“Commuting to office work is obsolete. It is now infinitely easier, cheaper and faster to do what the 19th century could not do: move information, and with it office work, to where the people are.’’
These prescient words were written 33 years ago by the late US management consultant and author Peter F Drucker, in his 1989 book, Managing for the Future. Little did he know it would take a pandemic to force employers across the world to adopt remote working policies.
Now, after nearly 2½ years of Covid-induced workplace disruptions, many corporates are grappling with if — and how — to get employees back to the office. There’s no denying that the novelty of working alone from home may have faded — but many are understandably reluctant to give up their newfound comforts.
Across the US and Europe, corporates including financial services giants Goldman Sachs and JPMorgan adopted the stick rather than the carrot approach and have been met with fierce resistance. Tech companies, including Google, introduced pay cuts for employees who want to continue working from home. And Tesla’s Elon Musk has threatened to dismiss those who won’t return to the office.
However, many companies have backed down from uncompromising demands that employees return to the workplace in-person, full-time. Instead, there’s been a noticeable shift, with employers becoming more attuned to employees’ needs and wants. US magazine Fortune reported in August that most of the top 10 Fortune 500 companies have now opted for a more accommodating hybrid working policy.
In SA, many corporates have adopted a more flexible approach, with a hybrid model (two or three days in the office) becoming the policy of choice, according to the latest workplace preferences barometer from real estate group JLL.
Mark Dixon, CEO of serviced office workspace group IWG, says hybrid working is about giving employees more choice. “It’s fundamentally a people-centric approach that enables companies to attract and retain the best talent, which is key in today’s competitive market,” he says.
The end of the office?
One of the upshots of the adoption of hybrid and remote working practices is that office tenants and owner-occupiers across the globe have been forced to rethink their space needs. There’s even a new term for the trend: “workspace optimisation”. It’s about shrinking or restructuring the office footprint to save money.
Twitter is doing it. The social networking company has announced it will be closing or downsizing offices in several locations, including San Francisco, New York and Sydney, in a bid to preserve cash. In SA, Nedbank has been “optimising” its real estate strategy to support more “dynamic ways of work” for its roughly 26,000 employees.
Nedbank CEO Mike Brown says the company has adopted a flexible working model to leverage successful work-from-home experiences. “Our optimal workplace distribution mix is expected to settle at around 50% full-time [staff] on Nedbank premises, 30% hybrid and 20% permanently off-site,” he said at the group’s results presentation.
Nedbank has already cut its SA office sites from 31 in 2018 to 24, with a longer-term target of 19. That’s brought substantial cost savings, says Brown.
But office downsizing has important financial implications for the commercial real estate sector. And it raises critical questions about the investment case for offices as an asset class.
Commercial hubs across the world are already experiencing record high vacancies. And landlords fear more office buildings may run empty over the next 12 to 24 months if tenants decide not to renew their leases — or downscale when they do.
Traditional office leases in most global capitals, in SA included, typically run for three to five years or more.
A recent study by New York University’s Stern School of Business and Columbia University’s Graduate School of Business found that remote work has significantly changed the risk premium on commercial real estate investments — and led to billions in income and capital losses for property owners. The study, “Work from Home and the Office Real Estate Apocalypse”, shows the pandemic has had a noticeable effect on landlords’ current and future cash flows.
For example, office valuations in New York, one of the world’s largest and wealthiest business capitals, were down a hefty 33% in 2020 on the back of a sharp rise in vacancies. Given the likelihood that hybrid and remote working practices will remain, the authors believe New York office valuations will probably remain about 28% below pre-pandemic levels.
That translates into a capital loss of $49bn.
An equally worrying scenario is playing out in SA’s commercial property market, believed to be worth a colossal R437.5bn at December 2020, according to a survey commissioned by the Property Sector Charter Council. That includes all private, listed, institutional and government-owned buildings.
Unlike elsewhere, SA’s office market was already depressed before Covid — the result of a stuttering economy and sky-high unemployment levels.
In December 2019, SA’s office vacancy rate touched a 16-year high of 11%. By June this year, it hit a record 16.7%, according to the SA Property Owners Association (Sapoa). The previous peak of 15% was recorded nearly 20 years ago. In addition, 20% of all office buildings had a vacancy rate exceeding 30% in June — up from 13% in March 2020.
More concerning is that SA’s unofficial office vacancy is believed to be much higher than 16.7%, as Sapoa doesn’t count “ghost” vacancies — space that is sublet.
In stark contrast, the vacancy rate of both SA’s retail and industrial property sectors is still below 6%, according to figures from investment analysis firm MSCI.
But the vacancy rate tells only part of the story.
Niel Harmse, vice-president of real estate research at MSCI in SA, compiles the quarterly Sapoa report, which tracks office take-up rates in 3,100 office blocks across 52 nodes. He tells the FM one has to look at the absolute amount of office space standing empty to understand the severity of the situation. While the current vacancy rate isn’t significantly higher than that recorded in 2003, the amount of unused space has nearly doubled over the same time — from a gross lettable area (GLA) of 1.6-million square metres to 3.16-million.
To put that figure in context, imagine an office block that’s roughly the size of a rugby field (about 144m by 70m, equivalent to about 10,000m2 of GLA). The 3.16-million square metres of vacant office space would require that same rugby field to be extended for 45km — from the middle of Sandton to the Union Buildings in Pretoria.
According to Harmse, the exponential growth of SA’s office stock, coupled with the pandemic-induced spike in vacancies, has taken a huge bite out of commercial property owners’ cash flow. He estimates that property owners have suffered additional pandemic-induced rental losses of R1bn a year since December 2019 (based on the 1.1-million square metres of space becoming vacant since the end of 2019).
The 16.7% vacancy rate amounts to a total annualised income loss of R3.8bn (based on an average rental of R99 a square metre).
Of course, these losses don’t take into account commercial landlords’ running costs — security, rapidly rising municipal rates and taxes, and electricity connection fees — as well as debt repayments, which must be made whether landlords have tenants in their buildings or not.
Besides the cash-flow squeeze, billions have also been wiped off the capital values of office buildings. The MSCI SA annual property index, whose sample covers mostly institutionally held office properties and is worth R78bn, recorded a cumulative decline in office valuations of 10.2% in the two years to December 2021. A writedown of a similar magnitude for SA’s entire office stock comes to R44.5bn (10.2% of R437bn).
SA’s ballooning supply of offices — there are close to 19-million square metres of office space in the country — comes on the back of a 20-year development boom. Sandton, SA’s largest office node by far, was a key beneficiary of this, as corporates fled the crime and grime of downtown Joburg and other older nodes. Unsurprisingly, the suburb now has one of the highest office vacancies in SA, with 25% of A-grade space standing empty. Worse, the vacancy in Sandton’s older, B-grade buildings has surged to 38.3%.
The problem, Harmse notes, is that tenants have an ever-widening choice of office stock at attractive prices, prompting a constant trade-up from rentals in older buildings to better-quality stock. That has encouraged overzealous developers to bring new stock to the market, even though it was already oversupplied.
The bad news is that a marked reversal in SA’s office vacancy rate looks unlikely any time soon. Harmse notes that, historically, annual economic growth of at least 3.5% is needed to drive private sector employment growth and, as a knock-on effect, increased take-up of offices.
Current growth forecasts fall far short of that. Economists expect SA’s economy to grow by no more than 1.5%-2% a year from 2022-2024 amid ongoing electricity supply issues, and higher inflation and interest rates.
A worthwhile investment?
Given the widespread income and capital losses suffered by office landlords — and with, potentially, more to come — it’s worth asking if investing in commercial property still makes financial sense.
The JSE’s real estate sector, which is made up of 50-odd individual counters with a collective market cap of about R400bn, has been aggressively sold down over the past three years. While there are a dozen or so specialist real estate investment trusts (Reits) that own solely retail, industrial, storage or residential property, at least 70% of counters have exposure to offices as part of a mixed portfolio.
The Covid-related income and capital losses suffered by the sector forced most companies to slash or even suspend dividend payouts in 2020/2021.
Though the sector is seemingly through the worst of it, with many companies recently resuming income and dividend growth, the SA-listed property index is still down nearly 30% from early 2020 levels.
Property stocks with a relatively large exposure to offices appear to be trading at bigger discounts to NAV than those without, which suggests JSE investors are shying away from these counters.
Zaid Paruk, portfolio manager and analyst at Aeon Investment Management, says there’s no doubt investors have become more cautious about investing in office-weighted Reits.
Growthpoint Properties, Redefine Properties and Investec Property Fund have the largest weighting to offices among the bigger companies.
Most have reported rental reversions (declines) on office lease renewals of 30%-40% over the past two years. So it’s not surprising that they’re trading at disproportionally large discounts to NAV — at least 40%, against the listed property index’s average 28%.
Key risks facing companies whose office portfolios have large vacancies and valuation writedowns include defaulting on mortgage repayments and/or breaching debt covenant levels (when loan-to-value ratios rise sharply on the back of falling valuations). That raises the threat of banks calling in loans and repossessing properties.
However, this has yet to happen on any noticeable scale.
Paruk says SA banks have generally given SA Reits enough leeway to de-risk their balance sheets through asset disposals and capital raises where necessary. This has allowed many to reduce their loan-to-value to an acceptable level.
The good news is that the market expects limited further downside for office returns, given the extent of rental reversions and impairments already seen over the past three years. However, Paruk warns that the Reit sector’s discount to NAV may not rerate fully until there’s more clarity on where the remote working trend is heading and there’s a “return of sustainable rental and occupancy growth”.
No quick fix
John Loos, property sector strategist at FNB Commercial Property Finance, predicts that developers and property investors will continue to cut allocations to the office sector as office attendance rates normalise and more firms embrace flexible working arrangements.
The upshot, he says, will probably be a long-term decline in the size of SA’s office stock relative to other sectors of the property market.
Until end-2021, offices represented 22% of all nonresidential building completions. Loos expects this to decline as new office supply slows and the repurposing of unused offices accelerates.
He refers to the latest Stats SA figures, which show that, in terms of square metres, the building plans passed for new office space for the 12 months to May was already 70% down on the 12 months to May 2019.
Encouragingly, the big listed guns such as Growthpoint and Redefine, whose sprawling holdings include multibillion-rand office portfolios, are starting to see light as corporates’ return to the office gains momentum, and the repurposing of empty space starts mopping up some of the oversupply.
Growthpoint is SA’s largest listed office landlord, with a portfolio of R27.1bn (39% of total SA assets excluding the V&A Waterfront) spanning 1.7-million square metres across more than 150 buildings. Its office vacancy figure clocked in at 21.2% in December; in Sandton, it’s at a substantial 26%.
Growthpoint SA CEO Estienne de Klerk tells the FM there’s been a noticeable uptick in inquiries for space in recent months. “Smaller tenants in particular, who vacated hastily during Covid, are starting to return,” he says. “Many have realised working from home is not a long-term solution. They need a corporate face and home for their business. Load-shedding is also working in landlords’ favour, as most offices have backup power supply.”
But, he adds, the uptick in demand has been sector-driven and nodal. So while some industries have adopted a wait-and-see approach, the tech and mining industries, for example, are aggressively growing their footprints. Demand is particularly robust in Umhlanga and Cape Town (at Growthpoint’s V&A, the vacancy is a “minuscule” 1.3%).
De Klerk is hopeful that Growthpoint’s overall vacancy rate will dip below 20% in the next 12 months. Take-up should be aided by repurposing projects and disposals. But while there are interesting opportunities to convert some of Growthpoint’s buildings into student housing and health-care facilities, he adds that “not every office building is suitable for conversion”.
Growthpoint has sold at least R4.5bn worth of office buildings since 2017 — but De Klerk has no intention of exiting the office sector. “About 80% of our R27.1bn portfolio is still occupied and generating an income,” he says. “So there’s still an undeniable need for the office.”
Ultimately, however, a marked recovery in occupancy depends on the SA economy improving. Even then, “offices are a lagging economic indicator”, De Klerk says, so it would probably take “12-24 months for economic growth to filter through to increased office demand”.
Redefine, which owns a R21.7bn office portfolio (37% of total SA assets), has also seen a marked increase in office inquiries after a two-year hiatus.
Pieter Strydom, Redefine’s commercial asset manager, tells the FM a key trend is a renewed flight to quality. Though Redefine’s overall vacancy came to 16.4% at the company’s May year-end, the vacancy in its premium-grade portfolio in Sandton is down to only 5.5% (including recently signed leases).
“While the pressure remains firmly on older buildings in secondary, nonprime nodes, we are seeing green shoots in the premium and A-grade sector, with rentals starting to creep up,” says Strydom.
And though the return to the office has been a “slow game” among risk-averse banking and financial services tenants, sectors such as the legal community — heavily dependent on knowledge and skills transfer to younger employees — are back at their desks.
SA’s office vacancy rate is at a record high of 16.7%. That looks unlikely to change any time soon — not least because a recovery will depend on the broader economy bouncing back
— What it means:
Redefine is looking at innovative ways to fill empty space. The company has just signed a 12-year lease with a private school to take up 4,000m2 in one of its office parks in Bedfordview, east of Joburg. Strydom sees further potential in the educational space, which he says offers an easier and cheaper conversion route than office-to-residential, which can be costly from a design, floor plate and plumbing perspective.
“Schools are typically stable, low-risk tenants with long-term lease requirements. They also tick the corporate social responsibility boxes,” he notes. However, they require external space for sport and extramural activities, and landlords need to apply for educational zoning rights, which can take six to 12 months.
Redefine has also repurposed about 30,000m2 of traditional office space for serviced and coworking usage across 12 locations, through leases with WeWork and IWG’s Regus brand.
Like Growthpoint, Redefine has no intention of significantly reducing its office investments. Strydom believes the office will remain an integral part of many businesses’ future workplace strategies, so there’s still money to be made in the long term. Though the company has earmarked some secondary, noncore offices for disposal, “we definitely won’t sell at any cost”, he says.
The bottom line, it seems, is that SA Inc is not entirely ready to give up the idea of a corporate address. So it’s probably safe to say that Drucker’s “death of the office” prediction remains premature — for now, anyway.
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