A Shield Against Office Armageddon: The Resilience of Smaller Office Properties

The widespread adoption of remote and hybrid work models has cast uncertainty on the future of the office sector. While "Office Armageddon" might be in store for some, recent research reveals a surprising resilience in smaller office properties. Could these be the hidden gems of the commercial real estate (CRE) market?

Bank Data Suggests Stability

A Federal Reserve Bank of Kansas City Economic Bulletin by Blake Marsh and Jordan Pandolfo analyzed FR-Y14 data (loan-level data from large banks). They found that smaller office properties exhibit better credit ratings and lower default (PD) probabilities within large bank portfolios. This suggests that the smaller regional and community banks that often focus on this segment may be somewhat shielded from the broader disruption within the office sector.

Advantages of Smaller Office Spaces

Smaller office properties offer several inherent advantages that explain their potential staying power:

• Agility and Flexibility: Compact spaces are easily adaptable to various layouts and tenant needs, a vital asset in a changing market.

• Hybrid Work Alignment: They're ideal for companies utilizing hybrid models, serving as collaborative hubs a few days a week.

• Affordability: Reduced overheads mean more affordable rents, appealing to cost-conscious businesses.

• Community Building: Smaller offices can create a stronger sense of community than large, impersonal spaces.
  

Caveats and Considerations

While the outlook for small offices is promising, their credit performance hinges on a complex interplay of factors. Location, building age, market fundamentals, and tenant mix all play critical roles. It's essential to be aware of risks as well:

• Tenant Concentration: High reliance on a few tenants increases vulnerability to vacancies.

• Financing Challenges: Lenders may view smaller properties with greater caution, potentially impacting loan terms.

• Amenity Limitations: Smaller buildings might not match the amenities of larger complexes.

• Obsolescence: Older buildings may require significant renovations to meet modern workplace needs.

• Local Market Dynamics:  Economic downturns or lack of dynamism in a given location can leave small offices struggling.
  

Mitigating Risks for Resilience

Proactive strategies help manage these risks:

• Tenant Diversification: Target a variety of tenants to minimize the impact of single vacancies.

• Niche Focus: Cater to specific industries or business sizes to stand out.

• Positive Tenant Relationships: Encourage renewals and open communication to anticipate tenant needs.

• Strategic Updates: Enhance the property's appeal through maintenance and targeted upgrades.
  

The Evolving Office Landscape

The office sector is undergoing a fundamental shift, and smaller office properties may hold exciting potential. As workplace norms continue to evolve, these adaptable spaces could offer unique opportunities for investors and tenants alike – provided that the inherent risks in this segment are carefully assessed and managed.