Where is commercial real estate headed next?

Comparing with retail, we have the counterexamples of shopping malls being converted to logistics and data centers. Image: Shutterstock

United States real-estate investors have spent the last several years on uncertain footing, facing wild swings in the economy and even more drastic pivots in how—and where—people work.

“The real estate industry is facing tectonic changes: inflation and interest rate increases, and technological shifts,” says Efraim Benmelech, a professor of finance and real estate at the Kellogg School. “As technology changes, the demand for certain properties changes.”

After convening the ninth annual Kellogg Real Estate Conference and Venture Competition, Benmelech joined Kimberly Adams, managing director at J.P. Morgan Asset Management, Suzanne Martinez, director of investor relations at AEW Capital Management, and Jay Weaver, founder and managing partner at Quartz Lake Capital, for a conversation about the state of the U.S. real-estate industry. They discuss why a lot of offices will need to be demolished, why repurposed malls are being repurposed yet again, and why we may be nearing the end of the warehouse boom.

This conversation has been edited for length and clarity.

Kimberly ADAMS: The rapid change in how people use space has forced real estate to become very innovative, particularly over the last 15 years. For decades before that, you went to the office, you lived in an apartment, you went to the mall to shop. That has been disrupted and recreated, and there’s something very exciting about that.

Suzanne MARTINEZ: The darling coming out of the last crisis was office. That’s where you were getting growth; that’s how you got dollars deployed. Largely up until now, how people function in an office hadn’t changed. Now you hear these discussions about whether office is going to be just meeting rooms where we show up for days of meetings and don’t actually have a desk. That seems a little ridiculous, but the difference between now and all the other periods is that office finally got a kick in the teeth.

Efraim BENMELECH: Office is in crisis because COVID has demonstrated that many jobs can be done from home or remotely. Even though firms are requiring that employees return, most projections show us that most firms will not require their employees to be in the office every day, which is affecting demand.

Now with advances in AI, there may be less demand for white-collar employees if they are displaced by technology, which may reduce even further the demand for office space. This phenomenon is here to stay. Throughout history we have had examples of technologies catching up and making older technologies obsolete. And since almost every technology has to be stored and operated from somewhere, that makes some real-estate properties obsolete and others desirable. Office is now the prime example of that shift. Whether people are working remotely or technology replaces them, the demand for office space is going to decline.

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Jay WEAVER: A lot of the prudent managers are already shifting their portfolios out of office. They’ve already shifted their portfolios toward multi-family, industrial, and warehouse distribution.

MARTINEZ: I love the analogy that today, office is very much like retail. AEW’s head of research used to say that retail was “under-demolished.” The “A” mall is always great. It’s always going to attract tenants. The “B” mall gets the next category tenants and there’s enough traffic. The “C” mall with 50 percent occupancy only scrapes along because they are either owned or have little debt because there hasn’t been enough stress to have them go away.

When our investors—pension funds, endowments, foundations—look at our office portfolios, they want to know how class “A” is our class “A.” Because being in a city center doesn’t mean class “A.” Like retail, there are “Bs” and “Cs” in office that really need to go away. They’d survived so far because there hadn’t been any major shift in how people did business, but now there really has. Now those “B” and “C” offices are on borrowed time.

When you layer on questions about the buildings themselves as they relate to resiliency and changing energy-efficiency standards, there are a bunch of buildings that are going to be functionally obsolete and into which you will never want to put another dollar. It’s like the money pit of asset classes. Why would you continue to pile capital into something when you’re never going to be able to get the income out?

BENMELECH: Even the demand for some A-rated office buildings has declined. We see the crisis in some of the most sought-after city business centers in San Francisco, in downtown Chicago, in New York, in Washington, DC.

In big city centers, it doesn’t make much sense to convert offices into industrial, and converting office buildings to residential is a big challenge: not all office spaces have the best views, ceilings in office buildings tend to be lower, and a lot of office buildings were built many years ago. So you actually have to demolish the offices and rebuild if you want residential. And to some extent, that will be a way to redefine city centers.

Of course, returning to the comparison with retail, we have the counterexamples of shopping malls being converted to logistics and data centers.

WEAVER: Many of those old “B” and “C” malls were re-concepted into call centers. People can do that work from home now. Regional malls are usually in very good locations—good ingress, egress, at crossroads of highways—so malls are being re-concepted again into live/work/play town centers, or demolished for warehouses.

ADAMS: Industrial outperformed everything else in the last five years: it didn’t matter if you owned great industrial or lousy industrial, so it’s not surprising that these lower-end malls are being repurposed for distribution centers. There is certainly the sentiment today that similarly to differentiation in the office and retail sectors, we are starting to see differentiation in industrial. Not all assets or locations are created equal, and driving rent growth in infill markets, as an example, will be more likely than in non-infill markets. The market is beginning to price industrial with that view. Industrial also has the benefit of being a low cap ex sector, which is what is also attracting capital to the “extended sector” segment of the market.

Are you going to spend 40 percent to 50 percent of your marginal dollars of your cash flow from office to find a new tenant? Or are you going to take those dollars and go buy a data center or go buy a parking lot for trailer parking where there’s no capital expenditure?

The institutionalization of non-institutional sectors has exploded, and we are watching investors move into sectors such as data centers, student housing, and trailer parking where the credit profile and operators are much less established than those in some of the more traditional sectors.

However, these extended sectors are desired because of the rent-growth expectation in the space and are well positioned for growth in the next part of the cycle.

WEAVER: Another reason why growth has been in warehouse space is because most of those leases are typically mid to short term, not long term.

ADAMS: People are willing to pay a higher price for a building today if the tenant lease in that building is going to expire soon because that allows them to move their rent. What people want to own is a building with a three-year-lease left so they can capture what they believe will be a continuing trend of consistent rent growth in industrial.

WEAVER: Over the past year, I’ve heard the top industrial brokers in the country saying that they’re advising their clients to leave vacant space vacant when they’re going to sell because the market rents are going up so fast. I only hear that in frothy times at or near the peak of markets.

ADAMS: Agreed. We have reached a point in the cycle for industrial where upcoming vacancy in the rent roll is more valuable than a long-term lease where buyers can’t access a “mark to market.”

WEAVER: But there are starting to be cracks. We are starting to see Amazon give back space or sublease space. I’m hearing from my industrial friends that there are no longer companies lining up to backfill it. Rents are still going up in the industrial space, but much slower than they were.

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BENMELECH: Whenever you have a technology boom, firms have a tendency to overinvest, or overbuy, or over-hire. There are several reasons for this. Usually when you go in, you do so with more lax standards because you don’t want to miss out on opportunities. There comes a point that either the business cycle forces you to tighten the belt or you recognize that it’s time for you to re-optimize. That’s when you realize that you are chewing more than you can swallow, so you have to get rid of some properties. That’s typical.

I’m sure Amazon is concerned about a recession. But in addition to that, the more properties they have, the more they are learning how to optimize. One reason why we have seen signs of cooling in office, logistics, and data centers is because they are finding ways to do more with less.

WEAVER: Returns are now converging to a mean. So what allows investors to succeed is stock picking. Now it’s about owning the right asset on the right corner.

MARTINEZ: We’re seeing Amazon do some of that picking now. They previously took an approach where they made sure they were everywhere and now they’re consolidating because they want to be in the right places.

[This article has been republished, with permission, from Kellogg Insight, the faculty research & ideas magazine of Kellogg School of Management at Northwestern University]