Another Reason To Ditch Property - Commercial Office Space Comes Under Pressure

Summary

• As we know, the internet has been making inroads into brick-and-mortar retail, leaving some portion of retail property empty.
• This has led to several of the retail property companies in the UK - intu most notably - suffering, with terrible problems remaining afloat.
• It's possible that the same is going to happen to office property, the other sector of the commercial property world.

As with retail, so office property?

The travails of the retail property world in the UK have been well-rehearsed by me here before. Roughly, and approximately, 20% of retail sales are now online. Some 20% or so of retail property is empty - this is not a coincidence. The estate built for the earlier form of brick-and-mortar buying is now not appropriate - is too large in supply - for our new internet-connected world.

This then interacts with the manner in which most property companies are - righteously - geared with borrowings. As the equity value of the properties falls, as rent rolls do, the debt burden does not - it's the shareholders that get wiped out, that is. This is what has happened at intu (OTC:CCRGF). Nothing really wrong with the company other than the world around it has changed.

So here's the thing, might the same be about to happen to office property?

The answer is yes, to at least some extent. The investment case for commercial office property is now rather worse than it was. No, not just because of the recession, but because of what we might call "coordination."

Coordinations

One thing that economists like to go on about is "coordinations." This is where there's a way of doing the thing, whatever it is. It doesn't particularly matter what thing nor the way it is being done. Only that it is done this way and that's the way everyone does it. This makes a change in that way of doing the thing difficult as we can't just have a marginal change, at the edge, which then slowly spreads. Because the way I do something is reliant upon the way everyone else does it means that a group of us at least must change at the same time.

At the extreme there's no point in making left thread holes in a right thread screw world. And, if it does change orientation, everyone has to jump together. Of course, that's to overstate the case. Left side of the road and right is one that has to be changed all at once though, as Sweden did in 1967.

Lots of things are affected by such coordinations even as the problem exists along a spectrum.

One of those things being how we go to work. Working hours don't entirely depend upon other people. They used to in factories, there's no point in being the only guy putting in overtime on the assembly line. But with office work not so much. But at least some. We're still not going to fit into the usual working world if we decide we'd like to work midnight to 8 am, leaving just as everyone else comes through the front door. We'd have to be very independent of input from others for that to work.

Another such coordination is that idea that we all got to work at all. Perhaps all this new internet stuff means that we can do all, or some, or more, of our work from home? A lot of us can - one recent survey said 37% of US jobs could be done from home. That it's recent this report tells us why this might be a problem now.

For of course they were looking at how much economic activity can continue during the coronavirus lockdown. But that brings us to our coordination. If no one ever tried or was allowed to work from home, then it's something that would spread very slowly if at all. However, we're all getting a couple of months' crash lesson in how much can be done remotely. This being something economists like to say about coordinations. Often enough in order to be able to change some external event has to break the current consensus. And there's no guarantee that the post-event consensus is going to be the same coordination. For having been broken this gives the space for the change to happen in.

Working from home

At this stage we've got someone trying to calculate the effects of this. The results are not pretty for office owning companies:

Businesses will abandon up to a fifth of their office space as part of a permanent shift towards working from home, experts are predicting, amid claims “there will never be a back-to-normal”.

Andy Pyle, head of UK real estate at KPMG, said: “Ultimately, I would expect there will be a need for less office space and also different office space. My guess is that the fall would be somewhere between 10pc-20pc, on an individual company level on average.”

A string of major employers have said they have learned mass remote working is easier than feared and are already preparing to cut costs by reducing their office estates.

It was necessary to have the shock to break the consensus, the coordination, and there is no guarantee at all that the post-coronavirus world will come to the same arrangements. Indeed, the forecast is that it won't, with about 20% less office space being desired. Which is a nasty echo of what happened in retail property, isn't it? It only takes that much property to be surplus to requirements for equity valuations to be strongly affected.

Cyclical and structural

We must always be careful about the difference between cyclical and structural effects. Obviously, the economy is floating around the u-bend at the moment and rents on new lets are depressed - if any new lets are happening at all - but that's a cyclical effect. As the economy comes back then so will general demand.

A structural effect though is something that isn't so affected by the business cycle. It's an underlying change in technology or demand. Which is what we're suggesting is about to happen here, in office property as it has in retail.

This isn't about individual companies

Obviously, it's possible to identify those who might be affected. In the UK market Land Securities (OTCPK:LSGOF), British Land (OTCPK:BTLCY) (OTCPK:BRLAF), Great Portland Estates (OTCPK:GPEAF). I'm afraid I know the UK market better than the US but I'd expect some of the same problem to occur there too.

The point being that it's entirely possible that the COVID-19 response has triggered a structural change in the office real estate market. Possible and not certain but still something we should be aware of.

My view

I do expect to see this change in the coordination producing some demand destruction for the office side of the commercial property business. Marginal buildings will go unfilled, rents will decline. The unknown is how much rents will decline, what the definition of marginal will be.

The investor view

As with the retail side of commercial real estate, we're going to see a secular slide as a result of the internet. We've not seen much of it as yet because of that coordination problem. The experience of the lockdown changes that.

Commercial real estate is about to not be as safe as houses. The prime properties, well managed and without excessive leverage, will be okay even if not stellar investments. Those - as with intu in UK retail property - with leverage that can lead to a wipe-out of the stockholder equity in the business are going to end up at best on the edge of failure. This is going to play out over some years but it's as well to be warned.

This is going to be a general effect right across office property. It's not going to be confined to certain markets, nor to particular organisational forms. So REITs and Inc.s and limited companies will be affected equally.

Do understand that the right office in the right place will still gain tenants. And as long as the purchase of the property is at the right price - one that reflects the rent that will be paid upon it - then we as investors can do very well on the dividend or rental income. Just as landlords right now do fine with retail property as long as they bought at the right prices.

So this is not an argument to never look at commercial property again. It is rather to suggest that there's going to be a secular decline in rents and thus capital values over the next few years, decade perhaps, as the new working habits filter into the marketplace.

For us as investors, this means looking very hard at any office property investment and understanding that uplifts in capital value are going to be unlikely - quite the opposite in fact. Good places on long-term rents will be okay in comparison to more speculative offers, that is.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.