4 rules for CFOs cutting office space
Cutting fat from office space budgets would seem like a no-brainer for CFOs as the economy heads into what could be the jaws of a recession. But realizing real estate savings is likely to be a more complex process than in past downturns, experts say.
“What organizations now need to do is say ‘ok, during every recession real estate has always been a line item that we look at’ and so they’re looking at it again,” said Julie Whelan, global head of occupier thought leadership and research consulting at the real estate services firm CBRE. “But they need to look at it with that lens of how much they cut during the pandemic and where they think their headcount is going.”
The halting pace of employees’ return to office and the toehold that hybrid work now has in corporate work models leaves experts like Whelan pegging office utilization rates at about 50% of what they were before the pandemic — even as hard-driving executives like Elon Musk and JPMorgan’s Jamie Dimon push hard to get staff back in their cubicles.
The latest round of office space cutbacks are playing out most visibly in Silicon Valley, the source of an almost daily drumbeat of announcements from high profile tech companies like Salesforce and Microsoft, many of whom are detailing layoffs and revising their real estate footprints. “Tech firms were famous for taking space to grow into. Then all of a sudden things came to a screeching halt,” Whelan said in an interview.
Real estate is a big cost center, with office space often the second or third largest expense for service companies after labor, Whelan said.
Still, companies shouldn’t swing the budget axe until they’ve figured out what their office utilization rate is now as well as what their goals are for the total number of people they ultimately want working in the office, she said. Only then can they zero in on the delta between how many employees are showing up now and how many will show up later, and as a result, how they will manage real estate costs this year, she said.
As they sort through their portfolios of office leases, CFOs should also keep in mind that they are in the middle of another cyclical downturn in the economy, and that it’s not possible to perfectly time their moves because it’s too long a lead item, according to Eric Anton, senior managing director with the commercial real estate brokerage firm Marcus & Millichap. Office leases can extend 10 years or longer.
“You can make a perfect turkey sandwich but if you had to plan how many turkey sandwiches you should order for the company in a year that’s really hard. It’s the same thing with office space,” Anton said in an interview.
Here are four evolving issues or unexpected curveballs that CFOs need to track when deciding how or when they will go about triming office space:
1. Savings won’t always come from lower rents:
The U.S. office market is signaling multiple signs of distress and in most but not all markets the tenants have the upper hand, experts say. But you wouldn’t necessarily know that from a quick scan of most average asking rents, the set price buildings say they want for space.
In fact, Class A downtown space rents in the U.S. ticked up to $51.41 per square foot in the fourth quarter from $51.08 a year earlier, while the asking rents for premier suburban spaces were $33.58 last quarter compared with $33.58 a year earlier, according to a Jan. 26 Colliers report.
Occupiers are gaining concessions such as periods of “free rent” and money that landlords give to tenants to build out space or so-called tenant improvements. Buildings in some big markets are offering 12-month rent abatements or $100 per square foot or more in tenant improvement allowances toward upgrading space, according to Stephen Newbold, Colliers International’s national director of office research, writing in a Jan. 26 blog post.
Those rents will likely be pressured further this year. The U.S. office vacancy rate rose to 15.7% in the fourth quarter from 14.8% year-over-year, according to Colliers. If that pace continues, by midyear vacancies could touch the 16.3% peak not seen since the height of the Global Financial Crisis, Newbold wrote. The jury is out as to whether there’s a market correction in the works, and there’s considerable debate over the future of the U.S. office market, he wrote.
2. Yes, location, location, location still matters
It’s a new twist on one of the oldest real estate sayings in the book: location, location location. Employees are dictating a flight to quality office space, and companies who want to lure workers back to work in an office need to make it compelling and easy to get there, Anton said.
That is likely to be offices on top of transportation hubs such as Grand Central or Penn Station in New York City that minimize commuting hassles as opposed to the latest “cool” neighborhood, he said. “If I’m coming in three days a week and I live in Greenwich, Connecticut or New Jersey or Westchester, I don’t want to take a train and then a subway or a train and then have a 20 minute walk,” Anton said. “I want to come in and go upstairs and bang, I’m in a class A trophy office building.”
Similarly, there’s a bifurcated market when it comes to where rents are weakest. So far, the demand for newer and more modern buildings with many amenities has held up better, experts say. For example, the average asking rent across all office rent classes was largely unchanged during the third quarter of 2022 at $35.23
per square foot, but effective rents for top-tier properties in some of the largest markets increased by 4.2% last year through the third quarter, according to a CBRE report.
3. Demand for office sale leasebacks wavering
Sale leasebacks are transactions whereby companies sell their office and enter into what is typically a 10-15 year lease with the new owner. They have long been viewed as a way for companies to monetize assets. In one of the latest large deals, Biogen announced a sale leaseback agreement in September with Boston Properties which gave the company gross proceeds of nearly $603 million.
But in recent years, investor demand for office property has cooled due to concerns about the outlook for the office market. Also, investors looking for property want to buy single-tenant office buildings, and even companies that own buildings will often have other tenants in them, according to Scott Merkle, managing partner at New York City-based SLB Capital Advisors.
Still, Merkle said that sale leaseback arrangements merit consideration because the cost of the capital is still cheaper in the current high rate environment. The cost of debt for many middle market businesses rose over 400 bps in 2022, making sale leasebacks more attractive today than 12 months ago, he said.
4. There’s no magic per person space ratio
Historically, there has often been a discussion in real estate circles around the right ratio of employees per square foot of office space. Right now, that is no longer realistic given the differences from industry to industry layered on top of the different ways companies are aiming to mix in hybrid, in person and remote approaches to working.
Then too, even as patterns for work are emerging, it’s not altogether clear how to accommodate workers who may not all be in the office at the same time. For example, most tenants are adopting hybrid work with a minimum of three days in the office, according to Colliers.
Many companies are settling in the increasingly embraced sweet spot of calling all employees back to the office Tuesday, Wednesday and Thursday. From that point some CFOs are seeking to extrapolate how much space they’ll need going forward.
Shared desks and other systems are changing the calculations companies are making. “The square foot ratio is almost a number that doesn’t make sense anymore,” Whelan said. Over the next few years, as companies adjust to the new work environment, CBRE estimates that companies will likely reduce the amount of space needed per person by about 15%, according to CBRE’s U.S. Real Estate Market Outlook 2023.