Episode 17: Adding Value to Office Space Post-COVID
Even with remote work becoming the norm, offices aren’t going away. In fact, we’re acquiring more of them because we see collaboration and office dynamics serving a crucial role for many years to come.
Narrator:
This is Durable Value. Get investing and business insights from industry experts and successful entrepreneurs every week. Like and subscribe now.
Ryan Swehla:
Well, thank you for joining us for the webinar today. Here we are, the week of Christmas and the week before New Year's, and we thought it would actually be a good time to reflect on what we've learned from the office environment so far. We're going to do this in kind of a casual environment and conversation back and forth between myself and my business partner, Joe Muratore.
Joe Muratore:
I appreciate people tuning in. I imagine, just like us, people are thinking about what's going to happen in 2021. It's the week of Christmas. We might all be sitting at home, but at least on these three days, many of us are planning for the next year. So I guess I'd congratulate people on that now.
Ryan Swehla:
Yeah. We wanted to start this by framing the discussion, talking a little bit about the macro trends that we're seeing and the context, and then we'll move into really kind of the boots on the ground tactical experience that we've learned.
Ryan Swehla:
One of the things that I think we all know is that on the one hand, things are changing. On the other hand, office space isn't going away. This is a very robust asset class and it's certainly interesting, to say the least. Interesting times to be investing.
Joe Muratore:
I was looking it up. There's $2.5 trillion worth of office buildings in the United States. So about 10% of the value of the stock market. These buildings are all over, and yet right now, they're not being looked at. Now is a very interesting time to be investing in them.
Ryan Swehla:
Yeah. What we're seeing already is trends of businesses recognizing that this work remote environment isn't perfect.
Joe Muratore:
Yeah. Yeah, one thing we've been reading about is companies like Google and Goldman Sachs now doing COVID testing weekly or daily. So there's pressure that they're feeling to get people back in the office even before a vaccine.
Ryan Swehla:
There was a recent Gensler report that talked about how effective office space is. And yeah, you'll notice, we put it up on the slide here, if you're in a low-performing work environment, the answer is working from home is more effective. It's a better place to be, so to speak. But if you're in a high-performing work environment, certainly employees prefer being in a office environment because that office environment creates that synergy, that business productivity.
Joe Muratore:
Yeah. So for companies that are innovating, companies that are being creative, they want their most valuable asset in its most valuable spot, an office building. So less innovative companies, less creative companies are probably fine for more work at home, but companies that are growing and being creative want people in the office.
Ryan Swehla:
But as we mentioned, things are changing. One of the things that we've noticed is that this really is kind of a tale of two cities. You have the urban markets, which are experiencing significant impacts from this, and the more suburban or secondary markets are not.
Ryan Swehla:
One of the metrics that we look at is sublease vacancy. Sublease vacancy is really the leading indicator of problems to come, because these are tenants that are saying, "I can't get out of my lease, so I'm going to put my space available in the market because I don't need that space anymore." So it really is a foretelling of things to come.
Ryan Swehla:
What we noticed, and this comes from a recent Cushman & Wakefield report, is that the top 15 markets in the country, meaning that the markets that have the least sublease vacancy as a percentage of total vacancy, they really have the same that they've had historically. Not much has changed in those markets. And you can see that the sublease vacancy is anywhere from 1% to 4.5% of the total.
Joe Muratore:
Well, in many cases, they've improved. They're doing better.
Ryan Swehla:
Absolutely.
Joe Muratore:
[crosstalk 00:04:00].
Ryan Swehla:
And meanwhile, we go to the bottom 15 markets, and the sublease... Let's pick San Francisco, which is the leader of the bottom, 52%, over half of the vacancy in the market is subleased vacancy. That tells us that there is still a tidal wave to come in those markets, because they have a large amount of inventory that is coming to market.
Joe Muratore:
Yeah. What you see between these two is you've got the gateway cities, or the 24-hour cities, and you've got the 18-hour cities. And often, these are adjacent to the 24-hour cities. So LA is moving to the inland empire. The Bay Area moves towards the Central Valley. But you see that with a lot of these cities. So during the last upswing, costs went up, and now they're moving away from costs, they're moving towards greater quality of life.
Ryan Swehla:
Yeah, and that really touches on a theme that we're seeing, which is the cities that are not ultra-urban, that don't have a high cost of living, that don't have significant commute times, all of a sudden, that remote work environment isn't as compelling. Meanwhile, if you're in a city where you have long commute times, you have high cost of living, you have a very dense environment, these are the cities where they're trying to re-imagine what work looks like because remote work is a compelling alternative.
Ryan Swehla:
We touched on this a little bit in a white paper that we did a month or two ago on the future of work. That's available on our website. It really elaborates more into where we see the workspace going. But today, we're really talking about how to add value in office space post-COVID.
Joe Muratore:
Right. So before we get to the five points of how we're adding value post-COVID, first question is, "Who are these guys, and why are they qualified to talk about this?" So I'd say we're geography-focused rather than asset-focused. So we've got office space, retail, industrial. But in the office part of our portfolio, we have about a million square feet.
Joe Muratore:
We've been in business now 13 years. We've been friends for about 30 years. Have a team of about 15. And most importantly, in this last year, we've purchased six office buildings and we're in escrow on the seventh. So we've definitely gone big on this asset class.
Ryan Swehla:
And we've negotiated 15 office leases in the last six months, so we can provide real boots on the ground experience as to how those negotiations are playing out.
Ryan Swehla:
I think an important thing that we wanted to underscore is we are looking at the breadth of the asset classes and we're not office-focused, so we're not trying to sell a particular worldview. Rather, we look at all the asset classes and we're looking at this as a particularly appealing time to be investing in office.
Joe Muratore:
But we tend to be contrarian investors and not follow the herd. And as we entered into COVID, we saw a significant value in office buildings, and buildings that couldn't be purchased easily last year were now at a 15% discount. Now we had fewer competitors, and that made the sector more compelling.
Ryan Swehla:
The one other thing that we wanted to just touch on before we get into the five values is culture. Culture is the two rails under which we operate under are trust and integrity. We believe that having a positive culture, having a good culture does transcend into the buildings that we operate in. Our team environment is one that raises trust and integrity above other things.
Joe Muratore:
Yeah. Well, companies reflect their owners, and culture is really important to us and it's really important to our company, and so it's really important to our buildings. I read a statistic recently that 50% of work time, especially in bad culture companies, is focused on politics and navigating social structures. We work really hard to remove that to bring trust and integrity, to bring leadership to our company and to our buildings. So you'll see that theme as we talk through the five points coming up.
Narrator:
By the end of 2021, what will work look like? Get our in-depth analysis and five predictions for the future of work and office space in our report, The Future of Work. Download at graceadapartners.com
Ryan Swehla:
Our five points to adding value in the post-COVID environment. Number one is acquire new assets that compete well in the post-COVID environment. What does that look like?
Joe Muratore:
Well, for us, that's meant multi-tenant building. So the six we bought this year, most of them have been 15 to 30 tenants, two to three stories, adjacent markets to the downtown, markets that are of value, but also offer a better quality of life. Easy parking, walk right up, courtyards.
Joe Muratore:
But with multi-tenant buildings, we are also limiting our risk and managing our risk. When you have large floor plates or whole floors, it's very difficult to make a change if one tenant goes out or one tenant downsizes. But with the buildings we've bought this year, they've tended to have 2,000 to 4,000 square foot suites. So we have more cards in the deck to play with, which means one tenant wants to downsize, another wants to move, we can create options that you can't necessarily create in a high-rise.
Ryan Swehla:
The other thing that we've focused on is buildings that are low-rise, that have onsite parking, they have outdoor common areas. I think in this post-COVID environment, tenants have recognized some of the challenges of being in a large high-rise office building. So we definitely have focused on buildings where the path of travel from the car to the tenant space is limited in the indoor common areas. And also, recognizing we're here in California, so having outdoor common area is a really important amenity.
Joe Muratore:
Yeah, modern control systems. With each building we buy, we work to upgrade, especially the HVAC, also the lighting, but create a very modern environment. We often say we want our buildings to be light, bright, and open. That's a feeling that resonates well with tenants and it works really well in a COVID environment.
Ryan Swehla:
One of the buildings we purchased recently was River Park. This is a highly multi-tenant building, has outdoor amenities that allow tenants to walk around and have time in an outdoor environment, and also has ample onsite parking.
Joe Muratore:
It's also a great example of... We often say you make your money going in, but in COVID times, we were able to lead the market with the price per square foot comp here by a significant amount. So we had a great value going in on this, but it also met our strategy at 30 tenants, two story, lots of onsite parking, easy access to freeways, and some of the largest residential populations in the area. So it fit our strategy and we got it at a great price.
Ryan Swehla:
Yeah. The second point that we wanted to make is prioritize flexibility and be responsive to tenants. This can't be underscored enough. Having open communication with your tenants during these times is critical. We're able to better react to the tenant environment by having an open communication line with those tenants.
Joe Muratore:
Yeah. You can either lead with a position of weakness or a position of strength. A position of strength in these sorts of buildings is communicating with tenants frequently, being responsive to their needs, getting way in front of tenant renewals. But as tenants have needs, we work to address them, either relocate them or mitigate the damage somehow, but keep the tenants in the building and keep them feeling heard.
Ryan Swehla:
One of the strategies that we've used is trading space reduction for rental rate or other terms. So we're able to turn what otherwise would be seen as a problem into an opportunity.
Ryan Swehla:
An example that happened recently was a law firm that was 3,500 square feet. They had a beautiful TI and they wanted to downsize. We had a 1,500 square foot space that was in a less desirable part of the building, so we were able to move them to a less leaseable space. We were also able to raise their rental rate. So they saw an overall contraction in rental costs. We saw an increase in rental rate and a space come open that is more desirable and more leaseable.
Joe Muratore:
Yeah. So we've been able to see times where we can move a tenant in a highly TI-ed space to a lesser TI-ed space, but reduce that amount of square footage. So the tenant's happy. Their overall cost and risk went down. But our price per square foot went up about 15% and we freed up a more desirable space that'll be easier to lease four to six months from now.
Ryan Swehla:
Yeah, and I think this touches on the other subpoint, which is be willing to relocate and reconfigure floor plans for contracting tenants. There is a recent Gensler report that talked about the need to be flexible. I think we've all learned in this COVID environment, certainly personally and professionally, the need to be flexible, the need to think of things differently. We take that to our tenant negotiations as well, and having an open eye to different ways to be able to meet their needs while still meeting our needs.
Joe Muratore:
Be comfortable with shorter commitments. Especially with these smaller tenants, five-year renewals isn't always an option. So there's definitely been several three-year renewals and the occasional two or one-year renewal. But the most important point here is to move away from danger. Now is the time to keep your building full, keep your rental rates at least where they were or raise them, but move away from the piece of danger that's right now.
Joe Muratore:
I'd also say though, on these shorter term rates, if we're going to give someone a shorter term, we're going to get that rate up another five or 10 cents. That works with the overall plan.
Ryan Swehla:
Well, and if you are negotiating during this environment, both the tenant and we have a more uncertain future. If the tenant is contemplating relocating or downsizing and you can get them into a one-year lease to defer that conversation, absolutely. Everyone's going to be in a better environment a year from now. Or rather, I should say their future will be more certain at that time.
Joe Muratore:
Right. Your odds of downsizing that tenant just went down, call it, 20% or 30%. You're taking risk off the table by negotiating in the future.
Ryan Swehla:
One of the other, or the third point, rather, in creating value in a post-COVID environment is add new revenue streams.
Joe Muratore:
This is a really-
Ryan Swehla:
This can't be underscored enough.
Joe Muratore:
Yeah, it's a really big deal. So there's new ways to add revenue to your buildings. Let's go to the next slide. We'll talk about it.
Joe Muratore:
First, the solar. We're making a very large investment right now in solar in our buildings. Many of them are full service, which means we pay utility costs. And there's a way to reduce that. With solar, there's both tax incentives and there's also utility rate reductions and savings there. But as we add solar systems, we're finding about a 15 to 30% IRR on our whole period. Often, this also includes roof replacements or overlays as part of the system. So there's a bunch of tax incentives, but it's also a win on NOI.
Ryan Swehla:
Well, and as we evaluate new buildings, if we find a building that is at the end of its useful life for its roof, we now have another card in our deck to be able to solve that problem and still acquire a building at a good value.
Joe Muratore:
This works for multi-family too. We're looking at a large apartment complex where this gives us a few extra points of IRR. So that's helpful.
Ryan Swehla:
Another way that we're adding new revenue streams is artificial intelligence HVAC control systems. As we know, the old systems, parts of the building were on when they didn't need to be, other parts of the building were off when they should've been on. This allows us to dial in that much more efficiently and increase NOI as a result.
Joe Muratore:
So if you're already thinking of replacing HVAC or yeah, in our case, replacing it, this adds a bunch of capacity and it pays for itself super quickly in about a year. This means that you can heat the floors you need to heat when they need to be heated, and you don't have to program it. The AI system learns this stuff and does it intuitively, and that saves a bunch of money.
Joe Muratore:
There's Ryan on the cell tower. No, it's not.
Ryan Swehla:
Well, one of the other areas of revenue generating, obviously 5G is rolling out as we speak. That's a tremendous infrastructure investment. So with all of our buildings, we're looking at ways to continue to be the leader in availability for cell towers.
Joe Muratore:
Sure. Point West Terrace. This is a great example. We're adding carports and putting solar on the roof. We put LED upgrades in the parking structure underneath. But this is a full service building, so very quickly, solar translates into IRR and increases our NOI directly. So it's like having an extra tenant. It's amazing.
Ryan Swehla:
Yeah. And Response Road is another one where we recently completely upgraded the HVAC system. And with that, we also went to artificial intelligence. Again, full service leases. So that benefit goes directly to the landlord.
Joe Muratore:
In this case, we had a vendor that partnered with us on the AI, and they take a portion of the savings. So the actual cost to start with them was very low, and we realized the upside and we share a little bit of it with this vendor.
Ryan Swehla:
Yeah. The fourth way that we're adding value in a post-COVID environment is find ways to improve the tenant environment. One thing that we've recognized through this COVID pandemic is we have a heightened awareness of our environment, and it's risks, I guess, as a way of saying it. So we've been very focused on ways that we can improve that tenant environment and make our buildings more appealing to tenants.
Joe Muratore:
Right. We touched on artificial intelligence, but creating the right environment, the right HVAC system is very important. Creates comfortable tenant spaces and reduces costs.
Ryan Swehla:
Absolutely. Another area that we focused on is lighting. We've done LED upgrades everywhere possible. But we've also focused on natural lighting and the ability to bring in more natural lighting to our spaces.
Ryan Swehla:
An example recently is Northpoint Towers. We were doing a new TI or a completely renovated TI in a space, and we were able to increase the ceiling heights to 11 feet. By doing so, you're able to cast a lot more of the natural light into the space. And of course, this translates into a more appealing space aesthetically. And of course, then a higher than market rental rate.
Joe Muratore:
Yeah, on those leases with new TIs, we had some of the best space in the submarket and were able to get the very top of submarket rents. And the tenants, delighted.
Ryan Swehla:
This happened this year, by the way.
Joe Muratore:
Yeah, we signed the lease.
Ryan Swehla:
We've been able to raise rental rates in this environment in many different aspects by using these strategies.
Joe Muratore:
Well, not all tenants are suffering. Some tenants are thriving at this time.
Joe Muratore:
Yeah, lastly, touchless features. 2101 Arena. Large state-occupied asset. We're working with the state to install an entry door that is totally touchless, and that's happening now. Also, there's touchless features on the bathrooms.
Ryan Swehla:
And everywhere throughout our portfolio, we're looking at ways to add more touchless features because of that heightened awareness of transmission.
Joe Muratore:
Let's pivot a little bit and say everything we've talked about so far was technology or strategy, but let's talk about psychology. So much of investing is psychology, both at the market and the crowd, but also of us as leaders of investments.
Joe Muratore:
Let's go to the first one, which is be bold when others are fearful. We borrowed this from Warren Buffett who says, "Be bold when others are fearful, and be fearful when others are bold." But most importantly, now's an outstanding time to be bold because the market is fearful. So now's the time to pick a strategy that you believe in and that's supported and act on it. That's what we've done. We're contrarian in nature, and where there is uncertainty, we work to see opportunity.
Ryan Swehla:
And we regularly say we make our money going in. So when you're in this fearful environment right now, we've been able to make some acquisitions at prices that were otherwise unheard of. By doing so, we're immediately mitigating risk, because now we have a low cost structure, a low cost basis that allows us to be flexible. As tenants say, "I need this instead of that," we have the bandwidth to be able to do that.
Joe Muratore:
There's an arbitrage because the market sees greater risk than we see, and we're able to price in the market's value of risk and get it at a discount because our value of risk is a little bit different.
Ryan Swehla:
Oops. Number two. Use the tools you know, like the mouse that I'm having trouble with here.
Ryan Swehla:
One of the things that we focus on is while on the one hand, be bold when others are fearful, we stick with the tools that we know. We have a very simple recipe, which is buy buildings at 40 to 60% of replacement costs, fill the vacancies, increase revenue, rinse and repeat.
Joe Muratore:
In addition to this analogy is the idea of a golf bag with golf clubs. We often, as we approach an investment, talk about, "Well, is this a seven iron or a three iron or a five iron?" The point is that there's different flavors of value add, and know which golf clubs you're great at swinging and know when to swing them.
Ryan Swehla:
And lead with culture.
Joe Muratore:
Yeah. If you start with those two things, which is be bold when others are fearful and stick to what you know, you have to add this third part. You have to hold these loosely, which is what got you to here won't get you to there. In other words, the world is always changing and there's a certain amount of discomfort that you have to live in. I'll call it 15%, but there has to be a pivot. You have to take the things you know, be bold, and you have to move differently into this new environment.
Ryan Swehla:
Yeah. Part of how we do that is by having a talent-dense organization, right? That way, we can be flexible. We're not here to preside. We're not here to preside over buildings. We're certainly not here to preside over our company, but we're not here to preside over buildings either. We're here to lead that change.
Ryan Swehla:
I think 2020 has reminded us of a lot of changes, but it also gives us an opportunity to sit back and recognize change is always present. This year, it may have been particularly surprising or in some cases, painful, but change is always happening. So the more we're able to embrace that and recognize that change is always going to occur, the better competitive advantage that we have.
Joe Muratore:
Yeah. The people watching are seeing two people, but there's 15 of us, and we've worked really hard to have the right talent-dense organization where each piece knows how to pivot and is experts in their spot. Companies get in trouble when two people say, "We're doing this. We only do this." And then the world changes, COVID happens, and they fracture. They don't know what to do. But if you have talent density and a culture that supports that, the culture, the company quickly pivots. It finds its right spot. That's what we've worked really hard to do.
Ryan Swehla:
Absolutely. So with that, we've hit on our five value add strategies. You may have seen at the beginning of the presentation, if there are questions, you can email them to ryan@graceadapartners.com.
Ryan Swehla:
We're going to switch to Q&A here and see what questions we have coming in. First of all, there's a question that says, "You mentioned this idea of a building's culture. How does that add to a building's net operating income and value?" That's a very good question.
Joe Muratore:
We can start with tenant retention. Tenants don't like to be in buildings that are managed by jerks.
Ryan Swehla:
Absolutely.
Joe Muratore:
I say that strongly, but the culture of a company leads to people staying and flourishing. A lot of the tenants, especially when we buy buildings that frankly, most of the buildings we buy start with a bad culture because that's why they're being sold. But when we come in and lead with a good culture, tenants that were thinking of moving or were considering other options, reevaluate. Our job with them is to create a plan that's a great fit for them. And also, to be a good partner for them. They're in that building to accomplish their mission, and the fewer real estate things that they can worry about, the better.
Joe Muratore:
I finish by saying the number one thing that that office manager wants is a trusted partner. They don't want the rug pulled out from under them. They want to know they can call you, they're going to be treated fairly, and they want to work with great people.
Ryan Swehla:
And that it's a collaborative environment, not an adversarial environment.
Joe Muratore:
Yeah.
Ryan Swehla:
Yeah, I couldn't agree more. Another question we have here is, "How do you see this playing out for the 15 cities with the highest sublease vacancy?" That goes back to earlier in the slide here. One moment. Technical issues. Anyway, we-
Joe Muratore:
I'll start by answering real quick, which is to say the pendulum always swings and it's swinging away from the gateway cities right now. But candidly, over the next five years, we're thinking about how it swings back too. And right now, things are getting attractive in secondary cities. Luckily, we've been investing there for quite a while, but primary cities will come again.
Ryan Swehla:
Well, and I think this also... You look at San Francisco and say, "Oh my gosh, over half of the vacancy is sublease vacancy." That's terrifying, but it's also an opportunity because what we see happening is a pricing reset. These are highly desirable, fundamentally desirable cities that have some real assets. And while there is a temporary hiccup, I think there's probably a buying opportunity in Manhattan and in San Francisco over the next year or two years as this plays out.
Joe Muratore:
Well, and then the buildings we have now, they took six to 24 months to buy. Of the last seven buildings we've bought, we've purchased, five have been off market. The other two were on market, but were stagnant and we found a new way to look at them. But to buy off market buildings, you have to develop your funnel and your pipeline, and that takes a long time.
Joe Muratore:
I bring up the point because if you want to be investing in Sacramento, especially if you want to be doing value add off market opportunities, you should be looking next year-
Ryan Swehla:
Yeah, absolutely.
Joe Muratore:
... to invest the following year or the year after.
Ryan Swehla:
The last question that I'm seeing here is, "What office buildings are you avoiding?" I think I'll start with that a little bit. The only thing that we would permanently avoid is functionally obsolescent buildings that we can't fix. If there's something chronically wrong with it that the cost is just too big to fix, we would certainly avoid those.
Ryan Swehla:
The thing I would say that we're temporarily avoiding is more of that high-rise, urban, dense. Sacramento, again, is a market that we operate regularly in. We're not actively pursuing high-rise acquisitions right now. That's not to say that they're not a fundamentally good buy, but we do believe that there's going to be a little more distress before we think that that's going to be a buying opportunity.
Joe Muratore:
Well, the most what we're buying is in the $10 to 30 or 40 million range, which is higher than the local investor or family office, but below the institutional. So things smaller than that or larger than that, we're not seeing as large an opportunity. There's just more competitors.
Ryan Swehla:
Yeah. That's all the questions that we've received. So we just wanted to take time again to thank you for joining us this week of Christmas.
Joe Muratore:
Thank you.
Ryan Swehla:
We're always available for further follow-up as well.
Narrator:
Thank you for listening to Durable Value, an investor's podcast, where we demystify commercial real estate with safe, sound investment strategies to help you balance your portfolio. If you enjoyed this podcast, be sure to rate it on iTunes or wherever you get your podcasts. To learn more, visit graceadapartners.com, where you'll find more information, investor's tools, case studies, and more.
Narrator:
This podcast is hosted by Joe Muratore and Ryan Swehla. It's produced, edited, and mixed by Melodic, with intro music by Ian Post. Thanks again for listening, and we'll see you next time.