Episode 12: The Future of Work
By the end of 2021: What will work look like? Joe and Ryan discuss their predictions for the future of office space as laid out in their recent analysis titled “The Future of Work”
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Ryan Swehla:
I believe that, not yet, but over the next six to nine to 12 months, may be some of the most fruitful time for investing in urban areas. And the reason is I saw a graph recently where San Francisco one-bedroom apartment rents were plummeting over the last three to four months, Sacramento one bedroom apartment rents were rising at that same period of time.
Joe Muratore:
Yeah.
Ryan Swehla:
So there is clearly a shift in demand. There's a shift in preference. And as an investor, that's an exciting time.
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Ryan Swehla:
So today we're going to talk a little bit about the future of office space. It's on everyone's mind, office buildings across the country. Our tenants are paying rent, but their workers are not working in the space. And that's only a model that can be sustained for so long. So we're going to spend a little bit of time today talking about what we think the future of office space looks like.
Joe Muratore:
Yeah, especially we're going to talk about, or we can start with talking about the rise of the secondary and tertiary markets. We've been talking about Lake Tahoe and how house prices have gone up quite a bit higher, and people want to live there and be there. And we're also seeing certainly secondary office space being more desirable too, as people aren't tethered to primary markets. But again with that.
Ryan Swehla:
Well, and we've seen already an exodus in terms of residents out of urban areas. What I think with office space is the preferences will change. People will have more of appreciation for office spaces where they can drive their car, where there's more space. And those are the kinds of office environments that are better accommodated in secondary and tertiary markets.
Ryan Swehla:
The urban core will always be the economic powerhouse. But I think we're going to see some of the wind come out of that sale for a temporary period of time, maybe the next few years. The businesses are going to be re-evaluating their need for office space. And in those urban core environments, that's where rents are highest. That's where the physical environment is the most dense. And so there will be some re-evaluation. I look at it more like a river that has some changes in its course versus a wholesale shift, but there will be change in preference. And I think that change in preference will benefit secondary and tertiary markets.
Joe Muratore:
Yeah. It's interesting. There's an interesting chance for people to experience habit change. As they've been working from home, they've realized they can work from home or they can work in a different way. They've realized that they don't have to go into the office every day. And also their employers who are paying high rental rates have realized they don't quite have to either. And this prompts some piece of change, even post-COVID where it's not the most efficient use of capital or time or people to have everyone in the same office in downtown San Francisco or Manhattan. So there will be change. There is a shift in supply and demand.
Ryan Swehla:
Yeah. And with that, you mentioned people having an opportunity to experience this environment.
Joe Muratore:
Yeah.
Ryan Swehla:
The other thing that we're all seeing is there are aspects of this work from home environment that work, and there are aspects that don't work, and some that work for some people and some that don't work for others. So there absolutely is a re-shifting, but we also are recognizing the shortcomings of the work from home environment. I spoke to an employer of a hundred employee business recently where everyone's working from home right now. And he said, "It is so hard to maintain company culture. It's so hard to be able to have people on a unified mission when they have competing distractions and you don't have that same tangible touch and feel."
Joe Muratore:
Yeah. We often talk about business pivots and the difficulty of businesses and the number of businesses that fail, 95% in the first five years or, no, 70% in the first five years. And then the point being business isn't easy and you can't quite phone it in. So there's that tension there, especially what are your competitors doing? What are we doing? And that leads to some sort of hybrid model where some portion of workers in some sort of roles should, can, and most efficiently work remotely in some way, and some portion need to be in the office and need to be in that sort of space.
Ryan Swehla:
Yeah. And I think we'll also see a hybrid of that where employees might have some work from home days and some office days, where office space isn't this square footage is assigned to this person. But rather when, on Tuesdays and Thursdays Bob is there, and then on Monday, Wednesday, Friday, Jenny comes in. And what we've realized with this experiment is that there are a multitude of modes of work and some that work well in certain areas and some that don't work well.
Joe Muratore:
Yeah. I think you'll see a rise in sort of the gig economy, the WeWorks of the world as well. It's in this sort of environment where you have people working remotely for some companies, including ours, it's been better to sometimes work with vendors. Vendors are not permanent employees. They don't have long-term contracts. They're there to provide a piece of value at a specific price. And you're just one of their customers. So I think there will be a continued rise in sort of a vendor group, which could also be seen as small business incubation, entrepreneurship, and many of those people, some will work from home, but as they get some scale to them, they'll want some sort of small office. And WeWork is great for that. And not WeWork in particular because WeWork is a famous name, but the idea of a Regis or a small business, small where you rent an office kind of place.
Ryan Swehla:
Yeah. And it still solves a need. I think there were plenty of headlines around the WeWorks of the world and how with the COVID environment, all of a sudden, no one's going to want to do that. But what we recognize is the flexibility associated with that is valued. And one thing that COVID has taught us is lots of flexibility. We have to learn to be flexible. And as business is responding as we get back to normal work, whenever that is, that normal work is going to change in some way. And those in real estate environments that offer flexibility that allow you to slowly scale up will still be an important aspect of the real estate market.
Joe Muratore:
And that's an important point. You said, we will get back to work. And I think, and maybe we can talk about it, that a year from now, six, eight, I think everyone would think we're going to be living in some sort of post-COVID environment. It seems that the stock market believes that the vaccine is going to be here. That's what I read. There's five or six trials. So let's envision for a second a year from now, or a year half from now, what the world's going to look like, and also, what does that mean we should do now?
Announcer:
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.
Joe Muratore:
Because I would say both as investors and as employers, people, occupiers of office space, if you wait until the trend happens, you're not going to get first pickings. You're not going to pick the thing you want. But if you're willing to take a piece of risk now, maybe not a crazy risk, but if you're willing to make a bet now as an employer or occupier of office space, you'll have a better shot at getting the thing you want.
Ryan Swehla:
Yeah. And I think you touched on that a little bit in an earlier podcast that as investors, we're not prognosticators. Our job isn't to just give opinions out. Our job is to act decisively based on sound investment thesis, but always be contemplating if that investment thesis doesn't come out and what that effect has on our investments. I believe that not yet, but in over the next six to nine to 12 months may be some of the most fruitful time for investing in urban areas. And the reason is, I saw a graph recently where San Francisco one bedroom apartment rents were plummeting over the last three to four months, Sacramento one bedroom apartment rents were rising at that same period of time.
Joe Muratore:
Yeah.
Ryan Swehla:
So there is clearly a shift in demand. There's a shift in preference. And these urban cores over the next six months, I think we will see a fair level of distress, especially as these office lease terms start rolling over because right now tenants are left paying rent unless they want to file bankruptcy. So what will end up happening is as these leases start to cycle over, there will be a reset in pricing. There will be a reset in demand. And as an investor, that's an exciting time because if you have a fundamental bet in these historically strong demand areas, but there are some headwinds, that's the time to put your money where your mouth is.
Joe Muratore:
Yeah. I sort of think that the tide turned a month or two ago. Usually you can't know when there's some sort of bottom. You look back and you see when it was. But certainly the stock market says, sees a more positive outlook. And we've often talked about the stock market leading the economy, leading the real estate market. What's interesting is normally cycles are very long, multi-year. In this case, it's a whipsaw. The stock market went down 30% and then came back up. The economy is in a unique spot where several trillion dollars has been put into the economy to support it. And the real estate cycle is sort of paused right now. There's lesser tenant activity, but there is still tenant activity. I think it's a confusing piece, but in that choppy water, now it's a very great time to be an active investor and be in the water in my opinion.
Ryan Swehla:
And be working your convictions.
Joe Muratore:
Yeah.
Ryan Swehla:
We hear about business owners that we know whose businesses are just trying to get by or survive.
Joe Muratore:
Yeah.
Ryan Swehla:
We hear about other business owners and other sectors that have more business than they know what to do with.
Joe Muratore:
Yeah.
Ryan Swehla:
We heard in an earlier podcast from a mobile home park investor about how more capital has come into that market and cap rates have compressed further in the last four to six months. So it is a case of turbulence and of volatility. But our job as investors is to clear that out and look to the future of where, what long-term structural changes will be and how we can take advantage of those.
Joe Muratore:
Well, as an investor, a common story we hear now is, "We were taking it to market pre-COVID. We went into escrow. It fell out for some reason. The investor got cold feet because of COVID. We're holding it off the market. It's been quite a few months." And for us, that means, well, all right, we've got a window where we've got this seller's full attention.
Ryan Swehla:
Yeah.
Joe Muratore:
They aren't even on the market. Now's the time to get an additional discount over what that previous buyer was going to buy while we have the time. We're not going up against four or five other investors. It's our moment. So there's several good investments I'm excited about that we're looking at right now.
Ryan Swehla:
And just as the nimble investor can take advantage of the market better than a more institutional investor, another prediction that we've talked about a little bit is, as these urban markets, in general, as larger corporations readjust their footprint they use, reduced footprint and work from home as an opportunity to cost save, as they do that, I think we'll see a resurgence of the entrepreneurial companies take back filling some of that space.
Joe Muratore:
Oh, yeah.
Ryan Swehla:
Particularly in the urban markets, because they have a kind of a long-term desirability. And if for a moment in time, some of the corporations are contracting their footprints, rents are going down and there's a reset, it's those periods of time where a startup business can take a chance, can get a space that otherwise they wouldn't have been able to get.
Joe Muratore:
Yeah.
Ryan Swehla:
So I think that's going to be a trend that we'll see over the next 24 months.
Joe Muratore:
Certainly there's some urban core stories, Detroit or steel towns that didn't recover when there was major trends. But I think it's dangerous to bet against us, the long-term viability of San Francisco and New York city. I think this is an interesting opportunity for some pruning. There's some old wood out there. Restaurants that are closing, businesses that are closing. I think that over time you'll see ... In fact, I think a year from now, you'll see and probably even right this second, you'll see a movement of people that are seeing opportunity and finding a way in. And that probably will be reflected in rental rates for a period of time.
Joe Muratore:
But I think come back three, five, seven years from now to these cities, and they'll be as vibrant as ever. They'll be different, but they'll be vibrant. So from an investor standpoint, the thesis we've had for a long time, which is that the secondary markets are growing is proving true and fortuitous, because we've been making that bet for a while. But at the same time, now's the time to be thinking, "Okay, Q1 next year, into this year, Q2 next year, when's the right time to be engaging in primary markets in a way that we couldn't before because it didn't make sense?"
Ryan Swehla:
Yeah.
Joe Muratore:
Let's close with this. What advice would you have for other investors, occupiers of office space? They're thinking about their long-term strategy. What are a few nuggets they could take away and make better decisions with?
Ryan Swehla:
Well, for occupiers of space, I would say now is a prime opportunity to be evaluating your needs. So certainly what everyone expects is that some of those office tenants will say, "I don't need the footprint that I have now." The counterpoint to that is, if you're a growing business or you're a business where culture, collaboration, the synergies that are needed in an office space, you may find a historic time to be able to buy, to be able to expand into a larger space or a more prime location than you would have otherwise been able to. So, as an occupier, I think it's a great opportunity.
Ryan Swehla:
As an investor, I think it's also a great opportunity. And again, that comes through that volatility. We will continue to see a reinforced headwind of movement toward secondary, tertiary markets, as people make different quality of life decisions, as businesses make different cost decisions. But I think with that, there will be some upset in these urban markets. I take Sacramento as an example. We have a vibrant downtown Sacramento core that is virtually shut down right now. Very few tenants and buildings, very little activity happening. And that's going to cause some form of a reset. And that reset is an opportunity for investors. So I'd say, keep your eyes open in the next six to 12, to even 18 months from now. What advice would you give?
Joe Muratore:
I think you're absolutely right. This is a period of disruption and we're contrarian investors. And I think whatever you're doing, whether you're an occupier or an investor, ask yourself, "What's the opposite play? What's the opposite of what the crowd's doing?" There's space there to create the thing you want. If you wait for the crowd to recover, if you wait for the crowd to ... If you wait till four months before the vaccine, three months, two months, one month, there's going to be plenty of people. We're already seeing interest, I mean, not already. Right now we have letters of intent on buildings that we have bought. Right now we are negotiating them and there are people making their moves now. So my advice is, make your move right now, like right now.
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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.
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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.