Dear Reader,
I don’t personally know the former owners of Burnett Plaza, but I promise they’re having a bad year…
Burnett Plaza was once considered the crown jewel of office space in the Fort Worth area. At 40 stories, it’s the largest building in town. And – until recently – it was valued at more than $100 million.
That’s all over now.
Last week, the building was sold at a foreclosure auction for $12.3 million. Just three years ago, the building was purchased for $137.5 million. That’s a more than 91% markdown in three years.
Ouch.
I’ve been investing in and developing real estate for my entire adult life. And I promise you: This is the stuff of nightmares.
And Burnett Plaza isn’t particularly unique. In recent months, there’s been a string of sales for large commercial buildings at a fraction of their former value.
And a quick look at the data for office REITs would seem to confirm something is wrong. As you’ll see, things have definitely slowed in office real estate.
It’s led many to speculate about an “apocalypse” for commercial real estate.
But as always, the reality is more nuanced.
Contrary to what many believe, the death of commercial real estate has been exaggerated. High-profile foreclosures like Burnett Plaza get the headlines. But under the surface, there are green shoots for a specific type of commercial real estate.
But first…
What Changed?
How did this happen? How did we get to a place where an asset like Burnett Plaza is now changing hands for a fraction of its former value?
The answer, of course, is COVID and the lockdowns.
Plenty changed during the lockdown era. But while things like air travel and restaurant visits have returned to pre-lockdown levels, the most enduring change has been remote work.
The Bureau of Labor Statistics estimates that as much as 50% of paid work hours between April and December of 2020 happened online. And while that figure has come down, as recently as last year, some 12% of U.S. workers were “fully remote.” And some 28% were on a “hybrid model.”
It’s a straightforward argument. Fewer in-office workers mean less demand for office space from buildings like Burnett Plaza. And that means the value of those assets falls, sometimes by a lot. And that’s how you get foreclosures like we saw in Fort Worth.
But contrary to what many believe, this is not heralding an apocalypse for all commercial real estate.
The Great Readjustment
The first thing we need to understand is that not all commercial real estate is created equal. For instance, how would you feel about working in a place like this?
That’s 2100 Pennsylvania Avenue in Washington, D.C. It’s got style, lots of natural lighting, a fitness center, and even a rooftop terrace. And plenty of shops and restaurants in the surrounding streets.
In real estate lingo, that’s what we call a “Class A” office building. They’re modern, energy efficient, have plenty of amenities, and are in a good location.
Now compare that with something like this:
That’s… depressing.
It’s what a “Class B” or “Class C” office looks like. These are older, cheaper buildings. They’ll get the job done… but nobody’s going to enjoy working there.
What’s happening right now is that Class A buildings remain in high demand. But Class B and C buildings are languishing.
According to Jacob Rowden, a research manager at the real estate broker JLL, the office market is in the strange situation of being “simultaneously oversupplied and undersupplied with office space.”
Some of the data is informative. It tells us that 90% of vacant office space comes from just 30% of all office buildings. In other words, the “apocalypse” in office space isn’t as widespread as you might think. It’s very concentrated.
Offices built after 2015 have seen a net increase of 133.2 million square feet of leased office space since the pandemic hit. Meanwhile, older offices continue to lose tenants.
It’s clear that demand for new, high-end office buildings is rising. But what about supply?
Office construction has dropped off a cliff. Over the past three years, new office construction has averaged 9 million square feet every quarter. But now, that has dropped off to just 300,000 square feet in the latest report.
That’s the lowest level seen in nearly 40 years of recorded data. And it means that record low numbers of new offices will be available in the coming years.
On top of that, developers have been getting rid of old offices at record rates. Last year, over 25 million square feet of offices were demolished or converted into other types of real estate, like apartments. That’s more than double the pace seen from 2013 to 2019. This year is on track to reach a similar amount of office space disappearing.
Markets are nothing if not adaptive. And right now, the market for commercial real estate is adapting to what customers want. It really is that simple. And once this trend finds its equilibrium, office rents and prices will start heading higher.
The future of commercial office space will not look like Burnett Plaza. The buildings will be newer, likely smaller, and loaded with amenities. And I wouldn’t be surprised if a modern office building is considered a “perk” for joining a business.
Rest assured, we’ll be keeping an eye on this trend and will be sharing any interesting investment opportunities with members of our premium services.
The so-called apocalypse may get the headlines, but the truth is far more nuanced and – for intelligent investors – potentially profitable.
Happy SWAN (sleep well at night) investing,
Brad Thomas
Editor, Intelligent Income Daily
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Source: Wide Moat Research