Second, growth in the U.S. economy is likely to be focused on businesses that are largely office-oriented which means that office demand will grow as the economy grows. We are still in the midst of the Information Age which means that economic growth, particularly in the U.S., will be based on ideas, information and computer modeling. All of which rely on white-collar workers, most of whom will be housed in office buildings.
This means that office-intensive areas such as traditional downtowns or office parks are not necessarily dead, they just need to be adjusted. Offices will become less dominant in the land use mix and other uses – residential, retail and entertainment – will fill the voids. Those uses are typically less valuable from a real estate standpoint which means that the overall value of the area may decline, but it will not reach “doom loop” levels in the vast majority of cities. In fact, the changing land use mix is likely to make these areas stronger and more resilient to future economic shocks.
The Bad News
The problem is that these changes will not be easy, quick or inexpensive. There will be a period of pain and uncertainty, which will lead to lots of political angst and unrest. Some properties will underperform, fingers will be pointed, and decisions will be second-guessed. The cities that bounce back the fastest will be the ones where strong relationships between local government and the business community help smooth the rough patches.
The second and more serious problem is that the transformation that needs to take place will not happen fast enough to save a significant number of buildings from default and, in many cases, foreclosure. It is estimated that $93 billion in office debt is coming due this year followed by another $54 billion next year. This is an obvious financial problem for the building owners, but it is also a problem for cities where the foreclosure rate is high. Foreclosure is a messy and time-consuming process, and it gets messier as the financing package gets more complex. [3]
Banks and other lending institutions are generally not adept at property management, particularly during difficult times. Worse still, the transformative actions that may be needed to restore value to the property are likely to require a capital infusion – something that lenders trying to squeeze immediate value out of a distressed property are unlikely to want to do.
All of this means that the urban change that needs to take place will take even longer than normal. In an age where negative news spreads like wildfire, cities and the real estate industry in general will need to manage the damage by emphasizing positive news and publicizing plans for upcoming developments. Downtowns, in particular, need to avoid the stigma of failure or the narrative of obsolescence that the media tends to leap to whenever “for lease” signs become too numerous. If the “doom loop” does become a reality, it is likely to be driven more by negative stories that are blown out of proportion rather than financial realities.
The Future
The key for the future is to focus on the needs and lifestyle of the worker. Historically, most office buildings have been more about the ego of the CEO than the needs of the thousands who occupy the buildings. Italian marble in the lobby might impress the CEO’s friends but is largely meaningless to the rank and file. That emphasis needs to change and cities need to reinforce that change by making downtowns and office parks more people friendly. If companies want workers in the office and if cities want workers in their downtowns, it will happen because of carrots not sticks. In short, office employers who want their workers back in the office need to “earn the commute” by making in-office work comfortable, productive and rewarding.
The challenge, of course, is that people are not all the same. What office workers need and want will vary based upon their age, their phase of life, their income, their profession and a dozen other variables. Employers (and cities) need to be flexible and willing to provide a range of perks and work schedules for workers to self-select.
Building owners can start by adding amenities that offset the hassle of commuting. For a start, building security systems need to be upgraded so that workers feel safe. This is almost a non-negotiable perk. Employees that don’t feel safe coming into the office will push to work from home as much as possible, and will eventually force companies to suburban or exurban locations that are perceived as low crime. Cities need to reinforce that focus on safety by making police highly visible and responsive. This is not always a popular strategy for cities with stretched budgets and where a visible police presence is interpreted as a slap in the face of minority groups. However, the failure of a major commercial center because it is perceived as unsafe will have economic ripple effects that will last for decades.
Building owners can also add lifestyle focused amenities like lounge spaces and gourmet coffee shops for workers who want a break from the standard work space. Showers, lockers and exercise rooms will appeal to workers who bike to work or want an exercise break during the day. The key is to remember that younger generations tend to blend their work and social lives much more than the baby boom generation or GenX. That is easier if their work environment is in close proximity with social venues and living options. Cities can reinforce these types of amenities by upgrading public spaces and interspersing retail, entertainment and residential uses with office uses.
The bottom line is that downtowns and office districts are competing for the time of the younger generations of workers who are crucial for the success of office businesses. Younger workers not only energize companies, they energize cities as well. Other segments of the population will follow their lead.
Unfortunately, modifications to existing office buildings to make them more attractive to workers will not completely solve the office occupancy problem. There is still more office space than will be needed in the near term. This means that some office buildings will either need to be converted to other uses or simply demolished. These are hard decisions because they represent a definite loss of value for the building owners – essentially acknowledging that cutting their losses and moving in a new direction is the only viable solution.
Converting office buildings to residential apartments or condos is currently the most popular option being discussed, particularly for class B and C buildings that are already lower in value than prime office space. The demand for residential units is still relatively strong in many cities and adding residents is a good long-term step for a more stable and resilient commercial district. Residents are a more reliable base for retailers to depend on than office workers and they help keep areas active long after most office workers have left for the day.
However, not every office building is a good candidate for residential conversion. Residential units need lots of windows and a relatively shallow distance from those windows to the central core of the building (e.g. 50 to 60 feet). Office buildings with large floorplates are generally not economically viable options for residential conversions. Plumbing and HVAC systems pose other obstacles. A typical office building has plumbing that is clustered near the central core while residential units have bathrooms, kitchens and laundry facilities that are much more scattered. Similarly, HVAC systems for residences are individualized for unit by unit control while office buildings tend to have much larger systems aimed at heating and cooling multiple floors. [4]
A key thing to keep in mind is that converting an office building to residential use is not cheap and the building owners need to commit to doing it right or risk failing a second time. Most office buildings have a distinctive look that isn’t always compatible with an attractive residential property. Glass cube buildings that remind people of soul-sucking cubicle farms are not likely to do well as converted residential properties.
There may be other conversion options available in certain circumstances such as educational facilities, scientific labs, medical space, or even fulfillment centers for companies like Amazon that are trying to do same-day shipping. All of these options have more limited demand and serious practical difficulties in terms of construction, but they may work in certain circumstances. It may even be possible to create “hybrid” buildings that blend residential, retail and office space, and are designed to be flexible enough to adjust the floor area mix over time.
The final, and worst option, is the demolition of the building if it drops in value below what the land alone is worth. This is likely to happen only to the oldest and most obsolete office buildings, but it is possible, and in fact, it is preferable to having “zombie” buildings that sit empty for long periods of time. Cities and developers should work quickly to get a new use under construction as quickly as possible.
A more curious problem is what will happen with suburban office parks. They were somewhat less impacted by the work-from-home trends but they were certainly not immune. For those that are struggling, the issue will be what to do in response. Office parks are traditionally focused exclusively on office (or nearly so) which means that shifting to a mix of uses will be more difficult. Zoning changes may be needed to allow multiple uses but the more difficult challenges are likely to be design and marketing related. Convincing people to live in an office park may not be easy without an enormous investment.
Conclusions
The COVID pandemic and the subsequent rise of work-from-home are further proof that cities are a constantly evolving entity. The problem is that this evolution happens so slowly that we tend to miss it – until, of course, things stop working the way we expect. In the case of the work-from-home trend and the office market, change happened relatively rapidly and caught even astute property owners and city officials by surprise.
The underlying issue is that nearly everything about a city – whether it be zoning laws, utility systems, building design and financing, transportation systems, or tax structures – is designed for either very slow change or no change at all. We build structures out of concrete and steel that will last for a very long time, and we are naive enough to think that our initial plan for how structures will be used need never change. In fact, we should be constructing buildings (and cities) with the explicit assumption that they will change – probably multiple times before they reach the end of their useful life.
Unfortunately, building adaptable cities is hard. So hard that we conveniently ignore the need for resilience and flexibility until we get smacked in the face by unexpected change. We forget that people are the crucial elements of any city, that enjoyable places are the ones that endure, and that community wealth-building happens slowly and incrementally rather than by following the cookbook trend of the moment.
Notes:
Jan Mischke, et al.; “Empty spaces and hybrid places: The pandemic’s lasting impact on real estate”; July 2023; McKinsey Global Institute; https://www.mckinsey.com/mgi/our-research/empty-spaces-and-hybrid-places
Anastasia Edel; “Opinion: Downtown San Francisco had a good run. Can it recover?”; May, 2023; The Los Angeles Times; https://www.latimes.com/opinion/story/2023-05-21/san-francisco-downtown-stores-closing-tech
Brian Pascus; “Inside the Room: How Handing Back the Keys On Commercial Real Estate Works”; July 2023; Commercial Observer; https://commercialobserver.com/2023/07/inside-the-room-how-handing-back-the-keys-commercial-real-estate-works/
Ben Abramson; “5 Reasons Why Office-to-Residential Conversions Are a Serious Challenge”; May 2023; Strong Towns; https://www.strongtowns.org/journal/2023/5/12/5-reasons-why-office-to-residential-conversions-are-a-serious-challenge
