The commercial real estate industry is facing an unprecedented series of challenges that center around a shift to Work-From-Home (WFH) and Hybrid strategies. Corporate occupiers have instituted WFH and Hybrid schedules to hire talent regardless of where they live, to retain their best employees, and to save money. These series of challenges are compounded by the sky-high interest rates which make refinancing underwater assets and buying/selling new properties (a key component of the primary commercial real estate business model) incredibly difficult, and oftentimes impossible.
Some markets across the country are showing signs of improvement, and trophy properties (especially newly constructed ultra-premium assets) continue to attract blue chip firms, but the overwhelming majority of the industry is in survival mode. Real estate is cyclical and downturns are nothing new, but the epic collapse which we are witnessing is something that most people (myself included) never expected to see in their lifetimes. Most downturns are the result of macro-economic changes that always eventually reverse course, and at some point, interest rates will come down to what is categorized as “normal”, but the WFH and Hybrid phenomenon has nothing to do with the state of the global economy. It has everything to do with a shift in behavior from corporate occupiers. A change of this nature typically requires some sort of massive event that changes the game for everyone, and that is exactly what happened when companies of all sizes sent their employees home early on Friday the 13th in March of 2020.
COVID Changed Everything
When COVID first entered the US, I was expecting to work from home for a week or two. But instead of being back in the office 2 weeks later, I found myself standing on a 2-hour line outside of The Home Depot with a mask on my face and anxiety flowing through every inch of my body. I remember seeing some people on line in what appeared to be full Hazmat suits, and that is when I realized that the world that we are living in had completely changed.
I had spent so many years traveling into NYC from northern New Jersey, driving to the nearest transit center, riding the bus, and then taking 2 subways to get to the office. I live only 40 miles from NYC, but the one-way trip took 2 hours in normal conditions. The thought of 4 hours of daily travel to and from work sounds insane to me as I am writing this, but it was part of the gig that millions of people did every day, and it felt totally normal.
When I first started to work from home, I thought that I was going to lose my mind. I love my family more than anything in the world, but with 3 kids trying to figure out remote learning, and the technology needed to properly work remotely still in its early stages, I could not wait to get back to the office. It took me a month or so to settle into this new lifestyle, but I quickly began to enjoy my new routine. I had so much extra time and I was super productive, and excluding the horror show of death and suffering that so many people were experiencing from the pandemic, I found myself less stressed about work and in a much better mood at times when I wasn’t working. And as sports started to happen again, I never missed a single one of my kid’s games – and I even had the time to coach as well. I never wanted to take that daily commute ever again, and I found myself wondering how I ever was able to do that in the past. It was almost as though many of us commuters had been in a zombie state of mind.
I want to stress the fact that I am a huge fan of in-person meetings and collaboration, and spending time with colleagues, customers, and prospects in an office setting is a vital component of a successful business. I am a huge believer in the need for quality office space. But I shared the story of myself above because I do not think that it is unique in any way, and I believe that many commuters in the corporate world shared similar experiences as I did. Adding this context to the millions of other commuters that can relate to my experience, helps illustrate my view on how COVID transformed the commercial real estate industry and played the leading role in how we got into the situation that we are in today.
My entire career has centered around real estate and technology, with the past 12 years specifically in commercial real estate. The challenges of the industry have been well publicized for years, but my daily interactions with property teams across the country have really punctuated the toll that these behavioral shifts are taking on the professionals that own and manage these assets. The most obvious signs of change to me are around the priorities that owners and managers are focused on, compared to their priorities pre-Covid.
Tenant Experience vs Cost Cutting
For the years leading up to COVID, the number 1 priority and buzz words used in the industry were “Tenant Experience”. Whether it was technology platforms like Tenant Engagement Apps, the latest and greatest in-building amenities, or the perks that they were providing to their tenants’ employees that worked within a building, every decision was based around leasing activity. Multi-tenant commercial buildings live and die by their ability to continuously lease space and retain their current tenants. Leasing remains the lifeblood of the industry, and its importance is as pronounced now as it ever has been. But with transaction activity falling to levels that nobody could have predicted, we entered a new phase where the industry needs to focus on other activities to save their balance sheets. Most properties, outside select trophy buildings, have few ways if any to generate significant revenue outside of leasing (some trophy buildings can generate revenue from non-leasing activities such as observation decks and experiences that can attract people who do not work in the building). With new revenue opportunities being limited and refinancing of debt off the table, the only way to improve the financial performance of these assets is limited to cost cutting and operating efficiencies.
I don’t want to give the impression that points of differentiation such as building amenities and fancy lobbies do not matter; in fact, they matter more than ever since the same number of buildings are competing for a piece of a much smaller pie. But operating efficiencies and cost cutting must remain front and center because leasing revenue, that generates the large majority of a building’s total revenue, doesn’t appear to be recovering anytime soon. And the runway is getting shorter and shorter since refinancing debt has become so expensive that it often does not pencil out.
How to Cut Costs
Outside of pushing pause on non-essential capital projects within a building, there are only so many places to make cuts. Property teams are already running very lean, and I have always considered property managers to be amongst the most overworked and underappreciated professionals in the corporate world. Most opportunities to reduce headcount have already taken place, and the skeleton crews that have remained are working harder than ever to provide their tenants with customer service and the experience that they expect when signing a lease. But there are still plenty of opportunities to reduce costs and increase efficiencies within these buildings to extend their runways and improve their balance sheets. The common theme that connects the different strategies available to achieve these savings is technology.
Energy Conservation
One of the largest line items on a building’s P&L is energy costs. Not only are there many ways to reduce energy consumption, but with much fewer people coming into the office on a daily basis, it is only logical to assume that less energy should be consumed than when occupancy levels were much higher. If a tenant occupies an entire floor and none of their employees come in on a Friday, it is beyond wasteful to heat or cool that space with nobody there. There are 2 issues however that complicate this process. First, older buildings often do not have floor-by-floor controls available from their HVAC/BMS. The larger issue that affects all buildings however is the standard language in leasing agreements that require the landlord to provide HVAC during leasing hours (one exception to lease languages are triple net leases where the tenant pays directly for their actual energy usage). But if you read most leases, there is an important nuance that should allow owners to save energy in unoccupied space while continuing to meet their lease obligations to provide comfortable working conditions for their tenants. The nuance is around the phrase “must provide”.
There is a difference in being forced to run the HVAC on floors that are unoccupied, compared to ensuring that tenants are provided with comfortable conditions when they are in the building. HVAC & BMS systems have no internal way of knowing when someone is in the building, if they are coming to the building that day, or if nobody is in the building or on a particular floor. Schedules are set in advance in a building’s BMS system, and any changes typically require the building engineer to adjust the settings to manually override the schedule. It is obviously impractical for someone to monitor everyone that comes into the building, determine what floor they work on, and then manually make changes in real time. Fortunately, inexpensive and easily deployed technology exists today to be able to automate this entire process so that a building can continue to operate at a minimum load, and only activate at the specific locations where an employee who shows up to the building on a given day will be working. One example of this technology is Genea’s On-Demand HVAC Platform (full disclosure: I am employed at Genea).
An enormous advantage to energy conservation strategies, above and beyond cost savings, is the benefits to the environment. Personally, I believe that the benefits to the environment are more critical than cost savings, but I did want to keep this article focused on economics. It is important to point out that energy consumption can affect a building’s financial performance in ways beyond reduction of costs. Regulations have been adopted in different markets that apply huge financial penalties to owners that do not reduce emissions and meet certain benchmarks by specific dates. One of the most prominent examples of these regulations is New York City’s Local Law 97. Not to mention that many large corporate occupiers have their own ESG goals, and they are demanding buildings meet certain benchmarks as a prerequisite to signing a lease.
Another misconception around energy costs revolves around Triple NET leases. In these types of leases, the tenant is responsible for all of the costs for their actual energy usage. Therefore, property owners and managers are not concerned about excess energy consumption because their tenant is solely responcible for the costs. But this does not take into account the depreciation of their building HVAC equipment. A tenant may choose to run their HVAC 24 hours a day for 7 days a week. Even though they are covering 100% of this excess usage, the lifespan of the equipment will be much shorter, which creates expensive maintenance costs and ultimately the need to upgrade the building equipment considerably sooner than if there was normal consumption. It is very similar to a car lease. When someone leases a car, they can drive anywhere that they want, but they must stay below a specific mileage number, or they are required to pay for the excess mileage. For this reason, building owners should be using technology to monitor and charge an overage fee for excess energy usage for Triple NET leases.
Operating Efficiencies
With all of the cuts to headcounts that have taken place, significant efficiencies require technology. The lowest hanging fruit is often related to old legacy on-prem technology platforms that are limited in functionality and expensive to maintain due to replacement costs and obsolescence that is synonymous with on-prem systems. If these legacy systems were installed many years ago and are accompanied by recurring fees, seat licenses, or software upgrade costs, chances are that the contract escalations built into the original vendor agreements have increased the pricing way above market. Commercial real estate has been one of the slowest industries in the world to adopt cloud, but that mindset is shifting, and cloud is now the norm for many owners. Additionally, newer cloud platforms have much more functionality than their predecessors, so it is often possible to replace several legacy solutions with a single cloud-based platform.
Earlier in the article I referenced that Tenant Experience Apps were the must-have solution for buildings prior to COVID as most owners and managers were singularly focused on tenant delight. Even though priorities have changed, it is my opinion that these platforms are as relevant today as they ever were. But there has been a branding shift which many of the leading providers of these Apps have undergone. Tenant Experience is still an important part of their value proposition, but they are placing more attention on the efficiencies that these Apps can provide to their building teams. By integrating different building technologies onto a single integrated platform, their promise is to help property teams streamline their operations and do more with less. With all of the critical building infrastructure integrated together, owners and managers can aggregate all of the data collected together to make informed decisions that in the past required numerous spreadsheets and many hours of analyst’s time.
Another way that real estate owners can achieve efficiencies and cost savings is via outsourcing. Operating a building is a massive responsibility and requires professionals with a wide variety of different skill sets. It becomes even more difficult to get the staffing right when owners continue to buy and sell buildings in different markets because the size and makeup of their portfolio is constantly changing. This provides a perfect opportunity for owners to outsource anything that can be outsourced. One example is Submeter Billing. The process of reading meters, calculating fees, and invoicing tenants for Submeters is manual, time consuming, and prone to errors that can result in a massive financial hit if tenants are mistakenly billed incorrectly. While this is one example, there are many other responsibilities that can be outsourced to companies that specialize in the specific task at hand. In one of the biggest announcements in Commercial Real Estate this year, Brookfield recently announced that they were outsourcing all of their US property management responsibilities to CBRE.
Signs of Life
The overwhelming narrative on the state of the Commercial Real Estate industry is negative, but there are a few bright spots that are starting to appear from newer industries such as the legalization of sports betting, cannabis, and the explosion of AI which has seen the formation of many new companies that are gobbling up real estate in certain cities. For industries such as AI, it’s not only office space that is being leased, but also industrial sites to house their data centers and critical infrastructure. These glimmers of hope are welcome news for the commercial real estate industry, but it still won’t be enough to solve the underlying challenges that many owners are facing. In order to come out on the other side in one piece, owners must leverage technology to reduce costs, increase efficiencies, and continue to be competitive with the amenities and perks that occupiers are demanding as a prerequisite for signing a lease.