ARA CEO Stanley Iezman and Head of Research Sabrina Unger discuss the outlook for the office sector given structural and cyclical headwinds. They explore the role of the pandemic in accelerating adoption of hybrid work environments, as well as Gen Z’s surprising role in office demand. 

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Stanley Iezman: Over the last several years, we've been talking about the future of office in the context of the shutdowns that occurred as a result of COVID-19. And today, what we want to do is really dig into this and really understand what your view is and what our view at American Realty Advisors is in regard to utilization of office. So why don't you share with us some of your thoughts on this?

Sabrina Unger: I think what's coming out is that the lasting impression from the pandemic will be hybrid as it relates to office demand. When we look at the Kastle Back-to-Work Barometer, for example, it seems to be finding stasis at around 40%-50% office attendance relative to pre-pandemic levels. So effectively, what that insinuates is people are coming into the office about half as frequently as they did before the pandemic.

SI: So what do you think this means for occupier demand in real estate over the next several years, given the lack of people coming into the office today?

SU: At a 30,000-foot view, office fundamentals are absolutely going to be challenged for the foreseeable future. When we look back to the period of 2020 and 2021, corporate tenants were signing short-term extensions because they didn't want to be making permanent space decisions at the peak of uncertainty. So now we have those starting to roll to market just at the onset of what may be a recession. So that's certainly going to be challenging, and then we also have to contend with natural lease expirations.

Putting aside those short-term extensions, we have something like 900 million square feet of office leases nationwide that are going to be rolling between 2022 and 2025. All that to say, each company's demand is going to be different, but I don't think it's a leap to assume maybe half or some of that 900 million square feet that's rolling, they're going to shed some space, whether it's to have more efficient floor plans, consolidate locations, what have you. The likelihood is that some of those leases, when they roll, they are certainly going to be smaller than they were initially. I think in terms of net absorption, that means it's going to look tepid compared to what is considered to be a normal year.

SI: So that sounds pretty bleak. We're investors. Are there any bright spots out there, and how do you think about that in today's world from an investment strategy standpoint?

SU: When we said that there were going to be consolidations or tenants are going to be looking for more efficiency, that insinuates that they are going to be signing leases. So there is some demand to be captured, it's just going to be fewer leases in the aggregate and maybe a smaller amount of it, so we need to fight for our share of what effectively will be a smaller pie. And when I think about characterizing office demand, it's really winner-take-all, and the winners are either new or freshly repositioned assets that have all the amenities, the bells and whistles, the green credentials, all the things that tenants want, beyond just their physical floor plan. There's going to be a disproportionate amount of leasing that takes place in these sorts of new or freshly repositioned buildings.

SI: So I'm glad you made that comment about the office market and the differentiation between higher quality and lower quality office. My question then becomes, what are we going to do with all this Class B and Class C space? Are these going to become zombie buildings? Are people are going to use them? What are the alternatives that we're going to be dealing with?

SU: We’re seeing a lot of discussion about office-to-apartment conversions. Cities are generally supportive of this—they’re looking for opportunities to add housing. Housing advocates are certainly a big proponent of this. So it seems like it's a great idea and it solves a chronic problem in most cities, but the reality is, I don't think it's going to be some widespread solution to the over-office issue we're facing nationally. We need to think about what functional obsolescence means when it comes to office. Most of the time, functional obsolescence is by virtue of physical elements, so whether it's bad column spacing, low ceiling heights, inefficient mechanical systems—the reality is, all of those things are very expensive to fix. Unless the B and C office really re-prices even more materially than it already has, we don't think we're going see conversions writ large across markets.

SI: With the workforce getting younger and the millennials aging along with us boomers, and technology becoming much more prevalent and ubiquitous, is there a need for office in today's world? How do you think about that today and juxtaposing that with the demand for office that is out there?

SU: It is precisely this young workforce that necessitates some sort of physical gathering place. We recently did a Change Agents piece about how millennials are gearing up to be in the C-suite in the next decade, and how they're going to be incredibly influential when it comes to space decisions. If we stop the conversation there, you could certainly say that millennials are ready to eschew the office because they've already built their professional networks, they've learned their jobs in place, they have their mentors, and so they're very happy to work from home.

But in reality, that isn't the end of the conversation, because the millennial leaders of tomorrow are going to have Gen-Z employees, and those younger, freshly minted college grads, they don't have their professional network. We as humans tend to find things easier to learn when we get to do it in person, so there's something about personal and professional development that, if there's no office at all, it's a detriment to those younger generations. So while the millennial leaders of tomorrow may be more than willing to permanently work from home, the reality is that their subordinates are going to require some space for them to come together.

SI: There are dueling headlines in the newspaper about CEOs of companies like Meta and Alphabet demanding that people return to work, and we read about it every day, and then you read in the same newspaper columns, the fact that there's quiet-quitting where the younger workforce is suggesting that they don't want to come back. How do you think that we should be evaluating that in the context of this conversation about demand for office and the future of office?

SU: Many of the companies that are leading the charge on the return to the office, they are titans in their own space, so whether it's Meta or Goldman Sachs, they have the reputational power to be able to try to bring people back, and they're willing to lose some of those people that don't want to be in the office, because they know that their recruitment strength will bring people back. What I look at in terms of the intermediate and longer-term outlook for office and whether there's going to be a shift in employer and employee power, is just structurally in the United States, we don't have enough workers relative to the number of job openings.

So unless we see something like 2 million jobs, whether it's openings or existing jobs, disappear, the balance is going to remain in favor of the employee. While I think some companies will mandate being back in the office five days a week, the savvy, strategic, growth-oriented companies, I think they're going to embrace the idea of hybrid because it allows them to capture the best talent and maybe capture some of those quiet-quitters from great firms that are more than willing to come over if they're given hybrid.

SI: Prior to the pandemic, the number of people per square foot was significantly higher. We were talking about density going from 300 square feet per employee to down to 200, and even in the tech companies, they were going down to 150. Do you think that there's going to be this level of concentration going forward? Leaving aside the health issues, do you think that that's going to continue?

SU: I think what we were seeing even before the pandemic is there’s certainly pushback against 100 square foot per employee. You feel cramped, you don't have your own space. There are certainly certain types of roles that require the ability to focus without hearing your neighbor's conversation, so we were already seeing a reversal in that trend, by and large. We do have to account for the recency bias of the health concern. We don't want to be on top of the people that we're working with, and we also have to think that people don't like hoteling.

There was this idea that if I have 100 employees, maybe I only need 50 desks because Joe will come in two days a week, and Mary will come in the other two, and they can share a desk. The reality is most people don't like that. People want to leave things, they want to feel like that space is their own. So I don't think that we get to a place where we continue to see densification push below 150 square feet per person. I think we probably settle back nearer to the mid-range. We probably don't get back to 300, but I don't think we go down to 100, either.

This transcript of the ARA In Conversation discussion has been edited for clarity.

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Watch more ARA In Conversation, as Stanley Iezman and Sabrina Unger discuss Industrial Real Estate.

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