Office is not dead – Operators forgot they have to Try
A Carolwood Investment Memo
“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful.” – Warren Buffett
Every investor’s favorite quote to regurgitate. But to execute… not so much. And fair enough; it’s an easy concept and a difficult reality, because fear obscures opportunity. Fear, though, is exactly what Carolwood sees in today’s domestic office market. We plan to act on it (and already have).
Let’s rewind: Before the pandemic, office owners and operators were extremely complacent; they just didn’t know it yet. They took for granted that employees came to an office every day while their employers boasted about their corner offices at extravagant lunches. Office footprints expanded without much thought as to efficiency because there was no viable alternative; the concept of “work from home” didn’t exist. Then came a global pandemic, the rise of zoom, the realization that employees could conduct meetings from their living room sofas and most importantly, the subsequent savings to the bottom line.
Now, fast forward to 2024. The historic vacancy across core office markets is highly touted and publicized. Marry this historically bad vacancy with the Fed’s desperate interest rate hikes, and the result is devastating distress across the domestic office market. However, putting aside the obvious macro problems, there is a deeper-rooted cause for this office collapse: simply go to an office building and you’ll quickly understand why no one wants to work there. The lobbies are drab. The building staff looks depressed. The amenities are designed to get leases signed not to keep employees coming into work. No wonder we have historic vacancy! Operators forgot they have to try.
At the core of Carolwood’s micro office thesis is a commitment to bring hospitality and service back to office buildings. In our latest acquisition, 707 Wilshire Blvd. (The Aon Building), we brought our own food concepts - Croft Alley, Pop’s Bagel’s and Cha Cha Matcha to the lobby café. We are renovating the gym, installing saunas and cold plunges, and purchasing house cars for executives to take clients to lunch. Putting aside the economics, operators now need to compete and beat the convenience and ease of work from home and we intend to in a big way. Carolwood believes your office should be an amenity to your life rather than a chore to attend.
I digress — back to Warren and the macro opportunity. The combination of historically fast rate hikes and a once in a generation pandemic created what Carolwood believes to be: “the perfect storm” for office. A perfect storm that led to the complete dismissal of office buildings as a real estate product of the future. This complete dismissal is an example of what we call at Carolwood – Absolute Assertions.
Carolwood has made our most significant returns when we bet against the absolutes. Absolutes assertions are often the result of extreme fear: fear of a product type because of fleeting micro and macroeconomic factors. More simply: massive overreactions to the moment. Here are some examples of absolutes both past and present:
“The internet killed the shopping center” (more on this in in a second)
“New York city is dead” (2020 new York times article)
“Work from home killed the office building” (today)
The media loves histrionic headlines like those and investors do too. Carolwood’s macro investment thesis: bet against the headline investor, and when given the asymmetric opportunity, bet big and be greedy. This is exactly the opportunity we see in the office market today.
Before we dive into the asymmetry in office opportunities, let’s roll the clocks back to Rick Caruso’s famous and eloquent speech dismantling the popular headline 10 years ago that the “internet killed retail.”
Rick Caruso's Opening Keynote at the National Retail Federation BIG Show 2014
I encourage you to watch the whole thing. It’s brilliant.
We’ve been referencing this speech a lot when discussing office deals with investors. The parallels between investor sentiment in retail in 2010 and office in 2024 are striking. In both cases, macro factors (interest rate hikes and the Great Recession) are driving down pricing while fleeting micro factors are blinding investors from the resulting opportunity. Investors are conflating a shift in consumer behavior with the death of a product type. Rick Caruso articulated this very important distinction: retail wasn’t dead when the internet arrived; dated shopping malls were dead. Similar to the dismissal of office product today, the assumption then was that people would primarily shop online. However, human beings aren’t robots. We seek human interaction. The distinction that Caruso capitalized on was that we like to shop in places that are vibrant, welcoming and exciting. He eloquently communicates Carolwood’s exact office thesis today: Office buildings aren’t dead; obsolete buildings are. The internet exposed the outdated in the retail space, forcing owners and investors to adapt to a new environment. Likewise, the pandemic exposed the outdated in the office space; it did not kill office. It will kill off operators who lack the ability or vision to modernize amenities and create vibrant spaces that speak to the modern employee.
We are already seeing this adaptation work in the office market today often characterized as a “flight to quality”. What does a flight to quality really mean? Highly amenitized and interactive buildings! For example, let’s look at the most significant office market in the world – New York City. With roughly 98m sqft. of vacancy, investors and LP’s are falling in love with the “office conversion” and running from traditional towers. However, SL Green’s new 3 billion dollar office tower at One Vanderbilt, that feels more like a hotel than an office building, is 99% occupied. Why is that? How could that be? I thought office buildings were empty?
Refer to this 60 minutes Video from the 6-9 minutes marks specifically.
SL Green’s leasing success solidifies our thesis of bringing a heightened level of hospitality to the office sector and emphasizes the flight to quality space. One Vanderbilts’ leasing velocity and occupancy also suggests an interesting caveat to the highly discussed vacancy statistics: while demand for office has certainly decreased, the distress has constrained the supply of quality, amenitized space, resulting in an effective increase in demand for quality office space from a supply and demand perspective.
Moving on to the macro and the alarming financial snapshot of the domestic office market. Let’s discuss the financial asymmetry in the distressed opportunity —or as Warren would say, the result of extreme fear. Almost every investor I’ve talked to is shocked that we bought 1.1 million square feet in Downtown LA. Why? Because it’s popular to talk about the death of office, the alleged permanence of work from home, and the highly touted vacancy. Extreme fear, above all else, has created generational pricing power for buyers of office buildings. With most deals in our pipeline, the price of the building per foot is in line with the leasing costs. In layman’s terms, the price per foot to buy office buildings is equal to the tenant costs to renovate their spaces! That’s crazy! Forget below replacement cost —high rises are the price of kitchen cabinets! One of our biggest challenges as investors is to determine how not to buy the building twice! Meaning, we don’t want to spend equally as much on leasing costs as we did to buy the buildings.
Moreover, extreme fear of office product is evident at every investor level. Institutional investors are completely sidelined because they are generally risk averse and prefer to invest in the hottest product of the day (industrial and multifamily.) Institutional allocators of capital get paid not to lose, rather than win big. Likewise, most private investors are on the sideline grappling with the fear that they’ll never be able to lease up the vacancy. Because the lenders foreclosing on office assets don’t want to own, lease, or manage them, and traditional banks won’t finance them, (for the most part), sellers/lenders are forced to fire sell assets at pricing never seen before. Banks’ willingness to carry paper adds another layer to the asymmetry because the buyer is able to purchase office buildings at a historically low basis, with high LTV’s from the lenders/sellers. This is exactly what happened on our deal to buy The Aon Center in Downtown LA.
Now the question most investors ask us: OK, but how do you lease the empty space?
Like any distressed cycle, the market must capitulate to new pricing realities before new landlords can meet the lower market rents. Simply put, sponsor equity is wiped out, and in most cases, lenders need to do deals below their debt basis. The reality isn’t that vacancy is permanent; but rather, pricing needs to reset. The landlords who haven’t turned over the keys cannot do deals at the market because their basis is too high and for the most part have no cash. Additionally, even if they do have cash, who would put money into their building that they will inevitably lose? No educated investor throws good money after bad. Thus, all roads lead to lenders foreclosing on the assets and in most cases selling below their debt basis to opportunistic investors.
One interesting caveat we’ve experienced to the inevitable pricing reset across the general office market: pricing power exists in the flight to quality. Because so many sponsors are handcuffed by their basis, the supply of capitalized high rise assets is miniscule, resulting in an effective increase in demand for quality space with available TI. In our first quarter owning/leasing the Aon Tower, we are not seeing any loss in rental rates, rather an increase in rents due to a lack of quality supply with leasing costs available.
Carolwood is not the only operator leasing above market expectations:
We are also not only the firm acting on Warren’s wisdom and now betting on these assets…
RXR, Ares Join in Venture To Invest Up to $1 Billion in Distressed New York Office Properties
Lastly, we want to discuss the most bullish case for office. Much of it is hinges on human nature and psychology. At Carolwood, we’re confident in two truths:
1. Human beings are fickle. They love to forget.
2. “It’s not what you know that gets you in trouble. It’s what you know for sure that just ain’t so.” – Mark Twain
Yes, I’m referencing Mark Twain in our investment memo alongside Warren Buffet.
The super bull case: the death of work from home. After the dust settles on distressed buying, employers and employees will someday forget the realities of a global pandemic and will again enjoy egotistical offices. Employees will forget that it was an option to stay at home and be half as productive (don’t lie to yourself – your family is distracting).
From a productivity standpoint, work from home is dysfunctional. A friend who is a criminal defense attorney put it nicely “at home everything is work and nothing is work. There is no division. My day just blurs and I’m less productive.” Remote work is also dysfunctional for employers managing their staff. With a home full of distractions, the office is a dedicated space for one purpose: productivity.
Contrary to popular belief, not everyone enjoys staying at home all day with their family, spouses, and children. The benefits of collaboration and team building are lost completely via remote work. Additionally, the choice to work from home is also a fleeting luxury in the employment market. At the height of the pandemic, employers were most scared of their employees. The market between employer and employee has shifted dramatically and we expect it to somewhat return to the status quo.
Regardless of the outcome in our bull case, Carolwood is eager to bet against the alleged permanence of work from home. The certainty that work from home will change office forever is another absolute assertion we want to bet against. Sure, there will be some successful lawyers and big real estate brokers that forever take less office space. But that makes sense doesn’t it? Luckily, the world isn’t exclusively comprised of rich lawyers and rich real estate brokers.
Office Space Demand Rises for Sixth Consecutive Month
Lastly, investing in real estate, specifically distressed assets, is never a game of certainty. Investors can only make bets on quality assets where they feel the returns are asymmetric; however, nobody truly knows the outcome. At Carolwood, we believe in the return of the office market. Are we certain of our assertions? Absolutely not. Yogi Berra famously said, “It’s difficult to make predictions, especially about the future.” Carolwood can only consider the factors we can control and “be greedy when others are fearful.”
P.S. I forgot the last thing. It’s a little known thing called cutting interest rates…
See you on the other side. I hope you join in before Warren reminds you it’s too late.
America is going to go back to work.
Congratulations on your Aon acquisition! Your success will be the envy of Warren Buffet! We're fully vested in helping create the space that brings the workers back into the office and are seeing it happen.