The Office as Hotel
I participate in a lot of “conversations” on LinkedIn in which people argue that office buildings should be as flexible as hotels. I love to explore the possibilities, the idea the office can be something different, something better. But sometimes these conversations are so detached from reality it makes my head hurt.
There was a time when office buildings were more like hotels. A time when the investment thesis and the financial structure were decidedly different than today. Take The Russ Building, for example. A San Francisco landmark, The Russ Building was built in 1927. It was the tallest building west of Chicago for 30 years. When I first came to San Francisco in the late 1980s, portions of The Russ Building interiors were still as they were decades earlier. Floors were pre-built with offices. These offices were individual rooms, accessed via a door off the common corridor. What’s more, there was another door inside the office connecting it to the adjoining office. If an occupier wanted to expand, they could simply open the door and rent the office next door. The set up was anything but custom. To me, this is one of the design issues with short-term solutions, the fixed design may not fit the purpose. We don’t get to design our hotel room.
The bigger issue, however, is one of economics. It cost a lot of money to construct buildings and spaces. This is among the economic realities which push office landlords to seek long-term commitments (this and others). If a landlord builds a speculative office space (many are), they can choose to be more flexible in how they lease the space, meaning they can do shorter-term leases. They do their best to anticipate the needs of the customer, to ensure their spend will result in a space that has lasting value for multiple users (much like a hotel room). But most landlords are constrained in how much they can deploy this approach. Indeed, they’re necessarily limited to a small portion of the building’s leasable space. Why? Because of the financial structure underpinning the office investment. In most cases, the landlord and its partners are investing not in perpetuity, but rather, for the purpose of achieving a certain return objective within specific time parameters. Further, they usually have lenders who lend based on variables like WALT (weighted average lease term), NOI (net operating income), CAP Rates, DCRs (debt coverage ratios), and tenant credit. None of these masters is served by short-term leasing. Sure, you could look at the aggregate NOI created from short-term flex leases over a comparable period to determine if it generates less, equal, or more income. It should result in more because it’s riskier. Occupiers should be willing to pay more for the flexibility of not being locked into a long-term lease (they’re usually willing to do so). But even if the case can be made for more income over a comparable period, the structure is fundamentally not financeable.
I believe the office market will continue to offer an increasing supply of flexible leasing options. Sometimes this will be curated and run by the landlord, directly (Tishman Speyer is doing this well). Other times, landlords will hire a third-party operator. Flex options will be good for the market, but they’re unlikely to account for more than 20%. It will remain important, even more so now, for companies to create spaces that are custom designed to facilitate fulfillment of the specific purposes for which they have an office. This is not “one size fits all”. Hotels are hotels and offices are offices.