In the course of the business cycle the economy goes through periods of expansion and contraction. When the economy contracts, businesses are forced to cut costs, often in the form of laying off workers. However, in times of economic tribulation, most firms remain bound to leases whose terms are in no way reliant on their economic health. This could potentially create a confluence of negative realities for firms: they will employ fewer people, use less of their office space, and pay rents that are above the market price. The byproduct of this reality is dormant office space that is often hard to subdivide or repurpose. This unused space, though listed as occupied, is known as grey space (also commonly referred to as shadow space). More recently, our research and analytics team at Hunneman have begun to examine a closely related practice called space banking. According to our definition, space banking, unlike grey space, is intentional. In times of strong economic expansion, many firms project rapid growth; this growth corresponds with the need for more workers and, consequently, more commercial space. Space banking occurs when firms sign new leases with more space than they need in anticipation of growth. In the meantime, the extra space either remains unused or is subleased until the primary tenant needs it. This term is gaining traction among commercial real estate (CRE) experts here in Boston. For example, the term space banking was invoked at the NAIOP mid-year review in relation to activity in the laboratory market in Cambridge where the combination of high rents and scarce lab space has sparked the practice of space banking among area life science companies.
Space banking can be healthy. If a firm has a solid product or can confidently assert that their expansion into new markets will be successful, then preemptively leasing a larger workspace is nothing more than a calculated, prudent business move. The firm can lock in a lease agreement that works for them long term and can hopefully save some money through subleasing the excess space. However, if a firm projects growth that is simply unrealistic, then space banking can go horribly wrong. If a firm doesn’t have a concrete product or service to market, then the presumption of their ability to fill a newer, larger space is speculative. Nonetheless, without claiming that space banking is necessarily good or bad, it must be noted that this phenomenon requires the collective attention of the CRE community. It is something we intend to take a deeper look into.
To begin our research into space banking and grey space, we studied a 2010 report from Property and Portfolio Research (PPR, now known as CoStar Market Analytics) that looked at grey space in the years following the 2008 financial crisis and subsequent recession. For the purposes of our research, we began by using the methodology laid out in the PPR report as the basis to determine the amount of grey space in the office market. In order to calculate grey space, one must find the usage factor, which is the average amount of square feet per employee in a metro office market:
Usage factor (Sq. Ft. Per Employee) = Occupied Office Space/Office Using Employment
Secondly, we determine the implied demand for office space that exists in the market. In other words, we determine the natural usage factor for a market using their lowest usage rate between 1998 and 2018. We then estimate what the demand for office square footage would be given a markets employment level and natural usage rate. Finally, to calculate grey space we must subtract actual demand for office space from the implied demand for office space.
Grey Space (Sq. Ft.) = (Office Using Employment * Natural Usage Factor) – Actual Demand
It should be noted that, though we use the same equation as PPR, we define the natural usage factor as the minimum usage factor. This not only helps us avoid a situation where the calculation would yield a negative grey space figure, which is a strange metric conceptually, but also allows us to get a better idea of how much space is “available.” In other words, using the minimum usage factor allows us to see what is the maximum number of employees a firm can house on a square foot basis.
Finally, we divided the grey space by total occupied space to arrive at the implied grey space vacancy rate, which is what we will use to compare across metros:
Implied Grey Space Vacancy Rate = (Grey Space/Occupied Office Space) *100
We use the implied ratio instead of the actual square footage because different metros have different office inventories. For example, New York’s total office inventory more than doubles the next largest metro. If we were to simply show square footage, New York would appear to have had a massive amount of grey space following the 2008 recession instead of hovering around the average of the seven metro areas we studied.
PPR’s report, written just as the economy was emerging from the worst part of the recession, highlighted a problem that was sure to have an impact on the CRE industry. They saw the prospect of firms, who were beginning to rebound and hire again, filling their abundance of extra room, or grey space, instead of expanding. They forecast that it would take until 2013 for the economy to add back the 1.35 million office-using jobs needed to return to remove the grey space overhang. Unlike PPR, as of the time of this analysis we are not facing a massive grey space problem, but as we reach the mature part of the current business cycle, we believe it is useful to think about what effect current CRE trends, like space banking, could have during and immediately after a recession.
For the purposes of our research, we examined grey space trends in seven major real estate markets in the United States: Boston, New York City, Washington, D.C., Seattle, San Francisco, Los Angeles, and Chicago. To highlight some of the trends we will be looking at, we have included two charts. To start, we looked at usage factor, which is a component of our grey space calculation.
Usage factor varies a lot by each metro. Interestingly, most of the metros reached their minimum usage factor in the lead up to the 2001 recession, and had slow post recession recoveries throughout the mid 2000’s. During the 2008 recession, all metros but Washington D.C., which has a unique employment composition due to federal government employees, saw large increases in their usage factor as firms laid off employees across the country. In the current recovery, most of the metros have followed a slow but steady decline in their usage rate and firms hire more workers. The two exceptions are New York and San Francisco; in both of these markets, rents have recovered quickly and demand has been outsized. These metros have also seen strong growth in coworking space, where the square feet per employee is particularly low.
Usage factor is an important component of the implied grey space vacancy rate, which is shown below.
Notably, most of the metros remain fairly close to each other. The outlier, San Francisco, saw its grey space sky rocket following the 2001 recession, only to plateau for 10 years. Part of this is likely to do with how we calculated grey space, where in the lead up to the 2001 recession San Francisco’s usage rate decreased very quickly. Unfortunately for San Francisco, it suffered a particularly harsh downturn in 2001, and it took the tech boom of recent years for the market to finally soak up its grey space. Regarding the seven metros as a whole, most are currently running at or near zero grey space which is indicative of a strong labor market in combination with higher construction costs, which is curtailing speculative office construction in some markets.
The importance of understanding the concepts of grey space should not be overlooked. Grey space is the physical amount of office space that companies are currently paying rent for, but are not using or is unneeded to run efficiently. Essentially, it is unoccupied space that is off the market and difficult to measure, but it can indicate a softness in office real estate beyond the standard measures of market health. The fundamental conclusion that we must understand is that this phenomenon of preemptive leasing and underutilized space must be examined further. At the very least, accounting for this reality will give analysts, brokers, and appraisers a more accurate outlook on the vacancy statistics in the office market, especially during economic recoveries. At most, this calculation could provide meaningful insight into the overall health of the office market. Now that the economic next economic downturn is likely approaching, we at Hunneman research feel that now is a good time to explore how grey space may manifest itself in a market that has innovated and changed over the last decade. Stay tuned for an upcoming white paper where we will delve deeper in to this interesting subject.
This post was written by Hunneman Research Analyst, Joey Biasi and Hunneman Research Intern, John Olds