In this podcast, Motley Fool host Deidre Woollard and senior analyst Matt Argersinger discuss:
- What downtowns might look like when they become more than just "containers for work."
- How different REITs are approaching the new commercial real estate landscape.
- The promise and problems of "15-minute cities."
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
This video was recorded on June 17, 2023.
Matt Argersinger: Cities don't have to be organized around the office anymore, they can be what else are known for. They can be their cultural centers, arts, education, entertainment, people just, you know, sometimes people just like to live closer to other people. I mean, there's a lot of reasons that cities can still thrive, but we always have to reimagine, almost reimagined them entirely.
Mary Long: I'm Mary Long and that's Motley Fool Senior Analyst Matt Argersinger. Deidre Woollard caught up with Matt to discuss creative ways to repurpose office space in a world where cities don't revolve around work. The shifting dynamics of the latest Sunbelt migration and the pivotal role that parking garages could play in revitalizing urban centers.
Deidre Woollard: Since the pandemic we've been watching with cities, kind of grapple with the nature of work. We've seen people spend less time in the office. We've looked at data that shows the amount of hybrid work. Maybe it's stabilized, but then I'm starting to see all of these reports about companies like Meta, Amazon, Alphabet, Redfin, a lot of them saying back to work in September or else. I heard this last year, is it going to be different this time?
Matt Argersinger: It's a good question. I think we should step back a bit and maybe use data to guide us a little bit as we try to answer these questions. But thanks for having me to talk about this, because I do think and will go into this, but I do think the future of city is really one of the defining, things of our time here. It kind of up there with climate change. It's just something that's going to change a lot and we need to figure out, and we need to figure out pretty rapidly. But talking about office and the whole work-from-home dynamic, if you look at the latest data from CoSstar, the US office vacancy rates, it hit a high of 12.9% in Q1. That's an all-time high, by the way, and it's the 6th straight quarter of increases. It was under 10% prior to the pandemic, but here we are at almost 13%. But you have to remember that's economic vacancy. That's just the amount of space that's not least. If you look at actual vacancy. Physical human occupancy, it's actually vacancies are lot higher. If you look at the Kastle System data, they have this great back to work barometer of data that they provide. It shows that office occupancy, physical occupancy of office buildings was just under 50% in their 10 City Index. They've got this index of 10 major cities.
Really it's less than half of these office buildings are occupied at any given time. In places like New York City, San Francisco, Washington DC, really big popular office markets, the average is closer to 40%. So we're seeing just not a lot of occupancy right now in office buildings, despite these headlines we're seeing about, hey, come back to the office, coming back at least three days a week, etc. The other thing too, is that this vacancy rate doesn't capture the the amount of space that tenants are actually making available for sublease. You have companies that are leasing space that are under long-term leases, but they've actually set aside a portion of their space to subleasing. Just as one example, it's estimated that 7.2% of San Francisco's office space, while it's least right now, it's available for sublease. I read an article in the San Francisco standard that says there's 3.5 million square feet of office from 13 companies in the city alone. Yes, major companies. You mentioned some Alphabet, Amazon, Meta, JPMorgans is the other one, they're urging mandating workers to comeback, at least on a part-time basis. I think it will have an effect, but I'm not sure it puts a dent and I don't know how you feel about this. It just doesn't feel like it's going to put a dent in this long-term structural secular movement that we have to a more distributed workforce. I just think the idea and we should get into this more. But the idea of kind of a centralized CBD headquarters or major office center, it feels like it's in the past and it became so in just a rapid fashion.
Deidre Woollard: Yeah. You mentioned San Francisco Salesforce is a great example of that in terms of sublease because they built this huge tower.
Matt Argersinger: I know, its one of the biggest skyscrapers in the country actually, just recently.
Deidre Woollard: Yeah, it's a gorgeous building. They built it and now at least part of that is up for sublease. The other thing is, as much as companies are mandating back to work, I don't think I've heard of any of them that are mandating five days a week. They're all talking about 2-3 days. So no matter what, you've got less occupancy in terms of physical occupancy happening. I think that's an important distinction too, because we've got physical occupancy, which is bodies in seats, and then you've got building occupancy, which is we paid for a lease. We're paying for a lease often for five days a week, but we've only got people in there, maybe 2-3 days a week. That is interesting too.
Matt Argersinger: Remember, those leases, by the way, a lot of these companies, unfortunately, they have those leases, but they're expiring. A lease is always expire. Imagine a lot of those leases expiring in the next year or two or three years. Many of those companies are not going to renew those leases. You've got this economic occupancy rate that's probably going to come down even further. I wouldn't be surprised if I hate to say it, but a year from now we might see more all-time highs in terms of the office vacancy rate.
Deidre Woollard: Yeah, that's an important thing to keep in mind because it has been this slow burn. When the pandemic happened and everybody said, well, buildings are still being occupied so it's fine, but what people didn't understand is that you've got three-year, or five-year leases that are all on different time frames and we're just now really seeing the impact of that.
Matt Argersinger: They're just going to keep rolling through. I expect it will just see those vacancy rates continue to climb.
Deidre Woollard: They're happening at a time when interest rates have shifted and the ability to negotiate is dramatically different as well. Well, let's talk about the what-ifs. If we have this assumption that OK, we're probably not all rushing back into the office when summer is over, what does a central business district look like? Because traditionally, central business district, you've got the big tall buildings, you've got people rushing in and out during the daytime, maybe it's not so active at night, you've got ground-floor retail. I heard this quote recently from Urban, like an Urban SDN thought leader, Richard Florida. He said that this is the opportunity to move cities beyond containers for working. I thought that was really powerful because that's what a central business district did. It is a place where we all go to work. If it's not that then what is it?
Matt Argersinger: It's very interesting to ponder, I would say, because if you think about how we organized work in the past, going back hundreds of years ago, it was all about around farms and agriculture. That's where we center the population. Then it became about industry, where we're factories, where we're plants, where we're big manufacturing facilities, where it was transportation, where we're ports or rail major rail lines. Then I think as we moved into the 20th century, and certainly as we got into the 21st century, it became the information economy, it became the services economy. It became about financial companies and so technology. All of a sudden we shifted the basis for work and the basis for population around cities because that's, like you said, that's where these buildings where, that's where we organize life. That's where during the day, a city like New York City or the Washington DC, their populations would swell because you have these workers commuting into the city, commuting to these buildings. That served many things beyond just the office. Like you mentioned, there's retail establishments, restaurants to serve lunch, transportation, public transportation of buses, subways to serve those commuters. That's all really, I hate to say it, but it's been abandoned since the pandemic. Cities will have to evolve, they will simply have to evolve, because if you look at New York City, for example, depending on the source you use, property taxes make up around 50% of New York City's revenue, and the lion share of that in New York City is office.
If a substantial portion that tax base is not going to be operational or it's going to shrink, where's the city like New York going to get its revenue from? There has to be some serious thinking around this. I'm an optimist, and I think you are too. I mean, cities don't have to be organized around the office anymore. They can be what else they're known for. They can be their cultural centers, arts, education, entertainment, sometimes people just like to live closer to other people. I mean, there's a lot of reasons that cities can still thrive, but we almost have to reimagine almost from imagined them entirely. I think people will always want to live in cities. I think they just might no longer want to commute to cities. That is, I think a big distinction and one of my big fears when you talk more about this later in the show, but my big fear is that cities are going to react to sharply to the change. They are going to realize that the office is going away. They're going to realize that their tax revenue is going to shrink, they're going to stop investing and funding things like public transportation or other projects that make it better because they're worried about short-term funding problems, or planning issues that would exacerbate. I think the problem with cities that would take away from what makes city special and livable and I worry a lot of city governments are going to take these drastic measures and it's going to be almost self-reinforcing.
Deidre Woollard: Well, the other thing I'm thinking about too, you've got this trend that mostly pandemic-driven, but before that you had this trend toward gig work. We know that that's happening. We know that the amount of freelancers is rising and the younger generations that I'm thinking about too, they're definitely breaking out of the 40-hour week. I go, I sit at a desk and I do my work eight hours a day and I come home. That's not the way that really the future is going to be lived. One of the things I'm thinking about is whether or not that changes how we consider the office now because even when I go to the office now, I'm not necessarily going for the full day. I might do a couple of hours at work at home. I'll go in to have a meeting with people or do something else and then I might leave right after that, go homework some more. I think that as we start to think about this, do things like we work and we can talk a little bit about where we are because they have so much of the office space, but are we going to see offices used in that more flexible manner?
Matt Argersinger: I love that. Like you and I went in a week or so ago to film some stuff in the studio. I showed up maybe an hour before we did that and I left shortly after we had finished. I think that is a good example. I like that you brought up the younger generations approaching work differently because I think a lot of those trends might have been in place even before the pandemic. Remember, WeWork was a major thing before the pandemic, before we even got close to it. The whole idea of this collaborative workspace, where it's not so much a centralized location anymore where you need all your employees to be. It can be more of a collaborative space or you can have satellite offices where workers get together on an infrequent basis or in things like travel to conferences or events or to bring teams together that work in different places. There's a lot of possibility. Obviously, it's going to be demand for office space or conference space. Whether or not it's in this centralized office location that we've been living in for probably 100 years at this point, that it certainly feels like a thing of the past.
Deidre Woollard: Yeah. Let's talk a little bit about the investing aspect of this because I've invested in a couple of office REITs. I'm looking for opportunities in others, but I'm nervous about that. The prices for these companies are very low right now, but the future is also a little scary because most of the forecasts I've seen say that office rates aren't going to go up until at least 2025. Really nobody knows, we can't really predict the future. How are you thinking about office REITs? Are you semi optimistic? Are you seeing any opportunities?
Matt Argersinger: I would call myself optimistic. I would say there are some areas of opportunity given what's happened to the space. You shared with me some data from the Oberlin Institute which looked at office occupancy rates, rents, and valuations. Like you said, it's going to take several years at least to work through what I think has rapidly become this excess supply of office space. The companies or the types of office I think is really going to suffer are your older class B buildings that don't have a lot of in-house or nearby amenities to track workers or tenants. Those are those are already tough and out-of-favor in a lot of places. Now, even post-pandemic, there's lower demand for office. They're just going to get left behind because workers and tenants are going to want to be in higher-end class A office space that's cleaner or more modern, with more amenities attached to it. Otherwise, it's going to be really hard to draw in a lot of workers on a regular basis.
I think if you're looking at REITs and you mentioned your own, I own some office REITs as well. I think if you're looking at traditional office REITs that focus on core CBD assets, your SL Green's, Boston Properties, or even smaller ones like Brandywine Realty Trust or City Office REIT, I think it's going to be really, really challenging for these REITs. It's going to take some time and there's going to be some defaults. There's going to be some real pressure on funds from operations, which is a cash-flow metric for REITs and rents aren't just probably not going to grow; occupancy is going to be lower. This is the key thing, debt is going to need to be rolled over or refinance on a rolling basis. A lot of these buildings, obviously the equity but a lot of times banks, especially regional midsize banks, own a lot of debt. If the equity is getting wiped out, which in lot of cases it has, those banks are going to want to get their debt out of it. It's just really, really challenging. Now there are some parts of the market. If you look at, for example, when we've talked about in the past, Alexandria Real Estate Equities, which is predominantly a life sciences REIT. Maybe Healthpeak Properties or even a Easterly Government Properties which focuses only on Federal government leases, those will probably work out. They're still beaten down and there's still some challenges there, but I think those are going to be workout OK. But traditional office REITs are the ones that you don't want to watch out for.
Deidre Woollard: SL Green, I know. They're trying to expand into other areas. I like them because they have a top-tier property, I little worry about them because they're almost 100% in New York. They're trying to maybe do a casino in Times Square, but that's way down the road. Other thing, speaking about New York versus other areas, I tended to see this originally as a coastal city problem. But now I'm starting to see signs of weakness in some of the markets that were considered to be the next big thing. Charlotte's, for example, their vacancy rate is going up partly because that's a banking city and some of those big banks are starting to reduce their space. How much do you think the Sunbelt migration thing that you and I've talked about a lot, is that going to shift again?
Matt Argersinger: Well, in terms of office, I think they'll hold up better, but you're right. You have to pick your markets. You mentioned Charlotte's, which I think is a great example. It's a banking financial hub. Those types of tenants have have been more amenable to flexible work relationships with their employees. So it's create problem. Just as we've seen in certain markets in San Francisco, LA that are more tech-driven. Same thing, more flexibility to worker, less demand for office. Places that will probably do better. If you look at maybe your Jacksonville Miami's, maybe your markets in Texas, in Dallas, or Austin, even though there are still pockets of weakness and those places saw huge demand. I think there's a lot of cases where there's been so much migration and so much movement among corporations down to those places that they're probably not going to face the same amount of challenges. But again, you have to be real specific and pick your markets. In a way that's the beauty of real estate. We talked about all this time, it's a very diversified sector. Here we are. We're railing against office and we're talking about that situation. There's also a lot of positive things happening with real estate and a lot of those markets, whether it's apartments or industrial, even retail and hospitality. But the office, no matter what I think if you're a real estate investor, it's really hard to get excited about office right now. You can do so much better on a risk-adjusted basis anyway, looking at other sectors, at least in the near-term.
Deidre Woollard: That's a good point. Speaking about that, what other areas should we be considering? Is there a way that some of these office buildings can be repurposed? Because we talked a little bit before, we've talked about this about residential. I've seen some of the stats that it's not necessarily going to be the easiest thing to convert. You can't really turn a lot of office buildings into apartments and then that's just the end of it. But there's some other things I'm seeing, so vertical warehousing, edge computing. I saw a post the other day about the idea of turning some of these buildings into vertical malls, almost like the old fashioned, like a Macy's where you've got different things except it's not one store, but just different stores on every level. Are we going to open up this creativity and is that going to bring energy back to cities?
Matt Argersinger: I think so and I hope so. And that just makes so much sense. It's going to be very expensive to do, and you mentioned it. A lot of people think, well, we can just convert all these office buildings to apartments. It's so difficult to do that. A lot of office buildings just can't be converted just because of the way they are structured. The plumbing isn't right, utilities aren't right, they have to be upsized, the floor plates are too large, column spacing is weird, there aren't enough windows. And so people tend to underestimate the cost and zoning changes that would be required to turn your traditional city office building into an apartment. But it's happening to a small extent. Your other ideas I think are much better, which is the whole idea of vertical warehousing or building more of a mixed-use property where maybe certain floors are still office, but then certain floors are retail or certain floors are a hotel, a hospitality maybe. There's a lot of things that can be done. I just think what has to happen is the cities themselves have to make it possible for those kinds of transitions to happen.
And there's such draconian, as you know, zoning regulations or tax implications that your typical developer is going to say. It's too expensive, it's too hard, it's going to take years. I can't get in there and do it even though I know that this particular type of real estate is much more in demand and has much more long-term potential. And so it goes back to what we were saying that beginning to show. There has to be almost its entire rethinking of how cities are designed and zoned. And think about things something simple like parking requirements. So many buildings have minimum parking requirements that have to be satisfied. It's never made sense to me as to why cities have such high standards there when we really don't want a lot of parking in cities, we want people to be using public transportation or walking. So even lessing some of those types of restrictions can really open up more development. It's just so many things have to be rethought, and it's going to take a lot of different players from both the private and public sectors to come together saying, this is what makes sense. In the past, unfortunately, those types of groups have been more in conflict with each other than collaborative. So like they say, the cliche, it's going to take a village [laughs] to make it all happen.
Deidre Woollard: [laughs] Well, yeah, I think you brought up something really interesting with the idea of public-private partnerships because you're absolutely right. For the most part, traditionally, it is a developer wants to build something, they see where they can make a profit. Then they go to the city and they ask for it. Sometimes you get, I mean, there are things like low-income housing tax credits. There other credits for affordable housing, things like that, but there's not a lot of public support for building offices unless they're going to have maybe public space with it sometimes. So it's a bit of a challenge to get the government, I think, behind that, but I want to zero in on what you talked about with parking because a few years ago, I was at this real estate conference and a guy got up on stage, he's like, cities are going to be redone in five years. Autonomous driving is going to be everywhere. There will be no more parking garages. Parking is not even something we're going to have to worry about. That didn't come to pass, but we are starting to see some things. You and I looked at an article recently from the real deal talking about Digital Realty Trust maybe tearing down a parking garage in downtown LA and putting in a datacenter. Is there an opportunity to take all of that real estate in cities that is parking and turn it into something else?
Matt Argersinger: Absolutely. And that's the future I would love to see. I think everyone would.
Deidre Woollard: They're not pretty.
Matt Argersinger: Those are pretty, but I'm just saying the whole idea of removing excess parking, especially remember if we move to a city or move to a future where a city doesn't have this big commuting population coming in and driving cars, there's better uses for a lot of that space. Of course, I think we'd love to see autonomous driving take over. It's safer, it's cleaner, it's more efficient. There's not need to have parking and it's more cars as a service. I'd also, of course, love to see public transportation continue to be funded and a critical part of cities because that's what makes cities livable. Autonomous vehicles, I know the future is a little farther off than we thought, but you think it's so much more possible and appropriate for cities than it is outside of cities where there's just a lot more variability. But cities tend to be, the way they're designed, very amenable to autonomous driving. So gosh, you'd love to see it because it just seems like such a better way to get around the city. I love New York City with the idea of hailing for cabs. [laughs] It's a pain to get around that city sometimes. Just imagine if there was just a fleet of autonomous vehicles that were constantly going around, you just jump in and jump out and that would make getting around New York City so much easier and more enjoyable. And that goes for all cities. And so there's a wide range of different uses for all kinds of assets within cities, and parking is one of them. We've probably too many parking garages, too many underground parking, and we can get rid of a lot of that and make that space a lot better used by, especially with the people who live in cities.
Deidre Woollard: Well, I keep coming back to the idea of the 15-minute city, which has been talked about a lot in Europe, but there've also been things like the super blocks in Barcelona. The poll 15 minute city idea is that you can do everything you want in 15 minutes without getting into a car. Maybe you need a bicycle or a scooter, but that's about it. And it seems to me some of our smaller cities are already there a little bit. That's one of the longer trends we've seen that as millennials move to some of the smaller cities, they wanted more walkable space. So that was a trend we saw pre-pandemic. Do you think that is more where we're heading?
Matt Argersinger: I hope so. As I said, it's a better future. And I think one of the things you brought up earlier about the younger generations, I think that is much more appealing to younger generation. Imagine living in a city, your job, the office that you go to three days a week is within 15 minutes, the place where you go get your groceries is less than 15 minutes, the place where you meet your friends or to go to the coffee shop, or go to a bar or a restaurant or out for the night is within 15 minutes. Who wouldn't want that? I think that's what you're seeing. Unfortunately, it seems to be happening in these isolated developments. These mixed use developments are seeing in certain places where the developers coming in and building all that versus you see less of it happening within existing cities. I think that's the question, is it something that can happen in our existing cities given our existing infrastructure. You hope to see it because I think that is a much better future for cities than what we have today.
Mary Long: As always, people on the program may have interest in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Mary Long, thanks for listening. We'll see you tomorrow.
