How office landlords can be flexible in the face of new market realities

This is a uniquely difficult time for many North American office properties, whose occupancy rates and valuations haven't recovered from the pandemic-inspired slump. The worry now is these depressed office metrics will represent a permanent, and adverse, change in office markets throughout the United States and Canada as work from home becomes of a permanent fixture of the economy.

The jury is still out on that prospect, however. Though it seems like the pandemic began a long time ago, it has only been three years, and the post-pandemic period – since the advent of widespread vaccinations – has been even shorter. So far, there isn't enough data to make a plausible long-term prediction of the direction of office leasing and occupancies. It's a new world.

Although current leasing and occupancy rates are notably slower than pre-2020 rates, it's important to note that not all of the current indications for office are negative. Moreover, there are steps office landlords and tenants are taking to encourage a higher rate of return-to-office, such as increased amenities and/or the redesign of space to empower better interaction. No single strategy will work for every building in every market, so each stakeholder needs to carefully examine the situation, and try solutions that fit – and if that isn't effective, try something else. Like in so many business challenges, persistence will be key for success in this landscape.

The new normal – for now

Admittedly, history isn't much of a guide for North American office markets in the 2020s. Once upon a time, demand for office space tracked activity in the wider economies of the United States and Canada. When a recession came to an end, prospects for office properties improved. This happened even after the deepest recession in memory, the one associated with the Great Financial Crisis.

In the post-pandemic landscape, work-from-home policy (at least a few days a week) has exhibited relative staying power. What began as a pandemic-specific response has since become something of a cultural shift – one that might not backpedal to pre-pandemic norms. Or would it? Throughout 2022 and into this year, office occupancies in major US and Canadian markets slowly but surely ticked upward. Progress was uneven and halting, but genuine in markets such as Toronto and Vancouver when looking north of the border, and Houston and Chicago when looking south of it. To this effect, in the US, Kastle reports that office occupancies in the 10 major cities it tracks was at nearly 50% in the first week of May, up from 46.3% a month earlier.

A handful of employers have tried, with mostly limited success, to mandate return to office on a roughly pre-pandemic schedule. As the dangers posed by the pandemic ebbed away, many employees whose work can be completed remotely saw little reason to come back, especially for the five-day routine. It wasn't even being in the office that much that they found objectionable, as surveys revealed. Rather, the drudgery and expense of commuting was the biggest barrier to a “full-time” return. On the other hand, some employees expressed relief to return to the office once it was safe to do so. These employees (usually those contending with cramped living spaces or small children underfoot), have seemingly realized that being at home all the time can be its own form of drudgery. Within this group, we see a demonstrated appreciation for in-person interaction with colleagues, employees, and clients. When employees return to the office, companies are better able to reinforce (and continuously cultivate) company culture in a way that benefits employee experience and retention, mentorship opportunities, cross-team collaboration, and more.

So, the “new normal” – for now – is some number of days less than five but more than zero in the office. A number of employers have mandated a specific number of days per week (three for Amazon, for example, and four for Snap). Similarly, in Canada, the federal government ordered public employees to return to the office up to three days per week.

The carrot rather than the stick

Employees will probably find ways to get around mandates they consider too onerous by post-pandemic standards, especially by seeking employment at more work-from-home friendly employers. As long as job markets are tight, employers are faced with the reality that their mandates might make them less competitive in the labor market. How landlords and owners can increase the number of days employees spend in the office to beef up occupancies and valuations (or at least stabilize those metrics), has become the million-dollar question. Increasingly, both companies and owners are increasing the level of amenities offered within their office spaces which give employees a place to socialize and interact. These amenities may include, but are not limited to, coffee shops, health and wellness rooms, outdoor space, and more.

However, this is admittedly a challenge especially for Class B and Class C office properties. As tenants have found themselves in a stronger negotiating position, they tend to look for deals in Class A properties, leaving vacancy rates for B and C lower. The challenge is to create space that workers genuinely want to return to via amenities and other features (the carrot), rather than forcing them to go where they don't want to (the stick).

Making Class B and Class C as much like Class A as possible is one strategy, though there is only so much owners can do. Still, adding amenities can help attract – or perhaps more importantly – help retain tenants who might otherwise leave. That represents capital expenditures, of course, and can be a stretch. Still, popular features can also offer a significant return on investment, if handled correctly.

Creating collaboration space

Some buildings, including Class B+ properties in strong markets (such as Toronto and the US. Sunbelt) are managing to keep their occupancies from cratering completely by reinventing part of their space.

One especially popular feature office buildings are eager to add is collaboration space. The goal of collaboration spaces isn't to curate exceedingly elaborate settings (the bars and Foosball tables of 2000s tech company space, for example), but rather, a comfortable space with chairs and couches and whiteboards and AV systems that make informal meetings and collaboration easier. Better kitchens encourage collaboration, too.

These improved spaces existed before, but were often developed or added as an afterthought. Now they are cropping up from Vancouver to Toronto, and Los Angeles to New York, according to office managers: some space for small groups of three or four, others for a dozen or more.

The rise of collaboration space ties into the reason workers might be persuaded to return in person: the human engagement and connection that comes with working in the same setting. For relatively modest expenditures, owners and managers can upgrade their collaborative space, and help evolve previously uninspired offices, as often found in older B and C assets, into something more attractive.

Coworking companies may also play a key role in re-inventing office buildings for the post-pandemic years. After all, coworking operators bring a decade or more of expertise and a proven business model to the task of attracting workers to a central location. Even companies that are in the same building as a coworking operation can benefit directly, as they are able to expand temporarily for a project, say, or indirectly as the people come to the coworking space and liven up the overall building environment.

The new flexibility is in lease terms

For many buildings in many places, it is ultimately a tenants' market. Amenities and coworking space are a tool to keep tenants and their employees, but they aren't the only strategies available to landlords and owners. Other, less visible strategies, are in motion as well.

Lease terms have undergone a major revamp in both the United States and Canada. The lease terms of the previous generations, in which 10 years was standard to thousands of square feet, with perhaps five-year renewal options. Leasing flexibility means much shorter terms, but also the ability to expand a corporate footprint more easily than before, or for companies to give back space they don't need anymore.

Such flexibility isn't new. Tenants were asking for, and sometimes getting such terms, well before the pandemic, depending on the market. However, the pandemic made flexibility a much more important consideration for both landlords and tenants.

That is certainly the case for Class B and Class C space, but also to some degree for Class A space, though its popularity gives it a stronger hand when negotiating lease terms. In fact, lease flexibility is one way, besides rent, that less-desirable space can compete with Class A space, especially for back-office uses. That has also long been true, but in the current climate, more than ever before. Good lease terms can be part of an owner's strategy that helps keep some office buildings afloat.

As some form of hybrid workweek becomes the norm over the next few years, North American office markets will change. To keep their buildings competitive, the most astute landlords are looking to adapt quickly and effectively to those new realities.