April 7, 2017
Interviewed by: David Snow
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Investing in ‘Creative’ Office Space

The millennial-driven demand for open-plan, fully digital, creative office space is spelling opportunities for some property investors but challenges for owners of aging, old-school office buildings in the suburbs and even on Park Avenue.

The millennial-driven demand for open-plan, fully digital, creative office space is spelling opportunities for some property investors but challenges for owners of aging, old-school office buildings in the suburbs and even on Park Avenue.

Investing in “Creative” Office Space
The Millennial Impact on Real Estate

David Snow, Privcap:
We’re joined today by Peter Ciganik of GTIS Partners, Andrew Jacobs of Metropolitan (a subsidiary of The Carlyle Group) and Michael Schwartz of RSM. Gentlemen, welcome to Privcap today. Thanks for being here.

Unison: Thank you. Thanks for having us.

Snow: We’re talking about the impact that the rising millennial demographic is going to have on real estate; specifically, we want to talk about office. Millennials—and also the internet and the decline of, let’s say, paper—have really transformed the way that people work and the spaces they work in. So, my question for all three of you is what does this mean for the investment outlook for office space?

Michael Schwartz, RSM US LLP:
We have seen a total repositioning of office space probably over the last five years and will look to continue to see that. Several points that you brought up—[such as] less paper—you’re seeing; as a result, you don’t need the war rooms that you needed before.

Snow: Define that.

Schwartz: For example, in the consulting world and these big corporate acquisitions that we perform due diligence on and/or account services or whatnot, you would have these banker’s boxes of documents before. Everything now is electronic. You don’t need the…storage space anymore. Everything is kept on servers or backup servers, too. I’ll speak to our firm specifically and then I’ll talk to our clients on the investment side—being a national accounting firm with 100 offices in 65 or so cities, we are seeing a downsizing of our space in these cities. We just recently announced a new lease in our New York office, where we’re downsizing from 140,000 square feet to about 93,000 square feet.

Andrew Jacobs, Metropolitan Real Estate:
As you say that, I’m thinking when was the last time I saw a law office, a law library in a new office, in a new build-out, in a new tenant space?

Schwartz: You just don’t.

Peter Ciganik, GTIS Partners:
We have a building where Goldman Sachs and Facebook are tenants and that’s an interesting combination. Needless to say, the interior looks quite different, but what attracted them to the building itself is that it has high ceilings. It’s all glass, so there is a lot of light, and it has redundant fiber. It’s heavily connected and has generators on the roof that can go on no matter what happens to the city. And it can go on for days. For Goldman, it was important for their trading operations. For Facebook, of course, their entire platform is based on that. But when you visit, the interiors are quite different.

The Goldman office is pretty traditional, although it’s becoming more fun. At Facebook, they have ridiculous amenities. Or, if you visit Googleplex in Mountain View, [there’s] everything from massages to laundry to free food—24 hours a day, people taking care of all your needs so that you actually don’t have to leave.

Jacobs: What we’ve seen as well within the creative space is that not only is Goldman going into the same building as Facebook, but the white-shoe fire traditional tenant is now also moving to that open plan—with the exposed ceiling, brick-and-beam feel to their space as well. So it’s not just the millennial tech-oriented tenants or TAMI tenants who are doing it, but also the more traditional tenants.

One other thought while I’m thinking about it: in New York, traditionally the highest office rents have been in what they call the “plaza district”—Park Avenue from 42nd Street up to 59th Street—and now we’ve actually seen higher rents. It’s peaked, but we’ve seen higher rents not only below 42nd, but below 34th Street in what we call Park Avenue South. I would say the buildings are physically inferior, but the rents are higher than they are in the better buildings in the plaza district.

Schwartz: Or even Chelsea with Google.

Jacobs: Yes. Chelsea would be part of that.

Ciganik: It’s ironic, because it started with affordability for the startups, right?

Jacobs: Originally, yes.

Ciganik: That’s when they moved into the loft spaces, when they were raw spaces, so that they could actually afford it.

Jacobs: Right, these mid-block nasty buildings with loft spaces.

Ciganik: Yes. I heard a midtown landlord say recently, “We’ve got plenty of old crappy buildings in midtown.” So it is interesting.

Jacobs: Yes.

Schwartz: We’ve seen that in Chicago over the last probably 10 to 15 years, where you look at our backdrop here of water. People used to want to be by the lake and [have] views of the lake. Now, they want to be by the transportation. The millennials want to get closer to the L, so the West Loop has really expanded and you’re seeing a lot of development in the West Loop of residential. In fact, McDonald’s just announced their headquarters are going down there. You’re seeing these office buildings with the gyms and whatnot and it’s driving market rents up there.

Snow: Let’s talk about the long-term investment outlook for office properties. What properties are positioned to really perform well given these trends? And what properties do you think might be challenged? For example, if you’re going to invest in a prestigious midtown office space that is filled with tenants who have the old style of office with the law libraries and such, is there a risk that as those leases expire they need less space and you have a hard time filling up your building?

Schwartz: Yes.

Ciganik: Yes.

Jacobs: And I would say they’re not only leaving the building to go downtown, they’re also leaving the building—in the case of New York—to the far west side, to Hudson Yards. Because if you look at the stock of buildings in the plaza district,  then look at an awfully high percentage of the Class A office in downtowns in the U.S., there was a real building boom in the U.S. post-war. I’d say the 1950s and ‘60s saw a lot of this product come up. Park Avenue—it’s all that you see there with a couple of exceptions. So, if you want new product in a major, dense market like New York or downtown Boston or San Francisco, you need to find new product. In the case of New York, you have to go to Hudson Yards and tenants are doing it in droves.

Ciganik: It’s going to be pretty difficult to reposition the 1960s and ‘70s buildings in midtown just from the point of architecture and the set-up of those buildings—[they have] very deep cores, low ceilings. Space that used to be quite expensive and cannot command those rents is emptying out and, for investors who have purchased those assets at 3% or 4% cap rates in a rising rate environment, I think that will be challenging.

Schwartz: And that transcends itself to an analysis of suburban office, which, in the typical outlying areas where you had to jump in your car, those are very problematic these days. In Chicago, for example, I mentioned that McDonald’s is moving into the city. They have McDonald’s University out in Oakbrook. That’s going to leave a giant hole there. United Airlines moved seven or eight years ago from Arlington Heights to Chicago.

Snow: GE just moved to Boston.

Jacobs: That’s a great one, yes.

Schwartz: Right, so what you’re seeing in these suburban office complexes is really going to hurt. The only ones they will benefit, to Andrew’s point, are those that are on train lines and it’s easy access.

Snow: If you think about it, what could appeal less to a millennial than a suburban office park? I mean, you have to take your car to get there. It’s not near anything that’s interesting other than maybe your big, suburban house. So, I can see how the demand for these places is going to be scarce over the coming decades.

Schwartz: If you’re living with mom and dad, it might be easy. But if your social life is in the city on the weekends, you’re right, it’s just—

Ciganik: That is true, but mitigating that is the pricing for those assets did not recover. So, you can actually buy them at a pretty cheap price and yield that, if you’re a cash-oriented investor, still might make sense as long as you retain that one tenant that occupies your property. It’s very selective. You really need to look at who’s the tenant, what’s the location? Are they going to stay? Are there other factors apart from being a suburban commodity office space that would keep the investment thesis alive?

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