Motley Fool Hidden Gems Investing - The Evolution of Urbanism

Episode Date: June 17, 2023

For the past century, cities have centered around work. What happens when that’s no longer the case?  Deidre Woollard and Matt Argersinger discuss: What downtowns might look like when they become more than just “containers for work” How different REITs are approaching the new commercial real estate landscape The promise and problems of “15-minute cities” Companies and REITs mentioned: CRM, ARE, WE, PEAK, DEA Host: Deidre Woollard Guest: Matt Argersinger Producers: Ricky Mulvey, Mary Long Engineer: Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

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They can be what else they're known for. They can be their cultural centers, arts, education, entertainment. People just, you know, sometimes people just like to live closer to other people. I mean, there's a lot of reasons that cities can still thrive, but we almost have to reimagine, almost reimagine them entirely. I'm Mary Long, and that's Motley Fool senior analyst Matt Argesinger. Deidre Willard caught up with Matt to discuss creative ways to repurpose office space in a world where cities don't revolve around work, the shifting dynamics of the latest Sunbelt migration, and the pivotal role that parking garages could play in revitalizing urban centers. You know, since the pandemic, we've been watching with cities kind of grapple with the nature of work.

We've seen people spend less time in the office. we've looked at data that shows the amount of hybrid work, maybe it's stabilized, but then I'm starting to see all of these reports about companies like Meta, Amazon, Alphabet, Redfin, a lot of them saying, back to work in September or else. I kind of heard this last year. Is it going to be different this time? It's a good question. I think we should step back a bit and maybe use data to guide us a little bit as we try to answer these questions. But thanks for having me to talk about this because I do think, and we'll kind of go into this, but I do think the future of cities is really one of the defining, I guess, things of our time here.

I mean, it kind of up there with climate change, right? It's just something that's going to change a lot and we need to figure out and we kind of need to figure it out pretty rapidly. But yeah, so talking about office and the whole work from home dynamic, if you look at the latest data from CoStar, the U.S. office vacancy rate. So, it hit a high of 12.9% in Q1. That's an all-time high, by the way. And it's the sixth straight quarter of increases. It was under 10% prior to the pandemic, but here we are at almost 13%. But you have to remember, that's economic vacancy. That's just the amount of space that's not leased. If you look at actual vacancy, Physical human occupancy, vacancies are a lot higher.

If you look at the Castle System data, they have this great back-to-work barometer of data that they provide. It shows that office occupancy, physical occupancy of office buildings, was just under 50% in their 10-city index. They've got this index of 10 major cities. Really, it's less than half of these office buildings are occupied at any given time. And in places like New York City, San Francisco, Washington, D.C., really big, popular office markets, the average is closer to 40%. So, we're seeing just not a lot of occupancy right now in office buildings, despite these headlines we're seeing about, hey, come back to the office, come back at least three days a week, etc., etc. So, the other thing, too, is that this overall vacancy rate doesn't capture the amount of space that tenants are actually making available for sublease.

You have companies that are leasing space that are under long-term leases, but they've actually set aside a portion of their space to subleasing. Just as one example, it's estimated that 7.2% of San Francisco's office space, while it's leased right now, it's available for sublease. I read an article in the San Francisco Standard that says there's 3.5 million square feet of office from 13 companies in the city alone. Yes, major companies. You mentioned some, Alphabet, Amazon, Meta, JP Morgan's another one. They're urging mandating workers to come back, at least on a part-time basis. I think it will

have an effect, but I'm not sure it puts a dent. I don't know how you feel about this. It just doesn't feel like it's going to put a dent in this long-term structural secular movement that we have to a more distributed workforce. I just think the idea, and we should get into this more, But the idea of kind of a centralized CBD headquarters or major office center, it feels like it's in the past. And it became so in just rapid fashion. You know, you mentioned San Francisco. Salesforce is a great example of that in terms of sublease because they built this huge tower,

right? I know. It's one of the biggest skyscrapers in the country, actually, just recently. Yeah. It's a gorgeous building. They built it. And now at least part of that is up for sublease. And the other thing is, as much as companies are mandating back to work, I don't think I've heard of any of them that are mandating five days a week. They're all talking about two to three days. So no matter what, you've got less occupancy in terms of physical occupancy happening.

And I think that's an important distinction, too, because we've got physical occupancy, which is bodies in seats, and then you've got building occupancy, which is we paid for a lease. So, we're paying for a lease often for five days a week, but we've only got people in there maybe two to three days a week. And that is sort of interesting, too. Right. And remember, those leases, by the way, a lot of these companies, unfortunately, they have those leases, but they're expiring. Leases always expire, right? So, imagine a lot of those leases expiring in the next year or two or three years. Many of those companies are not going to renew those leases. So, you've got this economic occupancy rate that's probably going to come down even further. So, I wouldn't be surprised if,

I hate to say it, but a year from now, we might see more all-time highs in terms of the office vacancy rate. Yeah, that's an important thing to keep in mind because it has been this slow burn. So, when the pandemic happened and everybody said, well, buildings are still being occupied, so it's fine. But what people didn't understand is that you've got three-year, five-year leases that are all on different timeframes. And we're just now really seeing the impact of that. Right. They're just going to keep rolling through. And I expect we'll just see those vacancy rates continue to climb. And they're happening at a time when interest rates have shifted and the ability to negotiate

is dramatically different as well. Right. Well, let's kind of talk about the what-ifs. So, if we have this assumption that, okay, we're probably not all rushing back into the office when summer is over. What does a central business district look like? Because traditionally, a central business district, you've got the big, tall buildings, you've got people rushing in and out during the daytime. Maybe it's not so active at night. You've got ground floor retail. I heard this quote recently from urbanist and thought leader Richard Florida. He said that this is the opportunity to move cities beyond containers for working. And I thought that was really powerful because that's sort of what a central business

district did. It is a place where we all go to work. So, if it's not that, then what is it? It's very interesting to ponder, I would say. Because if you think about how we organized work in the past, going back hundreds of years ago, it was all about around farms and agriculture, right? That's where we sort of center the population. Then it became about industry, where were factories, where were plants, where were big manufacturing facilities. Where was transportation? Where were ports or major rail lines? And then I think as we moved into the 20th century, and certainly as we got into the 21st century, it became the information economy. It became the services economy.

And so, it became about financial companies and technology. So, all of a sudden, we shifted the basis for work and the basis for population around cities. Because like you said, that's where these buildings were. That's where we organize life. That's where during the day, a city like New York City or Washington, D.C., their populations would swell because you have these workers commuting into the city, commuting to these buildings. And that serves so many things beyond just the office, right? Like you mentioned, there's retail establishments, restaurants to serve lunch, transportation, public transportation, buses, subways to serve those commuters. That's all really, I hate to say it, but it's been kind of upended since the pandemic. And cities will have to evolve. They will simply have to evolve. Because if you look at New York

City, for example, depending on the source you use, property taxes make up around 50% of New York City's revenue. And the lion's share of that in New York City is office. So, if a substantial portion of that tax base is not going to be operational, or it's going to shrink, where is a city like New York going to get its revenue from? There has to be some serious thinking around this. And I'm an optimist, right? And I think you are too. I mean, cities don't have to be organized around the office anymore. They can be what else they're known for. They can be their cultural centers, arts, education, entertainment. People just, you know, sometimes people just like to live closer to other people. I mean,

there's a lot of reasons that cities can still thrive, but we almost have to reimagine, almost reimagine them entirely. And I think people always want to live in cities. I think they just might no longer want to commute to cities. That is, I think, a big distinction. And one of my big fears, and we can talk more about this later in the show, but my big fears is that cities are going to react too sharply to the change. They're going to realize that office is going away. They're going to realize that their tax revenue is going to shrink. They're going to stop investing and funding things like public transportation or other projects that make cities better because they're worried about short-term funding problems or

planning issues. That would exacerbate, I think, the problem with cities. That would take away from what makes cities special and livable. And I worry a lot of city governments are going to take these drastic measures and it's going to be almost self-reinforcing. Well, the other thing I'm thinking about too, when you think about these, you've got this trend that's sort of mostly pandemic driven, but before that you had this trend toward gig work. And we know that that's happening. We know that the amount of freelancers is rising and the younger generations that I'm thinking about too, they're, they're definitely breaking out of the 40 hour week. I go, I sit at a desk and I do my work eight hours a day and I come home. That's,

that's not the way that, that really the future is going to be kind of going to be lived. And so one of the things I'm thinking about is whether or not that changes how we consider the office now, because even when I go to the office now, I'm going, I'm not necessarily going for the full day. I might do a couple of hours at work at home. I'll go in to have a meeting with people or do something else. And then I might leave right after that, go home, work some more. So, I think that as we start to think about this, do things like WeWork, and we can talk a little bit about WeWork because they have so much of the office space, but are we going to see offices used in that more flexible kind of manner? Right. I love that. I mean, I think, yeah,

like you and I went in a week or so ago to film some stuff in the studio. And I showed up maybe an hour before we did that. And I left shortly after we had finished. And I think that is a good example. And I like that you brought up the younger generations approaching work differently. Because I think a lot of those trends might have been in place even before the pandemic. Remember, WeWork was a major thing before the pandemic, before we even got close to it. And the whole idea of this collaborative workspace, where it's not so much a centralized location anymore where you need all your employees to be, right? It can be more of a collaborative space or you can have sort of satellite offices where

workers get together on an infrequent basis or, you know, and things like, you know, travel to conferences or events or to bring teams together that work in different places. I mean, there's a lot of possibilities. So, there's uses for office that, you know, there's still obviously going to be demand for office space or conference space. It's just, you know, whether or not it's in this sort of centralized office location that we've been living in for probably 100 years at this point, that certainly feels like a thing of the past. Yeah. So, let's talk a little bit about the investing aspect of this because I'm invested in a couple of office freets. I'm sort of looking for opportunities in others, but I'm nervous about that. The prices for these companies are very low right now, but the future is also a little scary because most of the

forecasts I've seen say that office rates aren't going to go up until at least 2025. And really, nobody knows. We can't really predict the future. So how are you thinking about office rates? Are you semi-optimistic? Are you seeing any opportunities? I wouldn't call myself optimistic. I would say there are some areas of opportunity, given what's happened in the space. But yeah, you shared with me some data from the Urban Land Institute, which looked at office occupancy rates, rents, valuations. And like you said, it's going to take several years at least to work through what I think has rapidly become this excess supply of office space. The types of office that I think is really going to suffer

are your older class B buildings that don't have a lot of in-house or nearby amenities to attract workers or tenants. Those are already tough and out of favor in a lot of places. Now, even post-pandemic, there's lower demand for office. They're just going to get left behind because workers and tenants are going to want to be in higher-end class A office space that's cleaner, more modern, with more amenities attached to it. Otherwise, it's going to be really hard to draw in a lot of workers on a regular basis. I think if you're looking at REITs, and you mentioned you own some, I own some office REITs as well. I think if you're looking at traditional office REITs that focus on core CBD assets like your SL Greens, Boston Properties, or even smaller

ones like Brandywine Realty Trust or City Office REIT, I think it's going to be really, really challenging for these REITs. It's going to take some time and there's going to be some defaults. There's going to be some real pressure on funds from operations, which is kind of a cash flow metric for REITs. And rents are just probably not going to grow. Occupancy is going to be lower. Debt, and this is the key thing, debt is going to need to be rolled over or refinanced on a rolling basis. And so, a lot of these buildings, the REIT controls, obviously, the equity. But a lot of times, banks, especially regional mid-sized banks, own a lot of the debt. And if the equity is getting wiped out, which in a lot of cases it has,

those banks are going to want to get their debt out of it. And it's just really, really challenging. Now, there are some parts of the market. If you look at, for example, one we've talked about in the past, Alexandra Real Estate Equities, which is predominantly a life sciences REIT, maybe a Health Peak Properties, or even a Easterly Government Properties, which focuses only on federal government leases. Those will probably work out okay. I mean, they're still beaten down and there's still some challenges there, but I think those are going to be working out okay. But the traditional office REITs are the ones that you're going to want to watch out for. Yeah. SL Green, I know they're trying to expand

into other areas. I mean, I like them because they have top tier properties. I'm a little worried about them because they're almost 100% in New York. They're trying to maybe do a casino in Times Square, but that's way, way down the road. Other thing, speaking about New York versus other areas, I tended to see this originally as a coastal city problem. But now I'm starting to see signs of weakness in some of the markets that were considered to be the next big thing. Charlotte, for example, their vacancy rate is going up partly because that's a banking city and some of those big banks are starting to reduce their space. How much do you think the Sunbelt migration thing that you and I have talked about a lot, is that going to shift again?

Well, I think in terms of office, I think they'll hold up better. But you're right, you really have to pick your spots. You have to pick your markets. You mentioned Charlotte, which I think is a great example. It's a banking financial hub. Those types of tenants have been more amenable to flexible work relationships with their employees. It's created a problem. Just as we've seen in certain markets in San Francisco, LA that are more tech-driven, same thing. More flexibility to the worker, less demand for office. Places that will probably do better. If you look at maybe your Jacksonville's, Miami's, maybe your markets in Texas and Dallas or Austin, even though there's still pockets of weakness and those places saw huge demand,

I think there's a lot of cases where there's been so much migration and so much movement among corporations down to those places that they're probably not going to face the same amount of challenges. But again, you have to be real specific and pick your markets. In a way, that's the beauty of real estate. And we talk about all this time, it's a very diversified sector. So, here we are, we're railing against office and we're talking about that kind of situation. But there's also a lot of positive things happening with real estate in a lot of those markets, whether it's apartments or industrial, even retail and hospitality. But yeah, the office, no matter what, I think if you're a real estate investor,

it's really hard to get excited about office right now. And you can do so much better on a risk-adjusted basis anyway, looking at other sectors, at least in the near term. Yeah, that's a good point. So speaking about that, what other areas should we be considering? Is there a way that some of these office buildings can be repurposed? Because we talked a little bit before, we've talked about this, about residential. I've seen some of the stats that it's not necessarily going to be the easiest thing to convert these buildings. You can't really turn a lot of office buildings into apartments and then that's just the end of it. But there's some other things I'm seeing. So, vertical warehousing, edge computing. I saw a post the other day about the idea of turning some of these buildings into kind of vertical malls, almost like the old-fashioned, like a Macy's where you've got different things, except it's not one store, but just different stores on every level. Are we going to sort of open up this creativity and is that going to bring energy back to cities? I think so. And I hope so. And that just makes so much sense. It's going to be very expensive to do. And you mentioned it. A lot of people think, well, we can just convert all these office buildings to apartments. It's so difficult to do that. A lot of office buildings just can't be converted just because of the way they're structured. The plumbing isn't right. Utilities aren't right. They have to be upsized. The floor plates are too large. Column spacing is weird. There aren't enough windows. And so, people tend to underestimate the cost and zoning changes that would be required to turn your traditional city office building into an apartment. But it's happening to a small extent. Your other ideas, I think, are much better, which is the whole idea of vertical warehousing or building more of a mixed-use property where maybe certain floors are still office, but then certain floors are retail or certain floors are hotel, hospitality maybe.

There's a lot of things that can be done. I just think what has to happen is the cities themselves have to make it possible for those kinds of transitions to happen. There's such draconian, as you know, zoning regulations or tax implications that your typical developer is going to say, it's too expensive, it's too hard, it's going to take years, I can't get in there and do it, even though I know that this particular type of real estate is much more in demand and has much more long-term potential. And so, it goes back to kind of what we were saying at the beginning of the show. There has to be almost this entire rethinking of how cities are designed and zoned.

And think about something simple like parking requirements. So many buildings have minimum parking requirements that have to be satisfied. And it's never made sense to me as to why cities have such high standards there when we really don't want a lot of parking in cities, right? We want people to be using public transportation or walking. So, even lessening some of those types of restrictions can really open up more development. It's just so many things have to be rethought. And it's going to take a lot of different players from both the private and public sectors to come together saying, this is what makes sense.

And in the past, unfortunately, those types of groups have been more in conflict with each other than collaborative. So, it's going to take, like they say, the cliche, it's going to take a village to make it all happen. Well, yeah, I think you brought up something really interesting with the idea of public private partnerships because you're absolutely right. For the most part, traditionally, it is a developer wants to build something. They see where they can make a profit. Then they go to the city and they ask for it. Sometimes you get... I mean, there are things like low-income housing

tax credits. There are other credits for affordable housing, things like that. But there's not a lot of public support for building offices unless they're going to have maybe public space with it sometimes. So it's a bit of a challenge to get the government, I think, behind that. But I want to zero in on what you talked about with parking because that is... A few years ago, I was at this real estate conference and a guy got up on stage. He's like, cities are going to be redone in five years. Autonomous driving is going to be everywhere. There will be no more parking garages. Parking is not even something we're going to have to worry about. That didn't come to pass, but we are starting to see some things. You and I looked at an article recently

from The Real Deal talking about digital realty trust, maybe tearing down a parking garage in downtown LA and putting in a data center. Is there an opportunity to take all of that real estate in cities that is parking and turn it into something else? Oh, absolutely. And that's a future I would love to see. I think everyone would, right? Because... They're not pretty. Well, no, those aren't pretty, but I'm just saying the whole idea of removing excess parking, especially remember, if we move to a city or move to a future where a city doesn't have this big commuting population coming in and driving cars, there's better uses for a lot of that space. Of course, I think we'd love to see autonomous driving take over. It's safer, it's cleaner, it's more efficient.

There's not a need to have parking, and it's more cars as a service. I'd also, of course, love to see public transportation continue to be funded and a critical part of cities. Because that's what makes cities livable. Autonomous vehicles, I know the future is a little farther off than we thought, But you think it's so much more possible and appropriate for cities than it is outside of cities, where there's just a lot more variability. But cities tend to be, the way they're designed, very amenable to autonomous driving. And so, gosh, you'd love to see it, right? Because it just seems like such a better way to get around a city.

I mean, I love New York City. I love visiting New York City. But the whole idea of hailing for cabs, I mean, it's a pain to get around that city sometimes. And just imagine if there was just a fleet of autonomous vehicles that were constantly going around. You just jump in, jump out. And that would make getting around New York City so much easier and more enjoyable. And that goes for all cities. And so, yeah, there's a wide range of different uses for all kinds of assets within cities.

And parking is one of them. We have probably too many parking garages, too many underground parking. And we can get rid of a lot of that and make that space a lot better used, especially by the people who live in the cities. Well, I keep coming back to the idea of the 15-minute city, which has been talked about a lot in Europe. But there have also been things like the super blocks in Barcelona. The whole 15-minute city idea is that you can do everything you want in 15 minutes without getting into a car. Maybe you need a bicycle or a scooter, but that's about it. And it seems to me like some of our smaller cities are already there a little bit.

That's one of the sort of longer trends we've seen that as millennials move to some of the smaller cities, they sort of wanted more walkable space. So that was a trend we saw pre-pandemic. Do you think that is more where we're heading? I hope so. I mean, like I said, it's a better future. And I think one of the things you brought up earlier about the younger generations, I think that is much more appealing to the younger generation.

Imagine living in a city, your job, the office that you go to three days a week is within 15 minutes. The place where you go get your groceries is within 15 minutes. The place where you meet your friends or to go to the coffee shop or go to a bar or restaurant or out for the night is within 15 minutes. And that, I mean, who wouldn't want that, right? I think that's what you're seeing. And unfortunately, it seems to be happening in sort of these isolated developments, these mixed use developments you're seeing in certain places where the developers coming in and building all that versus you see less of it happening within existing cities. And I think that's the question mark. Is it something that can happen in our existing cities given our existing infrastructure?

You'd hope to see it because I think that is a much better future for cities than what we have today. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Mary Long. Thanks for listening. We'll see you tomorrow.