Why working from home is not about to destroy demand for office space

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Working from home most likely won't have a big effect on demand for office space as the economy reopens, says Chris Bedingfield, principal and portfolio manager of Quay Global Investors.

In this episode of Expert Insights, Bedingfield looks to Google to explain why predictions of carnage in this sector are overblown.

"There's probably going to be some level of workplace flexibility going forward," he says. But it's just a fact of life that offices have to be set up to meet peak demand.

"So if most people are choosing to work from home on a Monday and choosing to work at home on a Friday, which is likely, then everyone's going to be in the office on Tuesday, Wednesday, Thursday." The result is little net change in demand for space.

In this wire, Bedingfield also considers the future of the huge Chinese developer Evergrande and explains why Quay avoids the standard development end of the market.

He also gives a primer in property development economics, explaining why the industry is so cyclical, even for well-known names like Stockland, and why replacement cost is a key metric.

Investing in global listed real estate

Quay, a Bennelong Funds Management boutique, focuses on the preservation and creation of wealth through innovative strategies in real estate securities. For more insights on global property, visit Quay’s website.

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Edited transcript

Why have we been seeing property developers here and overseas struggling or failing? What does this mean for investors?

I think the best way to think about the development business model is that it profits when prices are above replacement cost.

If it costs $100 to build an office tower but they're trading at $130, developers will build all day long, because there's a $30 profit incentive to do so. And they'll keep building until that profit incentive disappears, which is inevitable.

And that's why you get a real estate cycle, essentially. The thing is, when that development cycle turns, that $30 profit goes to a loss very quickly. So you end up with a very cyclical business.

If you overlay a lot of leverage on top of that, which some of these developers do, you get the big increases, but you get very distressed declines as well.

There's nothing really unusual that's going on here. It's your standard development model, which is why when we think about real estate, we completely stay away from that end of the market. We just don't like the volatility and history tells you that the returns aren't that great anyway.

I mean, you look at some of our local developers that aren't in trouble, companies that are fine, companies like Stockland that maybe some of your viewers would know, we've had one of the greatest residential booms in the east coast of Australia in the last eight years — you'd be living under a rock if you've missed it — but Stockland, which is a developer, is still the same price as it was eight years go.

So the risk-return trade-off in developers is not great, but they are deeply cyclical businesses. And as I said, if you overlay leverage, when the cycle turns, you can get into quite a lot of trouble.

Can something the scale of Evergrande ever recover?

The buildings don't know they're distressed. So is it a recoverable situation? It depends which stakeholder you want to talk about.

Equity stakeholders are going to be very different to debt stakeholders, who are going to be very different to the owners, who can be very different to the buildings themselves.

If the buildings are needed, if they're part of the required infrastructure of an economy, they'll just be recapitalised and taken over by someone else. The workers might have a holiday for a couple of months, but new equity owners will come in and they'll keep building.

So is it a recoverable situation? We're not close enough to really understand which one of the stakeholders are going to do well and which ones will do poorly.

Traditionally, the equity holders get wiped out. Junior debt holders take a haircut. Senior debt holders might do okay. Everyone gets a little bit stressed. But the cycle re-emerges and we keep moving forward.

What has driven property prices in the past two years and how have domestic and commercial markets been affected?

Real estate is so diverse, particularly global real estate. There's just so many elements to it. You're going to have two parts of the real estate economy moving in completely different directions at the same time.

When you think about the last two years, the first half of the last two years was the pandemic. So anything that was pandemic favourable, anything that was not social real estate — think data centre, think self-storage, think logistics — did really well in that first year during that pandemic.

And if you weren't in those sectors — if you're in sectors that require a lot of social interactions, so office buildings or shopping centres, restaurants — you really got hit pretty hard.

But then the second has all been about the recovery. And one of the things that I think has been really interesting about this cycle is just the ferocity, the speed of the government response, fiscal government response.

There's a lot of talk about monetary stimulus, which really doesn't have that much of an impact. It's really been the fiscal response that has caused a big drive in those reopening trades that have come back.

So you would have done very, very well in real estate, commercial real estate during the pandemic if you were in the data centres, as I said, or single family housing or self-storage or logistics, but if you weren't in that social sort of real estate sectors during the reopening, you've missed out on big returns.

And those sectors would have included things like senior housing, shopping centres, office buildings and the like. Hotels is another one.

Commercial real estate is really interesting. It's incredibly diverse. It depends where you were during the cycle. Some sectors have done really well. Some sectors have done really poorly but have come back.

But what's definitely true is it's been very uneven. So there is a lot of inconsistencies in pricing at the moment across all real estate.

How do you see the contest between office space and working from home playing out?

It's very difficult to say how we're going to behave going forward. I think the safest assumption we can make is that there's probably going to be some level of workplace flexibility going forward.

I think where people get a little bit mixed up is they don't really follow through the maths of what that means. So I'll give you an example.

I think Google was saying that next year, they're going to allow people to work from home two days a week. So they have to be in the office three days a week. Now, simple maths might say, "Well, that's 60% in the office, 40% at home. That's going to be a 40% hit in office demand."

The maths actually doesn't work that way, because when you're providing for office accommodation, you have to provide enough for the maximum amount of people that can be in on any one day.

So if most people are choosing to work from home on a Monday and choosing to work at home on a Friday, which is likely, then everyone's going to be in the office on Tuesday, Wednesday, Thursday.

That has no impact on office demand, because you're going to have to accommodate those people when they come in.

Of course, the flip side of that is you say, "Well, Jack, you've got to work from home on Tuesday, and Betty, you've got to work home from Thursday." That doesn't sound like flexible work to me. It sounds pretty rigid.

I think you can actually have a scenario, and I think it's a likely scenario, that you're going to have workplace flexibility, but you're not going to have that much decline in office demand either.

And I don't think people are really thinking one way or another. I think some people are thinking, "We're either all going to go back and office demand will be fine or we're going to have flexible work hours and office is going to be terrible."

I think the reality is it's going to be flexible and it will be fine. The key is to get the valuation right.

The key is to buy office buildings below replacement cost, because if you buy an office building below replacement cost and that needs to be built again at some point in the future, then you're going to be well-protected because prices have to recover in order for that development equation to work, a bit like the opposite of the developments thing we were talking about a moment ago.

So for us, we see opportunities in office, not because we have a strong view that people are going to come in.

We just have a view that if you buy below replacement cost and you're patient and people realise that you actually need more office space than you think, even with flexible work hours, then I think you'll do well over time.


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