Peter Abramowitz, vice president for equity research at Jefferies LLC, says office REITs that invest in the right assets, position them well, and have the confidence of tenants that they are well-capitalized, will be winners in the current cycle.
Abramowitz says the ability of well-capitalized landlords with good assets to take market share from those that aren’t willing to invest is one of the more encouraging developments in the REIT office sector. “I hate to say that it’s a zero-sum game, but until we’ve gotten through an entire space rationalization cycle, it likely is.”
Broadly speaking, how do fundamentals in the office space look today?
Peter Abramowitz: Fundamentals are still challenging but getting better. Office landlords spent 2023 dealing with the challenge of both structural (less need for office space in the post-COVID world) and cyclical (hesitant tenant decision-making because of macro uncertainty) pressures on leasing demand. The structural pressures will remain; If you think of the typical office lease as eight to 10 years, we’re still only 4.5 years post the start of a transformational event in the office market.
So even as demand recovers from cyclical pressures, we are still only about halfway through the cycle of tenants needing to rationalize space from leases they signed before the pandemic. There will be some offset from obsolete buildings being demolished and taken out of service for alternative uses, but the overall pool of demand is still shrinking. The smart landlords know that and know it’s becoming a game of how you can position your buildings to capture market share.
Do you think we’ve plateaued in terms of office occupancy post pandemic, or could there be further adjustment ahead?
Abramowitz: I think we have plateaued. Readings of physical office occupancy have been stubbornly stuck around roughly 50% since early last year. The normalization of rates has given some leverage back to employers to call employees back into the office, but much of that has played out since early/mid-2022. There may be some pockets for improvement, specifically in the tech sector, but I think companies have largely set their WFH/hybrid policies. Hybrid is here to stay.
What sort of variation are you seeing between different segments of the office REIT segment?
Abramowitz: In terms of fundamentals, trophy space continues to be most sought after, and is the only segment of the market where rents are really growing. Occupancy is tight because there’s limited supply, and that will only become more true given that very limited new construction has broken ground in the last several years.
Landlords down market that are smart and know how to reposition assets are taking advantage by redeveloping and amenitizing non-trophy buildings to compete. They likely still have to give more concessions than in trophy/new construction buildings, but they can still get net effective rents in some cases that justify their investment.
Looking ahead, are there other themes or developments in the office space that you see playing an important role?
New industries aiding in the recovery. I think AI will be transformational, and San Francisco always has an ace in the hole in that it is best positioned to capture demand from new technologies that are highly impactful. I think that eventually will help the market recovery, but how long it will take is anyone’s guess.