Office = Melting Ice Cube

A part of our outperformance this year (as of 6.30.22) is attributable to our active underweight of the office sector.

As of today we have zero exposure to traditional office and were at one point short ~5% office in Q2 (via several coastal office REITs). This was a profitable strategy that we use sparingly given this is an income focused fund.

Of course, this was not a difficult call for anyone tracking office attendance and talking to leasing brokers and property owners.

Office availability is exploding. More than 200 million square feet of office space has become available since the end of 2019 while the number of office-using employees (most of who are still working from home) has been roughly stable at ~21 million.

The world has put COVID in the rearview. Attendance at restaurants, sporting events and even airports is almost back to normal.

Yet office attendance is a sad 44% according to Kastle Systems, an office security firm with employee keycard access data.

If unemployment increases meaningful (which the Fed seems to want), the power dynamic could shift back to employers. This may or may not jolt employees back to the office. Regardless, WFH is ideal for many roles and plenty of employers seems to be embracing it. Therefore, it seems probable that February 2020 could have been “peak office”.

The public markets are starting to reflect that viewpoint. The average office REIT is now down 25% for the year and is trading at an effective 7% cap rate. Several NYC office REITs are at ~9% cap rates. Ouch.

Commodity Office vs. Trophy

If the WFH trend doesn’t reverse soon, older or “commodity” office properties are in trouble.

For example - in San Francisco, the vacancy rate among Class C buildings (older buildings) is already 37.2 percent vacant1. Class A is only 11.9%.

The best of the best (ex: Boston Properties) have mostly trophy assets and should be fine over the long term. However, plenty of office assets will be slogging through the next few years as current leases expire.

This should lead to either a) locking in much lower rents or worse b) increasing vacancy. Even small vacancy spikes can mean death in office. Not just for the obvious lack of rent. Re-leasing capital tends to be the real killer.

Office owners have to spend crazy amounts of capital - always up front and sometimes on spec - to attract the best tenants (construction allowances, new lobby redesigns, broker commissions, green retrofits to reduce emissions, etc).

If you don’t have a large balance sheet, what do you do when you need to come up with releasing capital when your office asset is struggling? Not many lenders are going to want to play white knight in this scenario.

Unless office usage quickly recovers, a staggering number of buildings will become melting ice cubes that need to be repurposed.

Evergreen investing

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