BlackRock’s Weekly Market Commentary: Death of the office? Far from it

The pandemic has led to widespread remote working, raising doubts about the future of offices. We believe the office is far from dead, but expect the impact of flexible working to vary across assets and locations. We see the restart and higher inflation driving up rental income and a more muted response of interest rates to rising inflation than in the past supporting real estate valuations.

Chart of the week

U.S. real estate valuations vs. 10-year Treasury yields, 2001-2021

Sources: BlackRock Investment Institute, National Council of Real Estate Investment Fiduciaries, with data from Refinitiv Datastream, as of March 31, 2021. Notes: The orange line shows U.S. core real estate cap rates as represented by the NCREIF Property Index. The yellow line shows the yield of the Refinitiv DatastreamU.S. 10-year benchmark government bond index. Cap rates – calculated as net operating income/property value – are a commonly quoted valuation metric for real estate. It is similar to an earnings yield – a lower cap rate means higher valuations. Past performance is no guarantee of future results.

Private market valuations have historically been closely linked to the interest rate and credit spread environment. The U.S. real estate cap rate – a measure of valuations – has trended lower since the global financial crisis, in line with the decline in Treasury yields. The cap rate stood around three percentage points above the Treasury yield at the end of March, in line with the 20-year average. A lower cap rate indicates higher valuations. See the chart above. We see a more muted monetary policy response to rising inflation than in the past – what we call the new nominal – and expect it to support real estate valuations overall. Yet cap rates are just one of the drivers of real estate returns. Cash flow growth is also key – and the pandemic has highlighted the uneven impact on cash flows across assets. Properties that have benefitted from the structural trends accelerated by the pandemic, such as warehouses, have performed well and are still attracting high investor interest. Office and retail lagged, though office occupancy rates and income have been rebounding amid the restart. We see a growing dispersion of fortunes even within the office sector, which accounted for nearly 40% of the global real estate market value at the end of 2020 as estimated by MSCI.

Flexible working will likely reduce aggregate demand for offices in some markets, but the effect may not be as large as one may expect – due to tenants’ desire for less density and the need to accommodate peak demand days, in our view. In a survey by real estate service firm CBRE just 9% of large companies expected significantly smaller office prints in the long term, compared with 39% last September. A wait-and-see attitude as the new normal of flexible working shapes up may also have helped moderate the desire to shrink the office size, with existing lease commitments limiting the short-term impact, in our view. We believe the effect will also vary by region, country and even city. For example, we expect much higher occupancy rates in parts of Asia Pacific where homes tend to be smaller and less conducive to remote working.

The pandemic has also accelerated structural trends such as an increased focus on sustainability – now a key consideration among real estate investors and building occupiers. Sustainable assets such as “green buildings” are likely to trade at a premium to non-sustainable assets, in our view. Large real estate investors such as pension funds and insurance companies are setting more stringent environmental, social and governance (ESG) metrics for their investment managers as the issue has risen to the top of investment mandate requirements.

A transformation to a “hub-and-home” flexible working model in some markets could take a couple of years, and will drive a shift in the capabilities and functions of offices, in our view. We expect higher-quality office properties – typically large, newly built spaces with greater flexibility and better sustainability credentials – to benefit at the expense of offices that are smaller, less energy-efficient, and outside core locations. Other factors that are also likely to contribute to the dispersion of performance include the proximity to major transport hubs, ease of access for employees commuting by car, and the quality of building management.

The bottom line: We still see opportunities in the office sector despite changing work patterns, but expect a dispersion across locations and property types and an increased focus on sustainability to be another key driver. Elsewhere in real estate, we still like logistics properties due to their exposure to the accelerated expansion of e-commerce, but see some parts of that market nearing peak valuation. We stress the importance of expert asset management as tenants, owners, operators and investors alike navigate an uncharted territory, both in the future of work and the macro environment.