Here’s a bad combination of factors in the office segment of CRE: most businesses expect a recession in the near future, and although office vacancy is about 15.1%, occupancy is somewhere between 43% and 44%.
The former means that corporations will expect to cut costs to lessen the impact of a recession. The latter kicks in because if your company doesn’t seem to need something it has been paying for and saving money is a critical strategy, cutting those extraneous costs would seem a logical conclusion.
That flips the pressure onto the already suffering office sector. Owners need tenants, unless they have a better idea of how to use the space they must pay for—including taxes—and support. When corporate outlooks on economics are reserved at best, that can mean being less discriminating. But short-term thinking can make for longer-term pain.
Tenant Risk Assessment, a CRE consulting firm, says that while 50% to 60% of a tenant rating is typically fiscal credit risk, there are many more issues at play, for example, legal and regulatory risk, key man risks, and sanctions risks. But there is also another type: industry risk.
Not all companies in an industry are alike, but there are frequently trends worth watching. “Oil and gas is probably the headline in terms of volatility and the whipsawing of credit profits changing more rapidly you might think,” says CEO Brad Tisdahl. It’s a good reminder that the energy business is often cyclical. Prices and profits rise and fall with macroeconomic conditions.
A recession will push down energy demand and economic activity slows. The bigger the recession, the more oil and gas can feel an impact. Remember that on April 20, 2020, West Texas Intermediate crude bottomed out at -$40 a barrel. There was such a glut in the market that buyers were running out of room to put the oil they had to take delivery of due to futures contracts.
“Every client we have that has oil and gas tenants are all very familiar with the movements of the industry and are sensitive to it, too,” Tisdahl says. “They don’t want to be the ones writing a huge lease for a company that isn’t going to be around in five years.”
Energy isn’t the only industry to watch. Tisdahl notes that the tech sector, “whether more established big tech or newer venture backed companies” has seen “a pretty significant change in that sector in the last six or seven months,” driven by monetary policy. “These lofty projections a lot of companies were making, they’re having to reassess the growth presumptions they have. They’ve gone into cost containment and savings mode.” Many are looking at layoffs and possible reconsiderations of their space use, “either seeking sublease space or putting their own space into sublease.” For startups, watching cash burn rates is critical because it’s unclear when more investment might be available.
Life sciences is beholding to external capital, but also is more resistant to changes in economic conditions. During the pandemic, money started to flow into the sector.
“A lot of companies in the space are looking for expensive lab space or office space,” Tisdahl says. But there is a cost for landing clients, as buildouts are expensive, with high tenant improvement allowances. “In life sciences, you’re looking at TIs that are north of $200 a foot,” he says. “We’re still seeing that space moving. It’s not necessarily growing as quickly as it was six or nine months ago, but it’s still growing.” But then their individual financial futures are uncertain as it takes “maybe five to seven years for FDA approval, authorization, or commercialization.”
Source: “In Challenging Times, Do the Right Checks on Your Tenants“