May 3, 2022

The Woebegone Office Sector’s Bright Spot: Class A Buildings

What work-from-home problem? The sparkling new properties are in demand.

Reported by Larry Light

Art by Jonathon Rosen

Those glimmering Oz-like office towers that define city centers, along with lower-lying office buildings across the face of the nation, are still only partially occupied. Due to new hybrid scheduling, just 42% of U.S. office workers are back, per Kastle Systems. While forecasters keep talking about how more and more office employees will return, no one expects a big flood, at least in the near term.

So, is investing in office real estate a loser’s bet? Not for discerning investors who ride a trend that the pandemic has only made stronger: The top-tier office buildings, called Class A, are doing well—and real estate experts believe they should thrive going forward.

Mainly constructed over the past 15 years, Class A offices boast lots of space and light, and are newer, environmentally friendly, and wired for the latest technology. Class B is the next rung down: more crowded, less light, less tech-oriented. And Class C … well, by comparison, these are pretty bleak.

The leasing action is concentrated on Class A structures. “New supply is still capturing an outsized amount of demand,” says a report from real estate firm JLL. Some 21% of leasing demand in this year’s first quarter was for buildings that have launched since 2015, even though that segment is just 13% of inventory, JLL finds. But the buildings that opened from 1970 to 1999, with 60% of the supply, got 39% of the new leases. Nationally, Class A rents are one-third higher than Class B ones.

The competitive advantage of Class A properties is clear, especially in a time when working from home still is an option, according to an office market analysis by Farouki Majeed, CIO of the School Employees Retirement System of Ohio, and his real assets investment team. “Class B and C office buildings that require a lot of retrofitting and have functional obsolescence (lack right electrical networking, layout, design) will struggle,” they write. “Tenants want open space layout. Why go into a dreary office when you can work from home?”

The A-Listers

Check out Manhattan, the nation’s largest office market, for a glimpse of Class A superiority. “New construction, mainly of Class A buildings, has come on line lately, meaning the older structures are being left behind,” says a study from real estate company Cushman & Wakefield. A prime example is One Vanderbilt, a gleaming 93-story midtown edifice that opened in late 2020: It is 95% occupied, with such tenants as private equity powerhouse Carlyle Group and white-shoe law firm McDermott Will & Emery.

Meanwhile, Google-owner Alphabet is expanding its footprint in New York by transforming a junky old waterfront space into a Class A property. The tech titan is renovating a former freight center near the Holland Tunnel, known as St. John’s Terminal, into a 1.3 million-square-foot office park that will house its 12,000 workers scattered around the city and the 2,000 new hires it expects to make.

Elsewhere, new Class A office palaces are debuting apace. Among the biggest recently are BMO Tower in Chicago, Texas Tower in Houston, RBC Gateway in Minneapolis, and 111 Harbor Way in Boston.

Burgeoning industries not commonly thought of as office tenants are also boosting demand for high-end space, Ohio SERS points out. Life sciences (which needs lab space), medical offices, and data centers all for various reasons cluster in certain vicinities. Biotech companies and the like tend to be in the Boston and San Francisco areas, and in secondary locales including Philadelphia, Seattle, and Raleigh, North Carolina. Medical offices gravitate toward hospitals and medical schools. Data centers want to be close to users, wherever they are.

Alphabet’s example shows that tech giants prefer large cities—what in real estate parlance are called “gateways”—and have so much money that the higher rents don’t faze them. Some smaller locations, Ohio SERS notes, also benefit from tech and other innovation-centric industries: Austin, Dallas, Denver, and the Raleigh-Durham area.

The allure of Class A should only increase, because new construction of these sparkling new spaces is tapering off—perhaps as a result of builder pessimism in the early days of the pandemic. By JLL’s analysis, the Class A construction pipeline is “on a thinning trajectory” and dropped to 93.3 million square feet at the end of 2022’s first quarter.

That pending supply constriction appears to be a temporary phenomenon, however. JLL believes that “the need for quality space will spur some anchor-led developments,” meaning big-name tenants desire spanking new buildings bearing their corporate names above the lobby door.

For investors, offices can be lucrative over time. The downside is they often require more capital spending to remain competitive than other commercial real estate does. Industrial properties (mostly warehouses, where such lessees as Amazon store merchandise for delivery) don’t need much in the way of creature comfort for occupants.

These days, even Class A landlords end up granting several rent-free months to entice tenants, which eats into returns. These concessions often go to underwriting tenants’ customization of their new spaces. Such give-backs, known as “tenant improvement allowances,” average well over $100 per square foot, and have hit $200 in a few areas, notably downtown Washington, JLL says.

Pension Plans’ Property Preferences

Ownership of trophy office buildings is a part of allocators’ strategy. In the allocator’s real estate category, offices rank third, with the largest asset allocation going to industrials (30.1%) and multifamily (26.8%) in second place.

Class A buildings work their charm on some of the largest funds. The California Public Employees’ Retirement System is the landlord of 54-story 787 Seventh Ave. in midtown Manhattan. Canadian pension systems hold a larger array of office properties internationally. The Canada Pension Plan Investment Board owns shares in office structures, often around 50% each, in cities ranging from Toronto to Los Angeles and from London to Rio de Janeiro. Offices are 21.4% of CPPIB’s properties, in square foot terms.

Most plans invest in office buildings, and real assets generally, via partnerships that possess a collection of properties, and avoid outright ownership. The Maryland State Retirement and Pension System, for example, holds 21.3% of its real estate assets in offices using these pools. Ditto for Ohio SERS, where offices make up a similar portion of the real estate portfolio.

Real estate overall is increasingly popular among institutional investors, as property is a key component of the burgeoning alternative investments category. Alts are in demand among asset allocators because these investments will diversify their holdings and, allocators hope, provide good long-term returns. In 2021, public pension funds had 8.1% of their portfolios in real estate, which ranked fourth in allocation after stocks (46.6%), fixed income (13.2%), and private equity (13.2%), by the count of Public Plans Data.

Beyond Class A

What will become of Class B and Class C buildings? Some will keep going, as not every tenant can afford to pay the premium rents that Class A commands. And up-and-coming enterprises, such as tech start-ups, often want grungy spaces.

Other Class B and C buildings may be repurposed for non-office uses, most often as residences. That’s what happened to the 55-story Woolworth Building in lower Manhattan, opened in 1913 as the headquarters of the then-dominant retail chain. The top 30 floors have been converted into condos, with the lower levels kept as offices.

Overall, the picture for the office market is improving, albeit slowly. U.S. office vacancy rates, which had been around 9%, soared when the pandemic first hit, and reached 17.2% in 2021’s second quarter. Since, it has improved, to a still-high 12.3% in this year’s first period.

To see the arc of office investing, let’s focus on real estate investment trusts. Office REITs, according to the National Association of Real Estate Investment Trusts, got crushed at the pandemic’s outset, losing 18.4% in 2020, as the S&P 500, after an initial swoon, bounced back to finish the year up 16.2%. In all, 60% of pension funds and endowments hold REITs, the association’s data shows.

Last year, though, office trusts climbed back, even though few office workers returned; many of their employers had long-term leases, making actual return of workers irrelevant, and this heartened investors. In 2022, as of last Friday, office REITs are in the red by a small amount, as the S&P 500 has tumbled 13.3%. The largest office REIT, Boston Properties (with holdings in major Northeast and West Coast cities), is down just 2%.

The moment of truth for the office market, and especially for the buildings below Class A, will be what happens when current leases expire. Office tenants are currently stuck with unused square footage thanks to employees working from home a few days a week or all the time.

As Ohio SERS observes: “Will tenants renew their leases at the same square footage and rents, or will the hybrid work-from-home norm translate to less space needed, giving them more leverage against landlords?”