In my ECONS102 class this week, we discussed the rental market for land. In a supply and demand model of this market, the demand for land (by tenants and owner-occupiers) is determined by the value of the marginal product of land. The value of the marginal product of land is, in turn, determined by the marginal product of land and the price of the firm's output generated by the land. If land is suddenly less productive, the marginal product of land will decrease, so the value of the marginal product of land will decrease, and the demand for land will decrease. That in turn should lead to a decrease in market rents.
This recent working paper by Arpit Gupta (NYU Stern School of Business), Vrinda Mittal, and Stijn Van Nieuwerburgh (both Columbia University) puts that theory to the test. The particular context is the impact of increasing remote work in the wake of the coronavirus pandemic. If office workers are increasingly working from home, then the marginal product of land (used to site office buildings) will decrease, decreasing the demand for office buildings, and decreasing the rent of office buildings. Decreased rents will also flow through to lower values of office buildings (and associated land), because the value should be a function of the discounted future rental flows.
Mittal et al. use data from 2000 to December 2021 for 105 office markets throughout the United States. They find:
...an 8 percentage point decrease in lease revenue between January 2020 and December 2021. This decline entirely reflects decreases in the quantity of in-force leases rather than shifts in rents on in-force leases. The quantity of newly-signed leases in our data set falls from 300 million square feet per year just before the pandemic to below 100 million square feet in the last quarter of 2021. Rents on in-force lease contracts growth throughout the pandemic. Rents on newly-signed leases fell by 9.9% in real terms between January 2020 and December 2021, before reversing sharply to pre-pandemic levels by the end of 2021.
Note that a decrease in demand for office leases is consistent with both a decrease in price (rents) and a decrease in the quantity (in square feet). Interestingly, Mittal et al. also find that:
The effects on lease revenue is not seen uniformly across properties. We find some evidence of a “flight to quality,” particularly in rents. Higher quality buildings, those that are built more recently and have more amenities (informally called class A+), appear to be faring better in the pandemic. Their rents on newly-signed leases do not fall or even go up, in contrast with the rest of the office stock. This is consistent with the anecdotal evidence that firms need to improve office quality to induce workers to return to the office given new remote options.
Since firms (who are the tenants for the office buildings) are trying to encourage their workers back to the office (in the US, at least), they are demanding leased space with more amenities, that will be more attractive to their workers. Our model of the land market doesn't offer any explanation for this, but it does suggest that firms believe that workers are more productive in the office than working at home (otherwise, firms wouldn't want to attract those workers back to the office). That may be because workers are inherently more productive in the office, or because the firm can then more closely monitor their work (it's surprising to me that I haven't seen more discussion of agency problems and moral hazard in the context of work-from-home).
Mittal et al. then go on to look at the effect on the value of office buildings. Using an asset-pricing model calibrated to the market for New York City, they find:
...a 32.95% reduction in the value of the entire NYC office stock between the end of 2019 and the end of 2020.
Then, looking forward and considering different scenarios for the return to the office (and consequent reduction in work-from-home [WFH]), they find that:
...office occupancy rises from the depths of its 2021 values and the economy returns to the no-WFH state with some probability. These mean-reversion forces push office valuations towards an average value in 2029 is about 28% below 2019 values. Along paths where the economy remains in the WFH state for ten years, office values in 2029 remain about 38% below their 2019 values.
That is a substantial reduction in the value of office buildings, and:
The short-term value reduction of 33% amounts to $57.7 billion, the longer-term reduction of 28% amounts to $49 billion. Extrapolating to all properties in the U.S. in our dataset, the $72 billion annual leasing revenue results in a $631 billion office value before the pandemic using the same 8.76 value/lease revenue ratio. We estimate that pandemic-related disruptions around remote work have lowered the value of office buildings observed in our dataset by $208 billion in the short run (33%) and by $177 billion in the long-run (28%). These estimates understate the value destruction of the overall U.S. office stock since our CompStak data do not cover the universe of commercial leases. We underestimate lease revenues by a factor of about 2.8.3 The total decline in commercial office valuation might be, as a consequence, around $586 billion in the short-run and $498 billion in the long-run.
It's little wonder that the title of the paper is "Work from Home and the Office Real Estate Apocalypse". Landlords and owner-occupiers of office buildings have taken a beating.
[HT: Marginal Revolution]
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