Borrower’s view: Rubenstein Partners sees nuanced path for office sector success

For investors that are picking the right spots, there is financing. But it is more difficult than it was in the past.

Rubenstein Partners isn’t believing the hype about the demise of the office sector.

The Philadelphia-based real estate private equity manager, which specializes in the value-added office sector, owns more than $3 billion of office assets, with more than six million square feet of office space throughout the US. And while there a shift toward best-in-class buildings, what is going on is much more nuanced.

For a building to succeed, it has to have a few key attributes, Michael Happel, who co-heads equity investment for the US Northeast, told Real Estate Capital USA.

“In order to succeed, a building has to be in a good location, it needs to have good light and air and hopefully it has a lot of elevator capacity. It is one of the things that we recognize when we see it. Sometimes it is not just about what is there today, it is what could be there in the future,” Happel said.

Rubenstein Partners has a longtime focus on the office market, with more than 30 years of experience in the sector. Happel’s team focuses on opportunities in the Northeast, including New York, Boston, and Connecticut, and there is a clear understanding of the challenges the office sector faces.

“In most markets, office leasing activity is down about 50 percent from where it was pre-pandemic. Decision makers are postponing leasing decisions and there is still a lot of uncertainty around this process,” Happel said. “There are questions around what the pandemic will do next or what the office will look like in the future.”

Moreover, there is a tenant flight toward quality that has thrown normal supply-demand metrics out of whack. In New York, for example, rents have been going up over the past two years for fully renovated or new construction buildings. That metric is a challenge for the market, where 75 percent of the available product is famously more than 50 years old, per JLL research.

“We are finding that more than 80 percent of the tenants are chasing 20 percent of the available product, Happel said. “There really is strength in that part of the market. What I am really worried about is commodity office space, especially the properties that haven’t had capital put into them. If a property doesn’t have the right bones or is in an inferior location, I’m not sure what will happen to those in the future.”

The one thing an investor can do is to pick its shots as carefully as possible.

“There is a big group of offices in each of the extremes – older buildings that are maybe not renovated or have the amenity package to compete with newer assets, but at least have the bones to become great,” Happel said. “That is the value-added buying opportunity. A building in the right with the right physical bones could be made into something great. I think tenants are more discerning than ever and we are chasing a smaller pool of tenants than in the past. If you don’t have the right product, you’re losing the fight.”

The lender community is obviously nervous about the outlook for office buildings and nervous about lending on them, Happel added. “Yes, you can get financing, but the lender pool is much thinner than it used to be, and the loans tend to be more expensive than in the past. It is a contrast to what is happening in the multifamily or industrial sectors,” Happel said.

The path forward

Rubenstein Partners is expecting to see a few things over the coming months. First, there is likely to be a rise in foreclosures.

“We haven’t yet seen a meaningful number of foreclosures, but that is something that could just be a matter of time. In the past, if an owner didn’t have the expertise or capital to invest in a Class B building, they might have been able to get away with it. That is no longer possible in this leasing market,” Happel said.

The other major trend is likely to be a meaningful return to work.

“A lot of companies are trying to figure out what kind of space will help them to attract and retain quality employees,” Happel said. “In New York, there are only 20 percent to 30 percent of employees at a company going into the office and yet New York’s office market is booming. And we are hearing the company wants to expand. We say, ‘Your space looks empty,’ and they say, ‘We’ve hired more people than can fit into the space and we think this all will change as soon as it is safe to be back in the office.’”