So far, 2020 has not been kind to office REITs. Across the sector, shares are down an average of 28% for the year through May 31st. Steve Kemler, an experienced real estate investor and currently Managing Director of the Stone Arch Group, believes there is good reason for concern: most American office workers haven’t set foot in their office in months. But does the sector really deserve such a severe beating?
Kemler believes there is strong evidence the trend toward remote work will be neither short-lived nor small in scale. A recent Gartner survey indicates that CFOs expect 10-15% of the American office workforce to shift to full time remote work in the near term, with 74% of CFOs expecting to shift at least 5% of their workforce to working fully from home.
Some major companies have announced even more aggressive plans; Facebook is planning for 50% of its personnel to be fully remote in 5-10 years, and Twitter, Square, and Shopify have already embraced a remote-by-default model for all employees. As a result, 22% of CFOs tell Gartner that they either have already taken or will soon take actions to reduce their firms’ real estate expenses.
If we assume that 10% of office workers go fully remote and that half work from home one day per week, offices will contain 20% fewer people on any given day. Over the past 20 years, office REITs have maintained an average occupancy of 94%, bouncing between a post-financial-crisis low of 88% and a pre-dot-com-boom high of 98%. The potential scale of the threat posed by remote work, even using our conservative estimate, is twice the difference between this multi-decade peak and trough. So, office REIT investors have good reason to be scared.
A 20% reduction in demand would be extremely painful in any sector, but particular aspects of the REIT model make their share prices especially sensitive. In order to retain their low-tax status, REITs must distribute most of their cashflow in the form of dividends; on average, office REITs pay out 75% of free cashflow. This leaves little cash on hand to invest in retooling multi-million-square-foot portfolios to meet unexpected requirements around desk spacing, air filtration, protected public spaces, and more. REITs also trade primarily on a dividend yield basis, so any threat to the stability of their dividend can cause share prices to crater.
The counterargument to all of this is that Covid-19 related safety concerns may increase per-capita square footage requirements. As of 2017, according to Cushman and Wakefield, the average office worker had approximately 194 sf of space including their desk area and share of common areas – a decline of ~8% from 2009. Part of this reduction was due to the trend toward open floor plans and away from private offices.
As companies look to spread their staff members further apart and potentially put more of them back in private offices, the increases in per capita square footage necessary to achieve social distancing could offset or even outweigh expected declines in in-office headcount resulting from remote work.
Yet this bull case is weak. While companies may space out their office workers in the immediate aftermath of the shutdown, they are unlikely to continue to spend significantly more on office space per employee than they did before Covid once a vaccine is widely available and public concern begins to fade – especially when other, less expensive options (such as air filtration, easily accessible hand sanitizer, and plexiglass shields) provide much of the benefit at a fraction of the cost.