Concerns About Economy Drive Demand for Office and Industrial Space
by Stan Ross
Before the September 11th terrorist attack on the World Trade Center, corporations based their decisions on buying or leasing office or industrial space on traditional criteria, such as future employment needs, location of their facilities in relation to customers, suppliers and employment centers, logistical needs and other issues. Now they must address a new set of complex questions, the most important being the safety and security of employees — always a concern, but now a greater one.
Companies also are focusing more on the safety, stability and continuity of their operations, which raises issues of site selection and location, building security, adequacy and reliability of backup systems as well as investments in technology to facilitate communications with employees, customers and suppliers. Simultaneously, they are trying to make decisions about reducing employment, trimming operations, cutting costs and forecasting future demand for their products or services in the face of great uncertainty about the economic outlook.
How can owners and investors analyze these complex issues, determine the effects on the real estate industry and their businesses, and revise and update their business plans? Trying to make predictions about the economy and real estate markets is precarious even in the best of times. Despite greater uncertainty, the forces that drive the economy and real estate markets have not been repealed. As always, owners and developers can analyze trends, frame questions, consider different scenarios, conduct sensitivity analyses and continue to plan. Indeed, the current environment has heightened the need for sound planning.
Employment Issues
An immediate concern of office owners and investors is the effect of the economy's downturn on employment, a key driver of demand for office space. Tens of thousands of employees have been laid off in the airline, aerospace, travel and other hard-hit industries. Many more have seen their jobs disappear because of continuing consolidation in many industries and in professional services. More layoffs could follow, depending on the severity of the downturn and when the economy begins to recover and employment stabilizes.
The more optimistic forecasts generally expect the economy, after contracting in the third and fourth quarters of 2001, to begin to grow in the first quarter of 2002 and average two to three percent growth for the entire year, fueled by some combination of new tax cuts and increased government spending. Some pessimists are concerned that this fiscal stimulus could lead to an inflationary environment and higher interest rates. They generally don't expect a recovery to begin until in the second half of 2002, with annual growth of less than two percent.
In any event, companies will be extremely cautious about hiring and high unemployment could persist for much of 2002. That would mean continued high office vacancy rates in most metropolitan markets in 2002, except New York, where perhaps 20 percent of the supply was destroyed or damaged in the attack and large blocks of contiguous space are difficult to find. Nationally, metro market vacancy rates may not peak until late in 2002 or in 2003.
If past downturns are a guide, some of the jobs lost in the current slump are gone for good, but other jobs could be created in the thousands of private companies and businesses serving the defense industry, as well as in other industries and businesses, such as biotechnology, pharmaceuticals, energy, security, professional and adult education, telecommunications and consulting. Some laid-off professionals and employees could start their own businesses. So could immigrants who came to the U.S. in the great wave of immigration in the 1990s.
Whether new job creation will offset the current round of layoffs, and to what degree, may not be clear for months or years. In Southern California, many defense contracting jobs disappeared in the 1990s, but over time many of the professionals and workers in defense were recycled into other industries such as aerospace, technology and entertainment.
Location Criteria
In deciding where to locate, companies traditionally have considered the availability of skilled workers, proximity to customers and clients, access to transportation systems and other factors. Now the issue of security looms large. Companies are evaluating whether to concentrate their senior executives, managers and employees in high-rise central city skyscrapers, or disperse them in multiple locations in suburbs or exurbs. People working together in a single corporate headquarters, exchanging ideas and collaborating on projects, can generate the creative spark that results in breakthrough ideas for new products and services.
Some of that creativity and productivity might be sacrificed if people are scattered in multiple locations, communicating mostly by phone, e-mail or fax. And the cost of owning and renting space could be more expensive than if operations were concentrated in a single building. But the risk that a single man-made or natural disaster could cripple or wipe out a company would be reduced. For security reasons, companies may prefer to keep a low profile, running their businesses from nondescript buildings.
Furthermore, if a company has multiple locations in an area, more of a company's employees might be located closer to their homes and have shorter commutes. More of these workers might work from home, either as employees or independent contractors. The trend towards outsourcing could create more demand for these workers and create more "virtual" corporations _ global companies run by a few managers and key staff that outsource everything from manufacturing to marketing and sales to other companies, small businesses or independent contractors.
It's too soon to tell how the central versus dispersed location issue will play out nationally, but an early sign could come from New York. Will companies that were displaced want to move back to lower Manhattan once the area is rebuilt, including the possible development of a new project on the World Trade Center site? Will new companies want to locate there? How will the fears of some employees about working in high-rise buildings influence the choices of companies about where to locate?
Even companies that disperse geographically may want to be near other companies in the same industry or service line, much like financial services on Wall Street or technology in Silicon Valley, in order to facilitate the exchange of ideas, share best practices and share talent. That could give rise to more clusters of companies across the U.S.
Just as in the selection of office locations, companies also will be more concerned with deciding where to locate new manufacturing and research and development facilities and warehouse and industrial space in order to reduce the risks of industrial sabotage or terrorist attacks. Finding the most secure locations, wherever they may be, will have to be balanced against issues such as accessibility to transportation systems, proximity to key suppliers and customers, and logistics — a tradeoff of increased security could be slower delivery of products and materials.
Another key question is how concerns about security will affect the decisions of U.S. multinational corporations to locate operations abroad. Some companies may elect to concentrate manufacturing and other operations in the U.S. which, despite the terrorism threat, may be perceived as less risky than other locations. Others may consider it essential to have operations abroad, close to end markets.
Technology Investment
Companies may step up their investment in technology, beginning with more investment in corporate Intranets and other communications systems, to better connect scattered offices and plants and also to better link to customers, clients, suppliers and vendors. More capital could go into creating computer and information backup systems or strengthening existing systems, an investment that enabled some companies whose operations were shut down by the World Trade Center attack to be back up and running within hours or days.
Companies may also spend more on acquiring or developing technology to increase the security of their locations and operations. And the trend toward more corporate investment in Web-enabling back office operations and other manufacturing and business processes will continue, helping companies to operate more efficiently and reduce costs. More workers could be displaced by automation, reducing demand for office and industrial space.
Building Security
No matter where they are located, companies are certain to be more concerned with building security. Companies are recruiting and hiring more security guards, increasing surveillance of public places, managing building access more closely, stepping up disaster training of managers and employees and looking at upgrades such as replacing water-based sprinkler systems with foam or adding geotextiles to reinforce concrete pillars. Longer term, architects, engineers and developers will work on designing and developing buildings better able to withstand terrorist attacks along with earthquakes and other natural disasters. Some existing buildings could be retrofitted for the same purposes. However, the need for tighter security must be balanced against the desire of employees and the public to work in or visit buildings that are open and inviting, not fortresses.
Real Estate Implications
In the aftermath of the September 11th attack, security suddenly is a much more serious concern of corporations and other tenants as well as commercial property owners. That concern comes on top of worries about the outlook for the economy in 2002 and beyond. With the economy, there are guideposts: past behavior may offer some clues as to future performance. Terrorism is an entirely new threat, creating a more uncertain environment. How are owners, developers and investors to respond?
They could begin by talking to their clients: the corporations and businesses that are among the largest users of commercial space. How do companies view current economic conditions? How do they expect the economy and their own businesses to perform in 2002? How will security concerns shape their decisions about where to locate, whether to centralize or decentralize their operations, and other issues. Owners and developers could monitor large companies in insurance, media, entertainment, financial services, transportation and investment banking, that are among the hardest hit, see how these companies are responding and try to determine the real estate implications of their actions.
Having some sense of companies' plans for more layoffs or perhaps new hiring in 2002 would help owners in developing their forecasts of demand for office space, vacancy rates, including vacancies in sublet space, and rental rates — contrary to past practice, lower floors in some skyscrapers might command higher rates than the upper floors. Owners should also review their property and casualty and other insurance policies to determine if they should add coverage for force majeure or terrorist acts or increase existing coverage.
With office vacancy rates expected to remain high in most metropolitan markets (New York being the notable exception), landlords are beginning to offer more concessions in the form of free rent of up to six months and more generous tenant improvements. Despite such incentives, companies will be cautious about long-term lease commitments, preferring short-term leases of two or three years.
Contrary to the general trend, demand for space could increase in some markets such as Northern Virginia as companies tied to the defense industry pick up more business. Demand for space in telco hotels also could pick up as more companies move to store electronic data offsite, which would help to absorb some of the severe overcapacity in that market.
In the industrial sector, demand could rebound in 2002 as the economy recovers and companies rebuild inventories. As with the office sector, companies will be cautious about acquiring or leasing industrial space. With vacancy rates relatively high in both sectors, there could be less speculative building in 2002. However, the build-to-suit market could be active as companies, for security reasons, choose to build in new locations and to their exact specifications. Despite relatively high office and industrial vacancy rates, the overhang of space is not nearly as great as in the recession of the early 1990s and real estate markets should recover comparatively quickly from the current downturn.
Concerns about security and the economic outlook have affected not only corporations and other tenants but property owners and investors as well. The amount of capital flowing into real estate might ease somewhat in 2002 as some investors decide to sit on the sidelines until the economic and property markets improve. Other investors may be more cautious, and more selective, in buying properties because of security issues. Some owners who have kept their buildings off the market may decide to put them up for sale rather than waiting for market conditions to improve. That could present attractive acquisition opportunities for buyers. Relatively wide spreads between asking and bid prices may narrow, leading to the close of more transactions.
Whatever changes are in store for the economy and real estate markets in 2002, this much is certain: owners, investors and developers are playing by a very different set of rules. They need to develop more flexible business plans than in the past, and be prepared to adapt quickly to changing market conditions. Speed, flexibility and adaptability have always been important, but never more so than in today's uncertain political and economic environment.
Stan Ross is chairman of the board of the USC Lusk Center for Real Estate. He is former vice chairman of Ernst & Young LLP.