The Recovery and Commercial Real Estate Leases

Takeaways

• In general, office and retail space continues to face challenges, while industrial, warehousing and multi-family residential real estate is booming. But location and sector always are key factors in determining the status of a real estate market.
• The post-pandemic office environment is likely to be a hybrid of in-person and at-home work. Also, hoteling—shared work space replacing designated personal offices—could be a growing trend rather than a fad.
• Companies should give careful consideration to known future real estate needs before making any long-term decisions. The work environment is likely to change again in the next couple of years, which could create further changes for commercial real estate needs.

The COVID-19 pandemic isn’t over, but with a large percentage of the population vaccinated and case counts dropping, now is the time to consider post-pandemic commercial real estate trends. With that in mind, Nellie Shipley Sullivan, a member of Womble Bond Dickinson’s Real Estate Sector Team, and Charlie McCurry, Senior Division Counsel in the firm’s GCSolutions service, discussed current and near-future trends in commercial real estate. The discussion took place with Womble Bond Dickinson attorney Mark Henriques on an episode of the “In-house Roundhouse” podcast, and the following article is based on that conversation. 

Few historical events have reshaped commercial real estate as quickly as the way the COVID-19 pandemic did in March 2020. In some sectors, such as office and retail, the shift to work-from-home and stay-at-home meant new swaths of empty towers and storefronts. But in other economic segments, companies scrambled to find enough space to meet increased demand.

So where does the commercial real estate market stand in late 2021? Commercial real estate is a broad sector and the answer to that question largely depends on sector and location.

For example, office leasing continues to face headwinds related to the COVID-19 pandemic. Office leasing activity was at 39 million square feet for Q3 2021, compared to nearly 54 million in Q3 2019. However, it should be noted that Q3 2021 was the strongest office leasing quarter since the pandemic began, and approximately 50 percent higher than in Q3 2020, when the pandemic raged and vaccines were not available. Likewise, the retail real estate market, which was hard-hit by the pandemic, continues to face challenges. 

“The pandemic has accelerated and in many cases exacerbated the issues we saw previous to the outbreak,” McCurry said. Trends that impact the commercial real estate market, such as working from home and online shopping, certainly grew during the pandemic, but were already in motion before COVID-19. 

But the Opportunity Economy already has been a boon for other sectors. Sullivan notes that industrial real estate is setting records, with Q3 2021 vacancy rates reaching a record low of 4.3 percent and year-over-year industrial real estate rent growth setting an all-time high of 6.7 percent. Warehousing and distribution space is particularly important, as companies reconfigure their supply chain networks to meet new challenges and opportunities.

The multi-family housing market also is booming, Sullivan said. Demand for such housing now exceeds pre-pandemic numbers, according to a recent Freddie Mac report. 

And economic and public health conditions look bright for the commercial real estate market as a whole as 2021 ends and 2022 begins. 

“There’s so much capital chasing real estate – and that’s not always so,” Sullivan said. 

The “And/Or” Question: Rethinking Office Space for 2021 and Beyond

In a LinkedIn poll conducted by Womble Bond Dickinson, 56 percent of respondents say they will lease less office space in next 12 months. Such thinking reflects an overall national sense that working from home has become a long-term approach for workers eager to shorten commutes and employers looking to cut office expenses.

“I do think some of it has to do where you are,” Sullivan said. “The Sunbelt continues to be an incoming area for businesses and workers.” An Oct. 2021 Atlanta Journal-Constitution article estimated that office leasing in Metro Atlanta is at its highest level since December 2019. 

Sullivan also said that while public health conditions have improved greatly this year, the pandemic isn’t over and companies have not yet been able to finalize post-pandemic plans. So what seems to be a “New Normal” for office life in late 2021 may not be the case a year from now.

Sullivan and McCurry discussed that “Working in-office or working from home” may be the wrong question for employers to ask when calibrating office real estate needs. Instead, employers are likely to find themselves dealing with an “And” environment, in which employees are in the office part of the time and working from home at other times. While companies and employees have proven that working from home does work, McCurry and Sullivan both say that many offices want to get recapture the sense of “unintentional collaboration” that comes from in-person workplace conversations. 

“Companies were looking for flexibility even before the pandemic, and landlords need to be prepared to offer shorter terms or perhaps concessions such as rights of first refusal for adjacent space. Tenants are going to demand of office landlords the ability to throttle up and throttle down,” McCurry said.

Sullivan also noted the so-called “Great Resignation,” in which workers have voluntarily quit their jobs in record numbers. So far, the trend has been concentrated in low-wage jobs, but Sullivan said it could impact office employment, too. 

“Companies should be cautious about what the workforce is going to be like. We don’t really know what it’s like to have a hybrid workforce outside of a pandemic,” Sullivan said. “It’s one thing for people to put their shoulder to the grindstone when we’re in a pandemic, but we still need to see what it’s like when there’s more freedom to return to the office.”

The Workplace of the (Near) Future

Sullivan said many employees and employers alike developed FOMO (Fear Of Missing Out) during the work-from-home period and are eager to work together in person again. In particular, Henriques said many team members may crave the opportunities for mentoring and collaboration. But that doesn’t necessarily mean the Opportunity Economy office will look like it did pre-pandemic.

One increasingly common approach is hoteling, or shared office space. Rather than have dedicated, permanent offices, employees reserve and use a space only if they will be in the building that day. Such an arrangement could allow employers to reduce their office footprint while still fostering a collaborative culture.

Sullivan said she sees a role for technology for anticipating office space need for companies that employ such an approach.

“What we don’t have handy (at present) is predictive analytics and people willing to say, ‘This day I’m going to be in the office and this day I’m not,’” she said. Such information impacts a wide variety of real estate and operational decisions, from how much square footage to rent down to how much support and staff should be available in-office on a given day. 

Companies that are able to accurately assess and plan for shared office space needs will have a competitive advantage in the marketplace.

So how widespread will hoteling be in the next year or so?

“I think it will be popular, but it depends on the company, the culture and the industry,” McCurry said. “For a lot of companies, especially large ones, it’s an attractive model. But for start-ups and early-stage companies, they may be more driven by collaboration. It really depends on the nature of your particular company. One size doesn’t fit all.” 

He encourages clients to take their time and give a great deal of consideration before making long-term office real estate decisions.

“Flexibility is so key right now. That’s an important consideration if you are renewing your lease or signing a new one,” Sullivan said, adding that such terms can be difficult to write into a lease and may require careful negotiations with landlords.

“On the whole, I think we will need less space,” Sullivan said. But she said that certainly could change in two to three years as opinions shift.

“And less space could mean a little less space, not a lot,” McCurry added. For example, “less space” could mean more emphasis on collaborative spaces, rather than individual offices. 

Sullivan noted that as with hoteling analytics, the technology currently lags the market’s needs. Current video conferencing technology largely assumes that all parties will be in front of a computer, rather than in a conference room. But she believes this technology will evolve to serve this need to accommodate more smoothly meetings that are attended partially in person and partially virtually. 

McCurry said that in the Opportunity Economy, “having different types of office environments within a different space is an important real estate consideration.” Some employees may need private offices, for example, while others may require collaborative set-ups. 

“I think that’s something we already were seeing before the pandemic,” he said.

Lease Considerations & Trends

By and large, offices were able to weather the pandemic storm well, as white collar businesses were able to quickly pivot to work-at-home. But that wasn’t the case for many other workplaces.

“If you could send everyone home and work remotely, you weren’t as stressed as those who had to shut down,” Sullivan said. “Retailers who can’t sell what they are supposed to sell have a very different tenant relationship with their landlord than the offices.” 

She also cautions that companies should avoid tailoring clauses too narrowly to just address COVID-19 issues. Other pandemic-related trends, such as the shortage of construction labor and supply chain complications, can be more impactful to many businesses at this point than the illness itself. Companies should take a big-picture approach in lease negotiations.

“I think when you have a good credit tenant and a landlord who says ‘I’d rather have a good tenant working at reduced capacity than put this space on the market,’ you can make a deal,” McCurry said.

Sullivan said that in hot commercial real estate sectors, such as industrial or warehouse space, the landlords hold most of the cards.

“If you are a tenant who bargains too hard on an industrial space, you’re going to lose the space. Come to the table with a couple of things you really need in that lease,” she said, noting, for example, that available warehouse space currently is at record low levels in the U.S.

“Secondary and tertiary markets need more warehousing space – they just can’t build it fast enough,” McCurry said. He also said that favorable interest rates make it a great time to become an owner/occupant.

“I advise my clients that now is a good time to take a serious look at their real estate needs and figure out what is best for their company,” McCurry said.

“One of the most important things we do as a lawyer is keeping an eye on both the details and the big picture,” Sullivan said. “It’s not just where the puck is – it’s where the puck is going to be.”