of markets in Florida and again the Sunbelt Southeast. In Phoenix, we’re seeing rents actually do quite well. Really nice rent growth for office in those markets. So that doesn’t tend to fortend an apocalypse.

Dave:
Yeah that’s super interesting. I mean, I do see a lot of headlines that sort of look apocalyptic. Obviously you’ve mentioned a few things that have kept office in a pretty solid state over the last couple of years. What is your, generally speaking, outlook for office over the next few years? Because we’re either in a recession or close to one or potentially facing one. Do you think that’s going to change the dynamics of office going forward?

Kevin:
Yeah, our baseline scenario on all our forecasts right now, don’t assume a recession right now. We’re getting close to that. I think our recession likelihood, our Moody’s house view is about 65% right now. I think when it hits 66 or 67% is when we’re officially baking in a recession in the baseline scenario. But at any rate, on our baseline we just have a very slow recovery for office to come back to where it was pre pandemic around 2024, 2025. And that’s based on a lot of different assumptions about office that I’ll mention in a second here.
But in the downside, we’re now taking a different approach where we say, “Okay, in a downside scenario where you do hit a recession, companies go into cost cutting mode. They need to figure out a way to make some savings.” One important point I’ll bring up right now is that office costs, your cost of your real estate as a corporate tenant, on average it’s somewhere around 4% of your gross revenue of your company. So compared to other expenses like your human capital, are 4, 5, 6, 7 times of that. That’s where all your expenses are and you have to make sure you manage that first and all of your thoughts about expenses really need to be focused on that.
So you hear a lot of CEOs and some CFOs have famously come out and said, “We’re going to slash our office space” and then had to retract that later when they realize they’re getting basis points of savings but don’t really know necessarily how they’re going to implement that, and it might come at the cost of their human capital and their ability to retain people. Interestingly for tech companies, it’s even smaller of a percentage of their revenue, their real estate. So you see Google and Facebook and companies like that opening up new offices in New York despite all of this talk about office not being necessary because they know their people want to be in those high amenity cool markets. Again, New York is still one of those. Maybe new San Francisco’s a different story these days, but the point is that real estate is expensive but it’s not your biggest expense. So your savings might come at the cost of other things that are a big deal to you. And that’s one of the reasons why we don’t foresee an immediate exodus out of the office.
So anyway, in our downside scenario we assume when you go into those cost cutting mode where you have to get some savings somewhere, you now have precedent in a triage situation where you got to cut costs to survive. You could just have everybody work from home for a little while, while you ride out a downturn, so if you’ve got a lease expiring. Only about 10% of leases expire every year overall. That role is actually pretty slow. The average lease term is nine, 10 years for office. So as that churn comes through through a downturn, we’d expect that churn to be higher and the downturn going forward. So in future down cycles, we expect more downside volatility for office so you can get dips that are much bigger than what we just saw now. So yeah, basically we have a slow recovery with a more intense downside scenario to answer your question shortly.

Dave:
It’s interesting because you had cited some other data about other downturns and it seemed like this 80 to 82% occupancy was the largest sort of like a basement you could say for how low occupancy going. How low do you think the further downside risk could be?

Kevin:
Right now it seems like it might be nominal but at least another full point of vacancy rate, which sounds nominal but it’s actually not. It’s actually quite a bit. And then there’s a big variance there too. The quality of your office can matter quite a bit. So if you have a high amenity building with good access to transportation, it’s a mission critical headquarters for a company, you’re just in a better position than other offices that just don’t have any of what I just described. So we’re starting to see what’s a lot of people in the market, conventional wisdom is that there’s going to be this separation of the Kurds from the way. There’s going to be a bar belling going on. We’re just starting to see a little bit of that when we just objectively look at the data and it makes sense that that would be happening where some of these offices might see some pretty big value to climb where others basically are fine.

Dave:
Yeah, I totally resonate with what you’re saying about the office and being sort of important to almost the identity of a lot of these companies, right? Google has formed their identity. A lot of people talk about like your hiring brand, like about having cool offices. Google’s an enormous company and they’re probably looking past a short term recession and want to maintain that brand and be able to attract really good talent. There are probably, to your point, some other companies where that’s not as important and working remote is more accepted or not as important to their hiring practices. So it’ll be super interesting to see what happens.
I asked you this before we jumped on, but one of the narratives I’ve heard a lot about a potential increase in the unemployment rate. Because right now we’re seeing a lot of the standard markings of recession but the one thing we haven’t seen is an increase in the unemployment rate and a lot of people think that will happen. And if that does happen, do you think that change in the power dynamics of the labor market where employers now have more power over the workers, they’ll start calling more people back to the office and sort of lay down the law? Or do you think we’re sort of entrenched in the amount of days work from home in the economy for now?

Kevin:
For sure some companies are already laying down the law as you say. I mean Citibank and Goldman had people back in the office frequently last year. This fall is very interesting because this is really the first official time that there’s no excuses. We had Omicron and then we had the summer. Nobody wants to work in the summer, so you just let that policy of being able to work from anywhere kind of keep going through the summer and now in the fall we’re seeing the C-suites are calling the people back.
We’re seeing a lot of anchor day strategies where you know have to be there on Tuesday but then you get to pick one other day. Some people are picking to be in the office more. That’s the other thing. Not everybody wants to be at home with their family or their kids or maybe they have a small apartment, but there’s a lot of motivated factors for either being in the office or being at home. We’re starting to see that change this fall. So I’m very excited to see how this starts to play out. And new leases if they get signed, what new floor plates look like.
Yeah, and so the power dynamic is definitely already shifting. And you’re right, as layoffs start happening, which look, per Crunchbase, we had 42,000 tech workers already getting laid off in this last quarter. Some other announcements are actually Meta/Facebook, they started taking down a lot more space in New York but now they’re planning to close one of their office as they’re expecting more layoffs coming. Same thing with Goldman and some other companies announcing some layoffs. So yeah, I think there’s some bargaining power on behalf of the tenants or the corporate tenants and their ability to get people back in the office.
But one important part about this is, you see the Castle data sided all the time, the security card swipe company that’s been posting the work utilization rates were Texas is in the 60% utilization rate now and New York has been climbing its way up from the 20% finally up into 45, 50% now. People want to correlate that utilization rate to vacancy rate. I’ve seen that happen in many, many studies now and there’s just no indication that that’s really going to be the case. So if everybody’s coming in on a Tuesday anchor day and that’s your strategy, how are you going to cut space? You really have to have a dynamic hoteling desk kind of situation and then add new collaborative space in order to actually make that vacancy rate match that utilization rate.

Dave:
Just to be clear, so what you’re saying is people are looking at data that shows how frequently someone goes into the office and how used, like you said, utilization rate, how used an office is and trying to say like, “Oh people are going to the office less. So that must mean that office space is going to see an uptick in vacancy.” But you’re saying those two things are not actually correlated?

Kevin:
It could be or it couldn’t be. We don’t even really know the degree to which it will happen yet. So let’s just say that you have a 50% utilization rate. Are you going to sign for 50% less space? I mean, the answer is probably no. We’ve been talking to consultancy companies that advice corporate tenants on how much space they should take down per employee, what their fuller plates should look like. And they’re definitely evolving right now.
There’s studies about how important collisions among your people are so that you get… Some people say, “Hey, I’m more productive at home. Why don’t we just all work from home?” The reality is the aggregate productivity of your workforce is what you really care about and you need your people running into each other to network. I mean, if you’re just starting an industry and you have no network and you have no mentorship, it’s not super easy to do that over Zoom, if not impossible. And that’s important for companies. Collaboration really is way more important. I think people kind of want to write it off sometimes, but it’s very important. Every day people aren’t in the office, they run into other people dramatically less. So the advice now is to have more spaces like libraries or bigger kitchens, just more [inaudible 00:25:55] space. Basically any way you can get your people to run into each other more, you need to have that more space.
So maybe you have less private offices but you have to take down more space on that side. So how this utilization rate actually translates into how much space you lease as a tenant is not clear yet at all and it’s not clear that it’s going to be dramatically less.

Dave:
All right, well thank you. This has been really helpful because I want for our audience to understand the state of play for office because not everyone is as familiar with office as they are with residential real estate. It sounds like things didn’t go as badly during the pandemic as the media has portrayed. It did go down, but not super dramatically. You do see additional downside risk but you don’t see the bottom really falling out. So I’d love to turn the conversation and I know most of your clients at Moody’s are institutional investors, but I’d love for you to just tell us a little bit about what are the opportunities that you see for investors in the office space going forward?

Kevin:
Yeah, well I mean the most obvious one is the topic that we’ve written about and the Fed has written about recently as well is the conversion of office space into housing. That’s certainly a viable way to get more housing. We’re in areas that need more housing. But there hasn’t been enough decline in value of offices. Actually the decline has been negligible almost. The capital markets can… Even though the volume is down on purchasing offices, there hasn’t been a lot that have been sold at big discounts yet.
But at any rate, if they do start, if on the edges, on the fringes, if you start to see some of these offices that might be an obsolete from an amenity standpoint, they’re just not the right floor plate size but they happen to be the right floor plate size for apartments, you’ve got that kind of 26 to 28 foot floor depth or whatever on either side of a mechanical well, then you might actually be able to profitably convert that into multifamily. Those are probably opportunities out there for scrappy investors. I don’t see it being widespread. The numbers just don’t work out.
For example, we track about 1,100 properties in New York, office properties in New York. Of those, we did a rough justice analysis. All this real estate analysis is very idiosyncratic to the asset itself, and I’ll get into that in a second. But just doing rough justice, we only found about 35 of those 1,100 that were suitable-

Dave:
35?

Kevin:
… for conversion into multifamily at a profitable.

Dave:
What?

Kevin:
Yeah.

Dave:
Wow.

Kevin:
Well they have to have the value of those offices be low enough, the rent has to be low enough, the vacancy hit needs to be pretty high because you got to kick out a lot of tenants or pay them out. And then the floor plate has to be the right size. And that’s not typical. You have much deeper floor plates in office than you do in multifamily. But look, that’s just the ones that we track and we made some rough justice assumptions.
Now, but let’s say that you find yourself an office building that doesn’t have great amenities, it’s floor plates are a little too small and you’re in an area that is a high rent multifamily kind of area. A kind of dumb example that just came to me right now is not too far away from me right here is the Woolworth Building. The Woolworth Building was the tallest building in the world in 1913.

Dave:
It’s 12 stories.

Kevin:
No, it’s about 30 something stories but it’s got a very narrow tower. And so a developer came in I think in 2014-ish and bought that tower for something like $100 million and now the penthouse is for sale for $100 million, so not forget about all the other apartments they were able to convert. But the point is that you had an obsolete floor plate in a high rent, high value as multifamily or condo kind of area. You probably will be able to find some opportunities like that for these kind of smaller office buildings of which there’s a good number of.
So I don’t see it being a big wave of conversions from… A lot of people have described this sort of dystopia where there’s no offices anymore. It’s very kind of 50 years down the line kind of thinking about the change of the urban fabric. But office, there’s still all kinds of what we call a conglomeration benefits for offices to be in dense areas. So I don’t see it being a wave of conversions but definitely on the fringes there’s going to be some good opportunities for obsolete offices as a new use, probably multifamily.

David:
Well if I’m hearing you right, part of your analysis in which of these properties would be best to convert was, are they not being used correctly now when you were going over vacancy. And was that my understanding?

Kevin:
Yeah. The what we call the highest and best use in the real estate world, not the highest and best use anymore. Yep.

David:
So it almost has to sink to a certain level before the conversion makes financial sense. This is more of a backup plan like, “Okay, we can’t make it work as commercial office space. People are moving to different areas. They’re working from home. Something has affected this industry so much, we’re going to convert to residential.” So even though only 35 of them qualified now in this hypothetical worst case scenario, if the market continues to trend downward, more than 35 would’ve been eligible, right?

Kevin:
Yeah. And there’s so many. There’s such a confluence of factors here because we were making assumptions around conversion costs. And when we were making those assumptions, we were still in a pretty high inflationary environment. A lot of construction had to slow down, some projects got put on hold because raw materials were either inaccessible because of supply chain issues, or if they were accessible they were much more expensive than planned, right? Commercial real estate lenders are pretty much putting their brakes on construction lending right now because there’s a lot of Fed CCAR scenario stress requirements where they have to hold too much capital to be able to do that kind of lending. Bottom line is there’s not a lot of construction going on right now because it’s expensive and also the lending is harder to get there right now. So there’s other factors, David, is what I guess I’m trying to say.

David:
Which is important to note because we would never just walk in right now and say, “Ah, it makes more sense to go residential than commercial.” Very few of them financially makes sense. But this is more of a discussion from, let’s say everybody just wants to start working from home and Simon Sinek becomes president and he starts telling every millennial like, “You should never work at a job unless it aligns with your core values” and everybody quits and we have this doomsday scenario. In that case, a lot of these factors would changed, which would make more sense.
It sounds like you’re also describing from a purely Adam Smith, the invisible hand capitalistic type approach where we know that the government doesn’t always work that way. They may come in and give grants to certain companies, they may give credits to them if they convert it to residential and make it low income housing.
So my question would be because I think a lot of the fear here is if I’m a commercial investor, this what if is hanging over people’s heads. And then the minute things start to trend downward, everybody skips 20 years into the worst case scenario and they says, “But what if we get to this point?” I think converting these into residential units is a very solid what if backup plan. That’s what we would do. In many cities, we don’t have enough residential real estate. So if you’re a commercial real estate investor or you’re considering jumping in, throwing your money into a project that someone else is running, are there certain cities that you think people should be avoiding because the population is declining so there’s not as much need for residential real estate? Real estate’s obviously local. What areas would you caution people to be looking towards and which areas would you say, “Hey, I’m much more bearish on this location”?

Kevin:
Well, I mean the migration in the country is pretty evident at this point, although there seems to be some counter migration happening into the Wisconsins of the world where climate change is making it more amenable to live in those kinds of areas. But obviously everything’s going towards the Sunbelt still. That’s the momentum. And so some of those markets might not have enough office space actually, so they might not really be the best examples of potential office to apartment to deal with migration issues.
I think potential landmines out there, and I don’t want to pick on San Francisco too much because there’s some countervailing forces that could cause it to have a nice comeback. But when crime starts to become such an issue that you start to get the 1970s and 1980s impression of urban areas versus today, I mean there are just high amenity, they’re safe, it’s easy to get around, it’s very convenient, lots of jobs available, there’s a lot of reasons why people live in dense areas that are positive, but whenever you start to get to the level of… Actually I can’t remember who just moved out. A big sport and good store just moved out of… There was a headline about it a day or two ago about they said that essentially San Francisco has devolved into chaos. And that’s a pretty striking thing for a large business to say and then actually pull all operations out of a city. Anecdotally, I think we all know somebody that lives in San Francisco or we went to San Francisco and got our car broken into.

David:
David lives there.

Kevin:
Yeah, exactly.

David:
Yeah, I’m very, very close to that area.

Kevin:
So I think when you start to have the breakdown of the benefits of living in urban areas, that’s not good for office or multifamily. And look, my thesis advisor from grad school is one of the kind of OGs of urban economics, his name’s Bill Wheaton. He’s revising his urban economic models for there to be less of a kind of demand to be in those areas and more of a demand to be in the little sister cities or pocket cities around there, or what we call excerpts. There’s a lot of debate on whether or not that’s going to happen. There’s some examples of it, like Hoboken is a good example around New York. It’s starting to be an up and coming desirable place for people. Good household formation there.
So I think maybe that’s a good point, is to say for [inaudible 00:36:52] on the opportunity side those excerpts around really in demand MSAs that have good household formation, that’s probably where you see your opportunities. And by the way, Hoboken will have old office buildings. So it has the anchor of New York, it has good household formation, it’s probably got some obsolete offices that can be converted into multifamily physically and maybe profitably too, because of that household formation you got higher demand for housing.

David:
I think it would be irresponsible not to mention that. So I live very close to San Francisco. We sell real estate in San Francisco and around it. It’s fascinating that as little as four or five years ago, I believe San Francisco had the cumulative most expensive residential real estate in the country. It had passed up Honolulu. It was almost impossible to get our clients anything in San Francisco. It just didn’t matter what they were willing to pay, someone would pay more. Basically, the COVID shutdowns alone stop that.
And then like you mentioned, the chaos that the city has devolved into, it went from being the top to one of the only cities that was losing value when everything around it was going up and it hit across the board. It was residential, it was commercial, it was multifamily. Then the city started making more restrictions on what people could and couldn’t do with their properties. Rent control became insane. I don’t know if anyone who doesn’t live there can understand how draconian some of those measures were that you could get a person in a house that would rent for $4,500 a month that would be paying $1,100 a month and was never going to leave. That just drove business away from that area. And it went from what was at one point the pinnacle creme de la creme of real estate into no one wants to touch it at this point.
I don’t want to just say it’s scary, but there are things that you could have noticed when the market was going up that would’ve been an indicator that this is shaky, this is volatile, this is not a solid foundation to build your house on, part of the pun. So I appreciate you bringing that up as an example because it’s not as simple as looking backwards at data and saying, “Well what happened? I’m going to just do that.” Because things, when they shift in, especially in the real estate space, they shift incredibly quickly.
So that’s why I’m asking questions about like, well what could we expect in the future? One of the areas that I feel real estate has evolved… Because even though real estate sounds just boring and dull and just it’s been the same as it always has been for 5,000 years, it actually evolves very significantly with architectural improvements and even technological improvements. I don’t think 10, 15, 20 years ago any of us were considering renting out a part of our home to a stranger.

Kevin:
Right.

David:
Just like with Uber, I was told as a kid, don’t get in cars with strangers. It’s now, people only get in cars with strangers, right? Things change pretty significantly. I don’t think that commercial space is immune from that same thing. It has worked a very specific way for a long time. But like you mentioned, Kevin, we’re seeing differences. When I see new buildings built, there’s much less cubicleness, individual office space. It’s much a very large common area with a kitchen, with seating. I mean a lot of the new buildings that I see almost look like a diner in a sense. They’ve got these little booths where people can sit with their laptop and eat and work and everyone kind of mingles. And then you’ve got a handful of very small offices that people go into and then big meeting rooms, they’re almost built like a movie theater style with seats that start low and they go up and a speaker can come in and talk to the big group.
That’s a very significant evolution in just the architectural structure of how we’re making buildings that reflects the difference in how business is being run. So if you’re a person who’s listening to this and you’re nervous about investing in commercial real estate because you’re just hearing the dooms day, “Oh everybody’s going to work from home. The tech industry is completely changing. We don’t need commercial space anymore.” Is there hope? Are there ways that you see that industry is going to continue to evolve to stay relevant in the modern day workforce demands?

Kevin:
I’m glad you brought up your last series of points there because it reminds me of something I believe is going to be a bit of a sea-change in office and maybe a good place to invest is coworking. So there’s this cowork… And the world more calls it flex office and I think that’s more the appropriate term, because when you hear coworking, you think more of the hot desk version of WeWork. But flex office is actually a subtype of office that’s tracked as a subtype of office in places like the UK for a long time, for the last 20 years now. Actually, started in 2003, I think Cushman & Wakefield started tracking flex office as actually property type because a lot of buildings, there have flex office in the building because it’s seen as an amenity for a bunch of reasons.
One, it’s just common area space that tenants can use. They can have guests come work out of there or maybe they have one of their people from another city, they can work there. As they expand and contract themselves, they can grow into that space if they need to until they decide they want to take down more space permanently somewhere else.
And so it’s just generally seen as additive to a building to have a curated flex office space in it. In the US, it has not at all only been WeWork that’s been growing, although you might have noticed WeWork had a bit of a hiccup there. But it hasn’t been WeWork only. There’s over 300 other co-working companies in the US. A lot of them are more these sort curated enterprise approach to it where they’ll work with the landlord and they’ll make a space that’s appropriate for the building. Maybe there’s a relationship with the tenants in the building. So like Apple actually, I was talking to some brokers and Apple actually demands that there’d be some co-working space in an office now, like at least a hundred desks for flexibility for them.
And so I think that coworking space is good because it’s doing what you just said. It’s very curated where they can change the space so that it’s suitable for whatever the use is that it is. So it’s very flexible. And it has just the amenities that you expect now. And so I think that that space is just going to continue to be a bigger and bigger part of offices as we go around. And that’s going to help hybrid as well by the way. So if you pop into an office and you need a place to be, maybe there’s a bunch of private offices upstairs, but hey, in the first five floors you can just reserve a desk. I mean, these companies, some of them are very small by the way. Like I said, I do think there’s some investment opportunities there in that space. There’s franchises and stuff.

Dave:
I’ve personally worked in a lot of those spaces over the course of the last 10 or 15 years, and like them. I think they actually work quite well for smaller companies and teams that need to get together less frequently.
This has been super helpful background, Kevin. For our audience, why should they consider office investing over residential or storage? What are the benefits to investing in office space that perhaps average retail investors like most of our audience might not be aware of?

Kevin:
Well just kind of stripping away all the discussion around the potential office apocalypse because of the hybrid working, one of the main reasons that office is attractive is because they’re long leases. And you can underwrite the tenant and you can get a tenant in there that’s there for 10… I mean, the average lease term at 30 Hudson Yards is 17 years.

Dave:
Wow.

Kevin:
I mean, you’re talking about some serious stability there. So larger tenants tend to come in and they want to have their costs be set, they don’t want to have to worry about that cost. They got too many other variable costs. And so that’s the benefit of office fundamentally, is that you have a long term lease, it’s professionally managed. You get a notification from the tenant 12 to 18 months ahead of time before their lease expires whether or not they’re going to do an extension or whatever.
So there’s a lot of stability in it traditionally. Obviously now that might be shifting a little bit. By the way, we haven’t seen lease terms start to get shorter. There’s been a lot of speculation around that. We haven’t really seen that happen yet. Lease terms are staying roughly as they are, but that’s the benefit of office. It’s a pretty well established asset class that you can have a pretty consistent expense controls, not having a lot of churn like you do in multifamily. Anybody that owns a multifamily property knows that the churn is your biggest problem. I mean, it’s very expensive and it’s a pain and there’s not really anything to do with it. You can’t get many people to sign five year leases or 10 year leases versus the typical one year lease. So yeah, that’s the fundamental reason.

Dave:
And what about price point? We’ve talked a lot about San Francisco and New York, which obviously have extremely expensive office space that’s probably prohibitive to anyone except institutional investors. Are the same opportunities available in small office spaces in smaller cities that could be more affordable and more feasible for people who are typically buying smaller residential real estate properties?

Kevin:
Yeah, I’ll try to find that one paper that we did about the opportunities for conversions, but typically the office market is more expensive for a square foot to a pretty substantial degree. I think the median in-

Dave:
Even investing in small office space, like if you live in a smaller city where it is feasible to buy like, I don’t know what the right size is, but let’s say 10,000 square feet of office space or 20,000 square feet of office space, do you think those smaller buildings still have the same prospects or is it really these big cities that have these really stable tenants that you’re talking about that will sign a 17 year lease that you’re talking about huge market cap companies here? Is that more of the benefit? Because I’m curious, do you see some of the same benefits if you’re leasing to a local doctor or lawyer or something like that? Is it the same kind of thinking?

Kevin:
Yeah, it is. So if you’re going to buy an office building, I mean the first thing you’ll do is look at the rent roll and you’ll see who’s in there and what’s your churn coming over the next five to 10 years. When are the lease expirations coming? That’s probably pretty much the most fundamental analysis.
So if you have somebody in there and you find out that maybe there’s three main tenants and it’s something like you described, it’s a lawyer office, an independent firm that’s been in business for a couple decades and got a couple decades more in them, that’s the kind of analysis you’re looking for. But if it’s something that just got built and has no tenants in it and now you’re thinking, “Okay, is it an infill sort of location to where it’s a high value from… Locationally, this is where people want to be versus where they live versus where they need services or whatever?” That’s the kind of smaller plays that you’re talking about. But the bigger ones, you’re really looking at the benefits of agglomeration, which are, “Are you in a cool market that has decent transport? Is it not cost that too much to get to your office relative to where people live? And is it kind of like an Austin where all these companies are starting to influx in there and then that’s the new hot tech market?”
So that’s the macro analysis if you’re going more of the big play and you’re trying to pull down the large corporate tenants or tech tenants. But in general, I think I was going to tell you the median apartment building in New York traded at $434 per square foot in 2021 in New York versus $542 for offices. So not that far off, but you do need a pretty big discount for those offices to come down to be convertible. But anyway, just offices are generally substantially more expensive per square foot.

Dave:
All right, great. Well thank you. We appreciate you coming on here, Kevin. Is there anything else you think our audience should know about the office or commercial space going into 2023?

Kevin:
Well, as I guess a real estate research nerd at this point, I’m very excited for the next year because we just have so many ways to see now what’s really going on with office versus the speculation. Is New York dead? Is office dead? And the kind of back and forth articles that we’ve been seeing for the last couple years. Now we can actually start seeing some real data as people come back into the office as and new floor plates get built. And we see we’re kind of right on the cusp of the real evolution of office right now. So I think keep your eyes open over the next year and let’s see how things play out.

David:
It’s fascinating. Office space is about to get exciting for the first time in a long time.

Kevin:
That’s right. Yep.

David:
Well thank you Kevin. We appreciate you being here and for sharing your wealth of information. What I love about somebody in your position is you’ve experienced real estate from several different perspectives. You were involved in the construction of it, you have college degrees and the background of it. You’re working in a position that I often refer to as the crow’s nest. You’re sort of up there at the top and you’re the first person to see changes happening in the market so you can yell down to everyone else the whole “Land, ho!” metaphor there. So thanks for sharing your information with us. Dave, I know you were saying something before I jumped in and cut you off, [inaudible 00:51:08] you finish that.

Dave:
No, I like your “Land, ho!” metaphor.

David:
All right. Thanks a lot Kevin. We appreciate your time.

Kevin:
All right. It was a pleasure, guys. I appreciate it.

David:
We’ll stay in touch.

Dave:
All right, so that was our interview with Kevin Fagan, who is again, the senior director and head of commercial real estate economic analysis at Moody Analytics. Boy, that is a mouthful and an impressive title, but man, guy really knows what he is talking about. He was just dropping knowledge about office space, bringing up stuff I didn’t even know to think about. What did you learn or take away from that conversation?

David:
Well, first off, that guy speaks your love language. His title, his background, everything he said, your eyes were like wide open the whole time.

Dave:
Yeah, you could see me dripping with jealousy at his title. It’s got so many words in it, it just sounds fancy.

David:
His syllable per word in his title, that would be a metric that Dave would start tracking. That’s amazing. This guy’s win above replacement is more than I’ve ever seen.
I think my favorite part of our conversation with Kevin was that he’s not just looking backwards at data that has already been there and saying, “Well, here’s what’s happened.” Everyone can do that, okay? There’s art and a science to every vocation. My personal opinion when it comes to data, the science approach is looking at what’s already happened and analyzing it. The art approach is in how you apply that information to what’s going to happen moving forward.
And I thought we got into some really good conversation about, like for instance, San Francisco real estate. It was at one point the creme de la creme, the king of real estate in the United States. And it fell very quickly. If you did it, if you just looked at the data looking backwards, you’d be like, “San Francisco’s the safest place to put your money at all.” But if you had the understanding of why it was so great and what was happening in that city politically, looking forward you would’ve said, “Oh no, no, that’s not where I want to put my money. I’d rather do it somewhere else” or, “These are the parts of San Francisco that I do want to put my money,” or “This is the strategy that will work, but these strategies won’t.”
So for instance, I think Salesforce had a huge building and a huge workforce operating in of San Francisco. And I believe they broke their lease or they were planning to, I don’t know if that actually happened, but it was a very significant thing happening in the commercial side of San Francisco. However, the residential side of San Francisco sort of kept moving without a huge blemish. The values are not increasing as much as they were, but commercially is being hit much harder than it is residential.
We got into a conversation with Kevin about, “Hey, creatively, if that were to happen, what would we do with the Salesforce building? What options do you have that are out there?” Which is what the good investors, they’re always thinking about what’s coming. What options do I have? How could I be creative? It’s less lazy than just saying, “Well, my spreadsheet said this is what I should get, so I’m just going to buy the building and trust that the spreadsheet’s going to work it out for me.”

Dave:
Totally. Yeah, I like those creative ideas. See, I’m going to wildly speculate here, but he was talking about office conversions in New York where cost of construction are super high. I asked a question sort of about small office spaces. When I first started working at BiggerPockets, we worked in probably, it was a two story, probably like 8,000, 10,000 square foot spot on an amazing area of Denver, definitely not the highest and best use of that spot. And I wonder, he is talking about these conversions of office towers that are hundred stories in New York. I’m curious about whether it would work in some of these smaller or tertiary cities that are booming right now. Could you find these 3, 4, 5 story buildings that maybe his analysis is not the same in those markets? Could you convert those? Because I don’t know. I get what he’s saying, but they just look so tempting. You drive by these places and you’re like, “That could be a cool house. That should be residential.”
And so, I don’t know. Maybe that will be the trend. I kind of hope so, because obviously in the US we need more residential and I think there could be cool ways to convert some of this office space.

David:
That’s a good example of how politics and real estate affect each other. It’s not as simple as just pure science, pure data, what does the spreadsheet say. If the political environment is inclined to change the zoning, all of these options that you just talked about become relevant, right? So calling your city, asking those questions, getting to know the people that are making those decisions, and understanding the political climate of where you are investing, right? If you understood San Francisco’s political climate, you would’ve avoided investing in commercial real estate there as you saw the trends of what was happening. Like he mentioned with the city turning into chaos, we’ve seen a lot of people fleeing New York recently, and that’s fueled the South Florida run up in prices. Those were actual political and macroeconomic factors that affected real estate.
So we’re never going to say, don’t look at numbers. Numbers are what make you money or lose your money, but it’s having a deeper understanding of what is affecting the numbers so that you can apply it and put the data on your side instead of working against you that matters. And that’s why you got to be listening to podcasts like this because it’ll change the way you think and it will give you the most recent data that will help you to work backwards and figure out what cause it to change.

Dave:
Well said, man. Well, yeah, I totally agree. I think what your point about zoning is particularly true. If you could find mixed use zoning where you can have some flexibility around that, that’s a really interesting thing to try and acquire and to hold onto. But yeah, I couldn’t agree more with trying to understand, not just politically, but you talk about infrastructure spending, just trends in your local market that can tell you what’s going on. If there are big corporations moving to your area like Austin, yeah, commercial’s going to be great. If those places are leaving but there’s still demand for housing, maybe it’s a good play for conversion. You have to just sort understand those local trends. And as David said, it’s a combination of looking at numbers and just staying informed, going to meetups, going to city council meetings and seeing what people are talking about. That’s like the unsexy but really beneficial thing that literally anyone can do to gain an advantage.

David:
And it’s part of being a real estate investor, right? It doesn’t get talked about when people are thinking about getting into real estate investing. They watch a 30 second ad on Instagram that someone tells them, “Hey, buy some [inaudible 00:57:29] in real estate. You never have to work again.” And no one ever explains it’s constantly evolving. This is an entire industry that you are getting familiar with, with a lot of nuance in it.

Dave:
Totally. How many real estate investors do you know that don’t work?

David:
That’s a great point, yeah. And how many do I know that have lost all of their money that were working? It’s very few. Almost all the people that lost money in real estate didn’t work and the people that are doing well do work. It’s just a different kind of work, right? So I’d much rather be doing this kind of work and having these conversations than sitting in line at an auto plant stamp and metal and pretending like I’m Eminem, hoping for my next big break in a rap battle. I think this is a better overall model.

Dave:
Totally. Yeah, I mean you’re working for yourself. You have some control. Yeah, I mean, personally I love the option to work, but people still do it. But yeah, it’s like that’s sort of-

David:
And the type of work you do.

Dave:
Exactly. Yeah. But it’s fun. Once you get into real estate, you get started and you get to look for these things. You look forward to those kinds of meetings, trying to find advantage, learning everything you can about a market. It sounds daunting, but it’s actually I think one of the more fun parts of being an investor.

David:
Absolutely. Well, thank you for joining me here, Dave. And if you were listening, thank you for that as well. Dave, where can people find out more about you/

Dave:
On Instagram or on BiggerPockets. On Instagram, I am @thedatadeli, or on BiggerPockets, just look for me. I write a lot of blog posts so you can find me there.

David:
You can find me on BiggerPockets as well. You could also check out my new website, davidgreene24.com. Check me out on all social media, @davidgreene24. Thanks a lot, Dave, appreciate you being here. We will have to do this again soon. This is David Greene for Dave “Land, Ho!” Meyer signing out.