5 minute read 23 Oct 2020
Older caucasion man working at home office

How to prepare for reduced office space demand post-pandemic

By Brett Johnson

EY US Strategy and Transactions Real Estate Valuation Solutions Leader

Client-serving principal; experienced advisor helping clients navigate complex capital allocation matters. Keen focus on real estate for both investors and users of space. Dedicated father, husband.

5 minute read 23 Oct 2020

Companies should rethink strategy, financial, accounting and valuation impacts of real estate in the post-pandemic era.

In brief

  • An EY survey of real estate market participants indicates demand for office space to decline over the next three years.
  • It’s critical to understand the strategy, financial and valuation implications of leasing decisions.
  • There may be opportunities to secure better office space once a new workplace strategy is set.

Whether your employees are enjoying the flexibility of working from their newly converted home offices or itching to get back into corporate office space, the virtual work environment will become their new normal. While return-to-office plans vary drastically across the US and worldwide, several major employers have publicly announced their intentions to remain remote until well into 2021 and beyond. Not surprisingly, Silicon Valley technology companies are leading the way to permanent work-from-home status. Other industries are following their lead, with multinational insurance companies and banking institutions expressing the same sentiments. These developments could mark a culture shift and a permanent change.

Regardless of company sector, it’s difficult to imagine a return to pre-COVID-19 office occupancy. Ernst & Young LLP (EY) conducted a survey of real estate market participants in July and August 2020 which indicates that 80% of respondents expect demand for office space to decline over the next three years.

As a result, a significant increase in excess and idle office space is expected globally, which could have a snowballing effect on market rents, concessions, downtime and sublease recoveries, as has been observed in the retail real estate industry over the past few years. While there is plenty of cutting-edge thought leadership concerning workplace strategy, an equal focus is needed on the financial, accounting and valuation impacts of this change in office demand.

How do you think property values will be impacted as a result of COVID-19?
What are your expectations for market office space requirements usage in over the next 3 years?

Practical recommendations

Per CoStar, the US office market includes more than 7.2 billion square feet of leased floor area with a historical vacancy rate of around 10%. Approximately 300 million square feet, or 4%, is set to expire within the next 12 months followed by another 225 million square feet, or 3%, in each of the following two years. Although companies may not be using their office space today, if they are not in this near-term expiration population, they will likely have to renegotiate their remaining lease obligations.

Second quarter 2020 real estate investment trust (REIT) earnings calls provided insight into the perspective of some of the country’s largest office landlords.

In general, many landlords are fielding requests for concessions and rent deferrals on an as-needed basis, but they have not yet agreed to many significant lease restructurings.

As leases near expiration, however, landlords are entertaining shorter-term renewals of 12 to 24 months to accommodate the uncertainty in the market.

Financial considerations

Traditionally, when a company identifies excess office capacity, it would call on its real estate broker to understand the secondary or sublease market. Unfortunately, discouraging data trends are already beginning to materialize here.

Jones Lang LaSalle (JLL) published a 2Q 2020 United States Office Outlook report which noted that gross leasing volume dropped by an unprecedented 53.4% in 2Q combined with 14 million square feet of occupancy losses (the steepest drop since 2Q 2009) and bringing year-to-date net absorption to a negative 8.4 million square feet. Sublease vacancy rose by 5.2 million square feet in 2Q and JLL is aware of an additional 15.7 million square feet of shadow vacancy becoming available soon, though not yet vacant.

These statistics may lead to sublease terms that are highly favorable to the subtenant and leave a significant portion of the remaining lease obligation with the prime tenant.

High-growth companies could have a once-in-a-lifetime opportunity to obtain highly desirable real estate for pennies on the dollar. For those who wish to downsize, however, losses could be substantial.

Accounting and valuation considerations

Companies that have adopted the new leases standard (ASC 842) may want to coordinate the rationalization of their leased real estate footprint with accounting and valuation analyses to aid in big-picture decision-making.

In some cases, companies may plan to abandon or sublease certain locations or discrete components of locations (such as separate office buildings or floors), triggering impairment analyses of the underlying right-of-use (ROU) assets. In other cases, a company may intend to remain in its leased space through expiration but have reason to believe the underlying market value of the asset has been permanently impacted. In either scenario, management should consider the following key questions:

  • What is the remaining term of the existing arrangement and does it include or exclude any renewal or termination options?
  • Do you anticipate receiving any rent concessions, deferrals or renegotiating other aspects of the arrangement?
  • Has management committed to a plan to sublease or abandon the space?
  • Does the company have the right to sublease space?
  • If subleased, would the company still be the primary tenant or would the sublessee “take over” the obligation?
  • When would the company be able to exit the premises and remove any remaining assets or inventory from spaces it intends to sublease or abandon?
  • What market data is available for prime and sublease positions in the area?
  • How long are similar spaces taking to find new tenants?

Companies should also proactively work with their valuation advisors, accounting departments, advisors and auditors to develop their own strategic alternatives and to consider a market-participant point of view.

Depending on the answers above, numerous accounting implications may exist, including how management decisions may apply to separate lease components, when leased premises may be considered abandoned and whether sublease arrangements are treated as a termination of the prime lease. They could also affect the timing and amount of impairments recognized.

Coordinating these practical, financial, accounting and valuation considerations around leased assets can help companies understand the implications of their leasing decisions and aid in a stakeholder communication strategy that is clear and comprehensive. While the long-term impact of diminished office usage is still uncertain, it’s clear that companies may need to start thinking about potential income statement and balance sheet impacts now.

EY's Joanna Acosta and Christine Tutaj also contributed to this article.

Summary

As companies continue with a virtual work environment, executives are re-imagining their workplace strategy and financial implications.

About this article

By Brett Johnson

EY US Strategy and Transactions Real Estate Valuation Solutions Leader

Client-serving principal; experienced advisor helping clients navigate complex capital allocation matters. Keen focus on real estate for both investors and users of space. Dedicated father, husband.