New York’s Class-B Offices Aren’t Dead Yet, But The Rest Of Their Life Is A Mystery

There are over 150M SF of Class-B offices in New York City, according to JLL, more than the overall office inventory of many states. The owners of this ocean of office are facing a conundrum over the future of their buildings — with absolutely no playbook to guide them.

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The view of Midtown from Brookfield’s One Manhattan West

Some 90% of the city’s Class-B office buildings are more than 50 years old, and while there has always been a gulf between the rents that Class-B and Class-A buildings reel in, the gap has been widening in the last decade.

Class-A rents are 33% higher in 2021 than those in Class-B offices, according to JLL, compared to a 31.5% gap in 2019 and a 27.6% gap in 2010. As tenants have gravitated more and more toward the higher-end buildings, much ink has been spilled over whether Class-B offices should carry on or be converted to housing on a large scale.

But not all Class-B office landlords are ready to give up the game just yet and say there’s still demand — even amid the “flight to quality” hype.

“As long as the owner of the building has done his homework and upgraded the buildings, then it’s not in bad shape,” GFP Real Estate Chairman Jeffrey Gural told Bisnow. “Not everyone is moving to a $150-per-SF building.” 

Some 47% of all leasing in Manhattan so far this year has been at Class-B or C buildings, according to tenant brokerage firm Savills. So far, the low-amenity, low-rent buildings are actually outperforming their pre-pandemic averages: Class-B and C buildings had a five-year quarterly average of 38% of leasing market share and a 10-year quarterly average of 43%, per Savills. 

Gural said his company, GFP, which owns an extensive portfolio of Class-B office space, has leased hundreds of thousands of SF of Class-B office space over the last six months alone. 

“The advantages [of Class-B offices] is they’re in neighborhoods that the tech people want to be in,” Gural said. “They have the look that the tech people like, the funky look of the space, but they’ve got to have been upgraded by their landlords.”

The break will not be between Class-A and Class-B but between Class-B office buildings that are newly updated and amenitized and Class-B offices that aren’t, he said. Class-B landlords who have invested in improving mechanical systems, elevators, amenity spaces and lobbies of these buildings have had success in leasing out space, he said.

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JLL’s Marion Jones and Greater Jamaica Development Corp.’s Hope Knight at a Bisnow event in 2018
 

JLL Capital Markets Managing Director Marion Jones said landlords are increasingly having to consider how much companies are seeking office space that will attract and retain talent — and how energy-efficient buildings lure more companies looking to adhere to ESG mandates.

“The most realistic position for much of this inventory is to maintain a delicate balance of trying to future-proof your asset with strategic upgrades while remaining a value play relative to Class-A,” Jones said.

That means owners of this kind of product need to weigh the uncertainties surrounding the future of work versus the payoff of investments, with no previous examples to pull on. 

“This is likely to be one of those times where it’s better to get ahead of the curve and come up with an individualized strategy,” she said. 

But Bob Knakal, JLL’s chairman of New York investment sales, predicts that cheaper spaces, without expensive renovations, may be more attractive to bargain-hunting tenants than spaces caught between Class-B and trophy towers.

“There is going to be a need for a low-cost provider. There are going to be tenants that want to only pay $40 a foot or $50 a foot. There’s gonna have to be someplace for them to go,” he said. “The longtime owners that don’t want to put fresh capital into their building or pay big [tenant improvement packages] or renovate their buildings are going to be that low-cost provider. The other buildings that are going to be improved and repositioned, the question is going to be how the repositioning compares with other options a tenant is going to have.”

As schools of thought around the future of Class-B offices diverge, the biggest names in the industry are rethinking the classification of buildings based on tenants’ evolving demands. Since last year, CBRE, the world’s largest commercial real estate services firm, has been redefining these standards in New York. 

Buildings that were once put in the best-in-class category may not make the cut anymore, CBRE Northeast Senior Director for Research and Analysis Nicole LaRusso said, as tenants look for elevated amenity space, new HVAC systems, and superior air and light. 

“In the midst of the pandemic, I think [class] definitions are probably going to be rewritten. It will be really hard to ascribe what a Class-A building is now, considering that tenant demands are really evolving,” LaRusso said. “[Before the pandemic] certain conditions were probably OK and … could still be Class-A. Today, the standard is probably higher.”

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JLL’s Bob Knakal speaks at Bisnow’s 2017 New York State of the Market event.
 

CBRE’s top brokers ranked office buildings in Manhattan on a scale of 1 to 5, given the tenant demands of the day, with 1 being the best, LaRusso said.

CBRE labeled those that were given an average rating between 1 and 2.5 “better buildings.” Those have an average age of 55 years, an average rent of $99.63 per SF and make up just under 40% of the city’s office stock, while those given an average rating of 2.5 and above were deemed “commodity buildings,” which have an average age of 87 years, an average rent of $64.41 per SF and make up about 60% of the city’s stock.

Office landlords, particularly those who own “better buildings,” have persistently sounded the siren call of a mass flight to quality among tenants in the office market.

Executives at top office landlords such as Vornado Realty Trust, Boston Properties, The Paramount Group and Highwoods Properties touted improvements made to their buildings over the past couple of years to settle any investor nerves about leasing on earnings calls this past quarter. At Bisnow’s National Real Estate Finance Summit in October, speakers said the pandemic could be the end for some Class-B and C properties. 

But leasing activity, despite recent improvements, is still well below pre-pandemic levels in Manhattan, and market experts say it is too soon to ring death bells.

“I still think you’re still going to see this flight to quality over the next several quarters, but really, to what extent is still a bit unknown,” Savills Research Director for New York and Tri-State Danny Mangru said. “We’re finally starting to see leasing activity somewhat get back to pre-Covid, but it’s not there yet.” 

Some Class-B office space will vacate entirely, and some could be converted into housing — but tax incentives are needed to entice most New York landlords to do so, some experts say. 

“Post-Covid, [landlords are] coming out of crisis mode, and now they’re just beginning to look at the future and in many cases are being forced to compete differently for leasing activity,” Jones said, adding that some owners are considering upgrades but need to weigh whether it is worth the cost. “There’s a recognition that the old business plan for Class-B office products is less sustainable today or in the future.”

But the jury is still out on whether there will be mass conversion of these buildings to residential, and this will be dependent not only on market factors but also on policy factors.

“If you look at what the economics are of converting an office building to residential, the value of the building from a conversion perspective is not that great compared to keeping the building an office building. So I think you really could go either way.” Knakal said. “I think it’s going to be very building-specific, it’s going to depend on whether there’s a tax rebate program that can be taken advantage of or not, and a lot of it is going to depend on lease roll.”

Full article below:

https://www.bisnow.com/new-york/news/office/class-b-offices-arent-dead-yet-but-the-rest-of-their-life-is-a-mystery-111002

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