CBRE Group, Inc. (CBRE) Earnings Call Transcript & Summary

Really excited for our next panel. It actually follows the prior panel where we had 2 REITs on. But this panel is titled as CBRE panel. Essentially, we're going to talk about changes in the workplace, and maybe weave in a bit of ESG in here. But I'm really excited to have 3 key speakers: Spencer Levy, who's the Global Chief Client Officer and Senior Economic Adviser for CBRE; Julie Whelan, who's CBRE's Global Head of Occupied Research, and she actually specializes in office occupier research; and then Lenny Beaudoin, who's CBRE's Executive Managing Director for Space Enablement Services. Essentially, he's the expert on what goes on in the office. And so you have a combination of all 3, and I'm really excited to have them to talk about the future of office and the puts and takes. But before we start, let me just read some quick disclosures. For important disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com, and if you have any questions, please reach out to your Morgan Stanley sales representative. For those of you who may not know me, I'm Vikram Malhotra. I'm one of the REIT analysts at Morgan Stanley. I focus, among other sectors, on office. And as I mentioned, I'm really excited to have CBRE here and talk about the future of work.

Maybe, Spencer, we'll just start with you, where in June, a lot of cities are opening up. I was just on with a couple of East Coast REITs, and they talked about New York essentially opening, Broadway potentially opening up. Same thing maybe on the West Coast maybe just a little later. From your perspective, what are you hearing about the timing for return to work here in the U.S.? And if you can maybe compare and contrast that with other markets, say, in Europe, that would be great.

Sure. Well, I mean, it really boils down to one word, safety. And, I guess, when people feel safe, then they will come back. And that's where I will start from outside the U.S. So I was speaking with the CEO of a large REIT the other day that owns assets in Seoul, South Korea. Their assets are back to 100% of pre-COVID occupancy levels. I was speaking with the CEO of a large REIT in Australia and her office assets are 70% to 80% back to pre-COVID levels in Sydney and in Melbourne. But if you look here in the United States, notwithstanding the fact that we are optimistic about the future of New York, Chicago and other high-density cities, their occupancy lags well behind where you would see in Austin, Texas, Dallas and Florida markets that not only have had less restrictions, but have less dependency on mass transit. That's really the key, is the mass transit dependency. And so what we see is that there's going to be the "new normal" and again, that's an overused phrase. But the new normal will emerge in the New Yorks, San Franciscos and Chicagos probably after the Labor Day.

Makes sense. Maybe just more specifically if we can talk about this new normal, like you referred to it. What are you hearing about sort of hybrid work more broadly? Some will say hybrid means everyone working from home or working remotely, others will say it's complete back to office. Maybe describe for us, and, Julie, we'd love to get your comments as well, what are sort of all the different narratives and the thought processes that you're hearing from tenants on the future of work?

Absolutely, Vikram. So hybrid is certainly the way that the new normal is progressing right now. And when we talk about hybrid, I'd say that there are 2 different types of hybrid that we see emerging, one much more so than the other. One is hybrid where companies are providing guidance around what that means and how employees operate in a new flexible environment, and the other is hybrid where employees can wake up in the morning and choose where or how to work under any circumstance. And what our clients are telling us very clearly is that they are moving towards hybrid. And by the way, that sentiment that they have towards more flexibility has increased over the pandemic, not decreased. But a very important nuance is that nearly all of them are in the bucket of driving hybrid within company parameters, within company guidance. What I've increasingly been calling it is we want flexibility, but flexibility with predictability. Because if we don't have that, then employers can't satisfy what their real estate needs need to be and employers are just going to be chaotic in terms of trying to understand when they come back to the office. Now we also track those that say they want to be fully office-based or those that want to be virtual first, which means that they're largely virtual, yet come together in very deliberate scenarios. And under 10% of our clients are telling us that they're going to fall into either of those buckets. Nearly everybody says hybrid, but hybrid within parameters that they're going to put in place.

That's really interesting. And maybe, Lenny, just to build on that. What about inside the office in terms of maybe adopting more open layouts, more common areas or collaborative areas. What variations have you heard? And what do you think we'll see going forward?

I think right now, what we're seeing mostly is organizations thinking about how they categorize workers into what Julie described. Do these workers need to be in the office more? Do they have the ability to work in a more hybrid format? Could they work virtually? And what they're really gearing up to do right now is change more the way that they use the office or assigned space within it rather than actually physically modify it in the near term. And what that means is they're adopting what we call activity-based work settings. So if you accept the fact that you would have some component of your workforce working structurally outside of the office for some percentage of time, you would naturally then look to share space inside the office. This was a trend that was happening pre-pandemic. And what it means is that organizations are implementing more shared neighborhoods and environments. Now we believe what will happen next is that as workers do work away from the office more of the time or some of the time and come into the office for critical collaboration and networking, we think organizations are going to lean towards increasing the quotient of collaborative space in their offices, increasing the amenities and the social spaces that exist in those places, so that when people come in, they have a more immersive and intensive environment with their colleagues to offset that time working away from the office.

That's fascinating. It's -- we have also heard of different broader strategies, hub-and-spoke, maybe moving from high cost to low cost. Maybe in your opinions, what do you think sort of prevails? I guess at the start of the pandemic, we heard a lot about folks having a headquarters in the CBD, and then maybe having more suburban space. Then there was, as I said, talk about moving to low-cost markets, maybe the Sunbelt. What are you hearing more broadly in terms of location? Maybe Spencer we'll go to you.

ure. Well, the phrase that -- if the new normal wasn't an overused phrase, acceleration of trend definitely was. And so acceleration of trend, what it really meant was we were seeing people moving from New Yorks and San Franciscos to the Phoenixes, the Raleighs, the Denvers, the Tampas, the Orlandos. Is that trend durable? That's trend number one, is that durable? Trend number two is moving from the CBDs to the suburbs. Is that trend durable? okay? Well, I think the first trend is -- has some durability too. We are going to see more people moving there. Their talent base is certainly going to increase, and they have these wonderful live-work play environments and lower costs. But does that mean the death of New York and San Francisco? Not by a long shot. Because CBRE has done studies on New York and San Francisco and said, well, yes, we are likely to see a net outflow in the total number of people, we're still going to see the most highly educated people, and there I say, most highly productive people moving to those markets. There's one thing you need to keep in mind when you're thinking about the cost of occupancy for a large company. Yes, it costs a lot more to occupy in New York and San Francisco, and I've heard numbers as high as 9% to 10% of total occupancy cost, while in a lower cost market, it might be 4% or 5%. Why do they pay those costs? They pay those costs for the productivity advantage they get in those markets. And if I were to use a fancy term, the agglomeration effect that you have, not only in these dense cities with these dense offices. So yes, I see more competition from the smaller cities. But remember, even though Austin, Texas, is everybody's favorite, Austin, Texas has 2 million people in the Austin MSA. New York City has 30 million people. So they still have this enormous size advantage.

Julie, are you -- from an occupier's perspective, are you hearing or seeing anything different?

So what I would add to that is that we have, obviously, been in a period where transaction activity has been reduced and it's been limited. And what that has pointed to is the fact that a lot of our clients are in a wait-and-see mentality. And I think that, that's mostly what we're seeing today is that especially the large enterprise occupiers are awaiting for this return to the office in order to get access to observable trends of how their employees are going to work before they really set their strategy too keenly on what the future holds in terms of a more suburban strategy or in terms of a hub-and-spoke strategy. On the edges, do we see that behavior increasing? Sure. Is it overtaking any kind of the trends that we saw pre-pandemic at this point? No because everybody isn't still very much a wait-and-see strength.

That makes sense. And I should just mention for any of the listeners, if you'd like to ask questions, feel free to type into the browser, I'm happy to weave them in. Maybe just digging into this a bit more in terms of the impact of all these changes we've talked about agile workspaces, hybrid models. I think in one of CBRE's earnings call, there was a view or a comment that eventually, you see leasing coming back to maybe 80% to 85% of pre-pandemic level. So some structural change, I guess, in the activity. Can you maybe elaborate upon that? And that's for either of you, but maybe Spencer, we'll start with you.

Sure. Well, I won't comment specifically on the earnings call. I will say that we see the new normal looking a lot more like the old normal that people think that 80% to 85% number is about right. It could be higher than that. Because even if people lease less space that they need to work somewhere, and that somewhere is either going to be in that hybrid environment where they take rather than less than the CBD more in the burbs. But what we're also going to see is more people working in flex space more regularly. And we know this. How do I know this? I read Julie's surveys, which shows that, that is the #1 amenity that everybody wants. So a building where somebody might take less what they call held vacancy. Held vacancy, what that term means is, if you want to grow, you'll take 25% extra space, maybe they reduce that to 15%. But they want to have the flow over space in flex. So yes, might there be less leasing velocity moving forward. There might be. But again, I think that's going to be made up for in other areas maybe in a different market talking about the acceleration of trend in the Denvers, the Raleighs of the world in the suburbs, but also in flex space. Does that translate into 80%, 85%? That's about right, it could be a little bit higher.

And Julie, Spencer mentioned your survey. So I'll ask you to maybe dig into that a little bit. From your surveys, what's your sense of any structural change in the demand profile from here on?

Absolutely, Vikram. So real estate decision-makers today are trying to balance a couple of things in their head. Number one, we know that before the pandemic, people did not work in the office 5 days a week. We think that on average, they spent about 0.8 days a week outside of the office. Post-pandemic, we believe that, that number is going to rise to about 1.8 days a week that they spend on average outside of the office. That's a 24% reduction in demand. And so the question is, does that totally translate into a 24% reduction in space. And our best estimate is that it doesn't even come close to that. And there's a few reasons for that. Number one, you are not going to be able to spread demand equally over a 5-day work period. If people could just get up and come to the office whenever they wanted, you would have nobody in their Monday and Friday, and you would have a lot of people in their Tuesday, Wednesday, Thursday. Well, this flexibility with predictability, we're going to try to even that curve, but we're not going to evenly distribute it. So therefore, we're going to have to satisfy for some sort of peak demand. Secondly, we know that occupiers got very, very dense before the pandemic. There was a decade of efficiency trends that were really taking place. Now in the collaborative world that Lenny is talking about, in these environments that they're building that are going to look different pre-pandemic, we are going to have to de-densify a little bit. So the way that, that comes together, along with expanded job growth and the economy that we're in right now and hopefully we'll continue to be in, all that is going to aggregate together to, hopefully, what is equal demand at least post-pandemic. So we are certainly going to be in a healthy range despite the fact that we do have structural headwinds coming at us.

That's interesting. And Lenny, Julie alluded to the density. It's certainly a key debate amongst a lot of people. I think on the coast, we're probably in the 170 to 190 feet per person on average. Do you see that materially changing from here on? And I asked that because when I ask our colleagues in Europe or Asia, hey, what's your density? It seems to be it's a lot lower. I don't know if the calculations are different, but where do you see density levels changing in the U.S.?

Well, I think Julie is correct. Density was becoming more efficient, meaning we were becoming more dense year-over-year, except for, say, the last several years pre-pandemic, where we started to see density shift the other direction, where they were allowing more square footage per seat. But there's 2 really important metrics. Their square footage per seat and their square footage per employee. So as it relates to square footage per seat, I think those numbers will increase and organizations will de-densify. And as a percent of other spaces, for example, collaborative spaces, those amenities and socialization spaces, those will increase that square footage per seat upward. And we think, again, that will vary from the starting point and certainly vary by industry, but that will increase 5% to 10%. When we, however, look at square footage per employee depending on if an organization is going to lean to being fully in the office or have some hybrid accommodation, we'll see efficiency being more in how occupiers utilize their square footage, right? Before the pandemic, as Julie noted, through the turnstile utilization of most buildings, average is out around 65% to 70% peak during a daily basis just because people are in client meetings, they're out of the office. So organizations are looking to increase that utilization, hence, why they're planning for that activity-based work. They're going to be making investments in smarter building technology to manage that occupancy. But I think what we can expect is a better-provisioned office that's used more intensely by more people in those organizations.

That's really interesting now. I've done some work as well on specific New York and San Francisco, looking at various factors. You mentioned density, the work-from-home or agile work penetration, new jobs, supply of office. And I have a view that at least New York and San Francisco, by no means, is office dead. But we do think we're going to see markets with structurally higher vacancy. Could it be 200 basis points higher than long run average, could it be 500, that's the debate. But I do think a higher vacancy and lower pricing power going forward. I'd love for any of you to agree, disagree, pushback, maybe give a different opinion.

Well, I think now that I've used the new normal and acceleration of trend, I'm now going to use the term of short-termism. Because I think that in the short term, you're right, there will be less pricing power in the short term. But will there be a permanent increase in structural vacancy. Based on our models, we do expect a modest increase in that. And when I say modest, not as much as you think. But even there, you can call that into question because of adaptive reuse. And all I would ask anybody here in New York City, which is many of you on this call is, walk down the Wall Street 1 day and just look up. What do you see when you look up? You see a bunch of old office buildings that are now condominiums and/or multifamily rentals. And so there will be that type of adaptive reuse. You will see less development. And so the market, in many ways, self-corrects through less development and adaptive reuse. But there will be some modestly more structural vacancy, certainly in the short term. But you will all see many of these markets come back much closer to normal than pre-pandemic levels than you think once economic activity picks up again. Now because you have to look at the macro when you think about this because the next 2 years, I think many of us, including Morgan Stanley's economists, agree that the next 2 years are going to be unbelievable. But after that, in 2023, you're likely to see a revert to normal economic growth. And so what many -- what you will see in many of these cities is faster growth in certain areas. So it's not just Midtown Manhattan, it might be the Meatpacking District for Brooklyn, or in Chicago might be the Fulton market or in Miami might be Wynwood. One of the beautiful things about these big cities is they're constantly reinventing themselves in these new submarkets that you previously would not have considered for all this.

That's interesting. Julie or Lenny, any pushback or any different thoughts?

So the only thing that I would add is, I think that we could take a lesson out of retails playbook, right? There has been a lot of discussions about whether or not retail is dead. And the reality is that there are some tranches of retail that are doing very well, even in the face of a lot of headwinds for them also. And I think that the similar thing could be happening in the office world, where there may be some structurally higher vacancy in certain tranches of space, i.e., the lower-quality space that is going to have maybe difficulty finding its adaptive reuse. However, the higher tranche of space, higher-quality trophy assets that we know large enterprise occupiers were flocking to pre-pandemic and will continue to flock to post pandemic. I predict it is going to remain very tight and the pricing power in that end of the market is going to remain very, very favorable because I don't think a lot of development is going to be happening, right, given until we see the trends work its way out. And there's going to be a period of time where that type of space is very sought after. And we're seeing some sublease space come back off the market right now, proving that occupiers are thinking twice before they give up too much space in the face of not being able to get back what they want when they need it.

That's really interesting. Julie, maybe I'll stick with you. I'm going to weave in a question I just got about sort of the hybrid model. And the question really is, when you think about employees by demographic or by age, it appears that perhaps older folks may prefer to work from home, maybe younger folks want to come in 3 days a week. In your survey work, as you talk to occupiers, are there any -- are they incorporating demographics in terms of age and functions into their space planning needs?