The Office Building Conundrum

There have been very few major office buildings constructed in the past 7 years, and it is unlikely that many new major ones will be getting built any time soon, other than Hudson Yards and the remainder of World Trade Center in New York, a couple of buildings in Denver, San Francisco, Houston and a few other cities. And it's because of an interesting conundrum now which inhibits such construction in many places.

Most law firms, accounting firms and banks are reducing floor usage. Other companies are going to open floors and in some cases that reduces floor plate requirements, while sometimes it does not. Many other companies are not fully restaffing after the cutbacks of 2009, and it is unlikely that they ever will. Technology has materially reduced the need for space. Paper files are becoming less of a requirement as the cloud now has become the filing cabinet for many companies and people. In addition, automated phone answering, interactive web and app sites allow customers to conduct certain functions previously done by humans, and it is now well established that it is easy to have spread sheets run over night in India at a fraction of the cost. The one area where staffing is materially increasing is compliance, but these staffers do not need a lot of space per person, and once Obama is out of office, there may be a material reduction is that requirement in all sorts of companies.

If the economy continues to muddle along for several more years, which seems very possible, then hiring will not increase materially and cost control, i.e. staffing levels, will be held to a minimum. In many markets, there is a ceiling to rents. It is unlikely that there will be any material rent increases in ost markets for at least three to four years, and maybe longer. There is a glut of space in downtowns that will be hard to fill. The local large law firms are not expanding, and accountants are not expanding their staffs to any great degree. In fact, law firms are consolidating and merging, which will cause a continued reduction of partners and accompanying staff. When combined with the technology revolution at law firms and the reduction in huge fees from the good old days of 2004-2007, there is little likelihood of the ability to get the huge rents larger law firms once apid for the best space.

Cities like Los Angeles have a vacancy of around 18%, and little chance this will change since one of the big Japanese companies has committed to build a 300,000 sq ft building in downtown which is far too much space to add to that market. Objective real estate people in Los Angeles say they would not invest in any office tower in that city. In New Jersey nobody can recall when office rents really rose, so on an inflation adjusted basis they have fallen over the past twenty years. Then there are cities like St Louis, and other large cities in the space from the Hudson river to the Rockies where not much is going to change and rents are not going to rise.

The real conundrum now is that in places like New York, San Francisco, Raleigh and Austin, there are a lot of office buildings that seem to be better occupied, but the tenants are new high tech businesses many of which will not survive. They are new, may be flash in the pan successes, and within three to five years many will flame out. So there is a real question in many locations as to how occupied some buildings really are if you credit risk adjust the tenant roll. We all know that even some of the bigger names will not survive then next round of tech changes which come rapidly. These companies will either go out of business or bought for the technology and the office closed. That will happen more and more, and for lenders this is a real serious risk. In many tech areas, here today gone tomorrow will happen too frequently. It is the nature of the business. Consolidation will occur. In media the same will be the case and in publishing and related businesses this is a dying and consolidating industry. The problem for landlords is you have no way to really know who may survive and who will be consolidated out of their space.

So if the big professional firms, publishing houses, and banks are shrinking usage, and if hiring stays weak, and tech becomes a risky tenant group, owning office in many cities could become a much bigger risk and less value creation than many think is possible.

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Joel Ross began his career in Wall St as an investment banker in 1965, handling corporate advisory matters for a variety of clients. During the seventies he was CEO of North American operations for a UK based conglomerate, and sat on the parent company board. In 1981, he began his own firm handling leveraged buyouts, investment banking and real estate financing. In 1984 Ross began providing investment banking services and arranging financing for real estate transactions with his own firm, Ross Properties, Inc. In 1993 Ross and a partner, Lexington Mortgage, created the first Wall St hotel CMBS program in conjunction with Nomura. They went on to develop a similar CMBS program for another major Wall St investment bank and for five leading hotel companies. Lexington, in partnership with Mr. Ross established a hotel mortgage bank table funded by an investment bank, and making all CMBS hotel loans on their behalf. In 1999 he formed Citadel Realty Advisors as a successor to Ross Properties Corp., focusing on real estate investment banking in the US, UK and Paris. He has closed over $3.0 billion of financings for office, hotel, retail, land and multifamily projects. Ross is also a founder of Market Street Investors, a brownfield land development company, and has been involved in the acquisition of notes on defaulted loans and various REO assets in conjunction with several major investors. Ross was an adjunct professor in the graduate program at the NYU Hotel School. He is a member of Urban Land Institute and was a member of the leadership of his ULI council. In 1999, he conceived and co-authored with PricewaterhouseCoopers, the Hotel Mortgage Performance Report, a major study of hotel mortgage default rates.