But that’s just Act One. And Act Two will affect us all, as the face of work and home life responds to the aftershocks. The behavioral shifts have already had major effects on real estate in “superstar” cities – that is, the great metropolitan areas producing a disproportionate share of the world’s GDP as well as driving economy-wide growth. For example, in superstar cities’ urban cores (the densest part of each metro area), the percentage of office and retail space that is vacant has grown sharply since 2019, and home prices have increased more slowly (or fallen more rapidly) than their counterparts in the suburbs and other cities.
Will the superstar cities (or at least the owners of real estate therein) continue to suffer? We modeled future demand for office, residential and retail space in multiple cities across the world, looking at a range of scenarios. In those simulations, demand for office and retail space is generally lower in 2030 than it was in 2019, though the anticipated reductions in demand in our “moderate” scenario are smaller than those projected by many other researchers. Moreover, our analysis also suggests that the ripple effects will be complex – for example, that certain kinds of cities and neighborhoods will be much more heavily affected than others.
But there’s no escaping the reality that real estate in superstar cities faces substantial upheaval. This dislocation could imperil – in some cases already is imperiling – the fiscal health of the cities. And it could hardly come at a less opportune time, since many of them were already straining to address, among other issues, homelessness and overwhelming traffic congestion, before the Covid shock. But the challenges also provide an opportunity to spur a historic transformation of urban spaces. By becoming more flexible and adaptable in everything from the makeup of neighborhoods to the design of buildings – in essence, becoming more “hybrid” themselves – superstar cities can not only adapt to hybrid work but also thrive in the new environment.
Behavioral Shifts
The rush to the suburbs (and exurbs) triggered by Covid-19 is over, and the rate of out-migration – while still positive – has now returned to its pre-pandemic trend. But our research suggests that few of the people who left will return, and that urban shopping will not fully recover.
By the same token, employees are still spending far less time at the office than they did before the pandemic. In early 2020, office attendance in the superstar metros we studied dropped by up to 90 percent. It has since recovered substantially but remains down by about 30 percent. As of October 2022, workers were, on average, visiting the office about 3.5 days per week. That number varied from 3.1 days in London to 3.9 in Beijing.
Office attendance also varies by industry and neighborhood. In large firms in the knowledge economy – professional services, information and finance industries – employees generally go to the office the least. (See figure below right.) And not surprisingly, office attendance is higher for small businesses, many of which are in service industries.
There are several reasons to believe this hybrid work model will persist. First, office attendance has remained fairly stable since mid-2022. Second, three key numbers – days per week that survey respondents go to the office (3.5), days they expect to go to the office after the pandemic ends (3.7), and their preferred number (3.2) – are not far apart. Third, 10 percent of the people we surveyed said that they were both likely to quit if required to work at the office every day and willing to take a substantial pay cut if doing so let them work from home when they wanted. This 10 percent contains many senior, highly paid employees, suggesting they will wield disproportionate influence over companies’ decisions.
Nevertheless, there are still some imponderables here. Office attendance could change, for example, if ongoing research convinced employers that there was either a clear negative or a positive relationship between hybrid work and productivity.
Last One Out ...?
New York City’s densest counties lost 5 percent of their population from mid-2020 to mid-2022. San Francisco’s urban core (San Francisco, Alameda and San Mateo counties) lost 6 percent during the same period, while London checked in at 7 percent from mid-2020 to mid-2021. All told, from 2019 to 2021, the pace of net out-migration from U.S. superstar city cores doubled, then it fell in 2022, although it remained above 2019 rates. In other words, people who moved out during the pandemic are not moving back, and others keep leaving.
The suburbs grew, of course, or shrank less dramatically. Note, though, that suburbanization was already a trend in the U.S. before the pandemic, so the shock only accelerated change. By contrast, in most of the European and Japanese cities we studied, suburbanization is a new phenomenon.
In general, U.S. urban cores were more affected than European and Japanese ones, which generally have more mixed-use development with office, residential and retail space existing alongside one another. China is a special case. The migration trends in Beijing were primarily shaped by pre-pandemic efforts to control the ballooning population of the urban core by encouraging out-migration – efforts that were paused during the pandemic.
Macy’s ... or Amazon?
With people staying home during the pandemic, foot traffic plummeted near brick-and-mortar stores, and online spending spiked as a share of retail spending. More recently, foot traffic near stores in metros has risen again, but it is still 10 to 20 percent below pre-pandemic levels. The new habits in shopping, it seems, have proved sticky, since online spending remains higher than it was in 2019.
Retailers in urban cores face particularly acute challenges. As of October 2022, foot traffic had recovered noticeably less near those stores than near suburban stores. In the New York metro, for example, foot traffic near suburban stores was 16 percent lower than it had been in January 2020, but traffic near urban stores was 36 percent lower. And of- fice-dense neighborhoods in urban cores are facing even starker failures to recover: When people come to the office less often, they shop nearby less often.
The Impact on Real Estate
To project demand for real estate, we built a model that accounts for population growth, shifts in migration patterns, shifts toward remote work, changes in per capita spending, online spending as a share of retail spending, and suburban shopping as a share of the total.
In our models, demand for both office and retail space remain below the 2019 level. Residential space is less affected, though the price differences between urban cores and suburbs are narrower than they used to be.
Vacancy rates for office space have increased in all the cities we studied. In the U.S., transaction volume (the total dollar value of all sales) fell by 57 percent, average sale price per square foot fell by 20 percent, and asking rents fell by nearly 22 percent (all in real terms) from 2019 to 2022.
In San Francisco, the hardest hit city in the U.S., the share of office space that was vacant was ten percentage points higher in 2022 than it was in 2019, while transaction volume was 79 percent lower, sale prices per square foot were 24 percent lower, and asking rents were 28 percent lower (also in real terms).
The decline in demand has prompted tenants to negotiate shorter leases because they are wary about current macroeconomic conditions, uncertain about how much their workers will come to the office – and therefore uncertain about how much space they will need. Shorter leases, in turn, may make it more difficult for owners to obtain financing or may cause banks to adjust real estate valuation models, which rely in part on the duration of existing leases.
As noted, we don’t think depressed demand is a passing cloud. In all our scenarios, the amount of office space demanded in most cities does not return to pre-pandemic levels for a very long time. In 2030, demand remains as much as 20 percent lower than it was in 2019.
That, by the way, is our moderate scenario – one in which office attendance is higher in 2025 than it is now, but still lower than it was before the pandemic. In a more severe (that is, disruptive) scenario in which attendance in 2030 falls to the very low level already experienced by large firms in the knowledge economy, demand in some cities may be as much as 38 percent lower than in 2019.
In the nine cities we focused on, a total of $800 billion in office real estate value (in to- day’s dollars) is at risk by 2030 in the moderate scenario. On average, the total value of office space declines by 26 percent from 2019 to 2030 in the moderate scenario and by 42 percent in the severe one. The decline in value could be compounded if real interest rates rise more, weighing on prices in general. Similarly, the impact could be greater if troubled banks move quickly to mark-to-market their real estate assets in response to pressure from regulators and are forced to sell.
Falling demand will of course mean a surplus of office space, particularly in the lower-quality and older buildings that the real estate industry calls Class B and Class C. From 2020 to 2022, rents, demand and sometimes prices generally fell less sharply (or grew more quickly) for Class A buildings than for Class B buildings in U.S. superstar cities. For example, in New York City during that period, the average sale price per square foot rose 3 percent for Class A buildings but fell by 8 percent for Class B buildings.
There are a number of reasons for this flight to quality. One is that many employers see high-end space as a way to encourage office attendance. Another is that Class B and Class C space is often not suited to hybrid work – for example, it may lack the infrastructure for sophisticated audiovisual equipment. Also, now that hybrid work has reduced the total amount of space employers need, they have the option to spend their rent budgets on smaller amounts of higher quality space.
Living in the Urban Core?
During the pandemic, residential vacancy rates increased in every superstar urban core that we studied, from a 0.8-percentage-point increase in Tokyo from 2019 to 2022, to a 9.9-percentage-point increase in London. Meanwhile, vacancy rates in the suburbs grew much less or even declined.
Prices followed suit, rising eight percentage points more slowly in U.S. superstar urban cores than in their suburbs. In San Francisco, prices in some neighborhoods fell by 12 percentage points from the end of 2019 to 2022. Residences in San Francisco’s urban core are now worth $750 billion less than they would have been if prices there had tracked national averages. The disproportionate superstar impact seems to be a global phenomenon.
Our models imply that the demand for housing in superstar urban cores will be 10 percent less in 2030 than would have been expected if the pandemic hadn’t happened. Nevertheless, demand will still be higher than in 2019 in every city we studied except San Francisco and Paris. That estimate rests on the assumption that the residents who left urban cores will not return, but that population growth in each city will recover to its pre-pandemic rate by 2024.
However, prices will probably adjust, as will rents, so homes in urban cores are unlikely to stay empty. Residential space differs from office space in that regard: given shortages of affordable housing today, once prices and rents fall, any available space is usually taken up quickly. Indeed, vacancy rates in urban cores have increased less than the pace of out-migration would suggest. Unfortunately, the downward pressure on prices and rents is unlikely to be enough to make housing in superstar cities affordable for those with moderate incomes.
Retailer Blues
Vacancy in retail space has increased and rents have declined in all superstar cores we studied – and more so in office-dense loca- tions. The vacancy increases range from 1.8 percentage points in San Francisco to 6.2 percentage points in London.
The resulting drag on rents is likely to continue for a long time. In San Francisco’s urban core, for example, projected demand is 17 percent lower in 2030. That estimate is derived from our model scenario in which there is a partial return to office (and therefore a partial recovery of retail spending near the office), online shopping returns to its pre-pandemic rate of growth by 2025, and people who moved during the pandemic do not return. In a more disruptive scenario, the decline in demand in San Francisco’s urban core could be as high as 42 percent.
Note that, in most superstar urban cores, demand would be projected to decline even if the pandemic had not happened: a combination of demographic trends and the movement toward online shopping assure that outcome. As with residential real estate, however, rents and real estate values are likely to adjust, partially offsetting the impact.
What Hard-hit Spots Have in Common
A review of various components of our research suggests that cities where the pandemic has strongly affected real estate demand tend to share characteristics. Some are related to the mix of businesses. Specifically, cities with a larger share of workers in the knowledge economy, a higher number of large firms, a higher ratio of commuters to residents, and more cultural acceptance of remote work have experienced a greater impact on demand.
Those factors lead to lower rates of office use, which reduces demand for office space directly, reduces demand for retail space by diminishing the local shopping traffic, and reduces demand for residential space by creating incentives for residents to leave urban cores.
Other characteristics that correlate with the impact on demand are related to city structure – specifically, cities with office-dense real estate and little mixed-use development, as well as expensive housing and little green space.
Two of those characteristics seem to correlate with the impact on demand at the neighborhood level as well. We examined neighborhoods defined by zip codes in Manhattan and San Francisco. We found that the larger the share of real estate in a neighborhood that was occupied by offices, the more out-migration from that neighborhood. Similarly, home prices correlated with out-migration, with pricier neighborhoods experiencing more of it.
Consider two Manhattan neighborhoods. The business mix of the first, the Financial District, is heavily skewed toward the knowledge economy with half of all office space occupied by knowledge-economy tenants. The Financial District is office-dense: 80 percent of real estate is dedicated to offices. And the average price of a dwelling is roughly $1.5 million. Compare that to the nearby Lower East Side, where just 22 percent of office space is dedicated to the knowledge economy, just 7 percent of all space is dedicated to offices, and the average home price is about $1.0 million.
It stands to reason that residents of the Financial District could easily work from home, as the prevalence of the knowledge economy there suggests, and were therefore likelier to move to bigger homes far from their offices. Meanwhile, expensive housing may have given them another reason to leave. And as expected, the residential out-migration rate from the start of 2020 to the start of 2022 was 2.2 times higher in the Financial District than in the Lower East Side. At the aggregate level, too, business mix and use structure drive differences in cities. Take San Francisco, which has long cultivated a technology-focused economy with a large population of office workers, especially knowledge-economy workers. It has many inbound commuters, as the employment-to-population ratio shows: that ratio, a proxy for the prevalence of commuters, is 0.87 in San Francisco, starkly higher than the national average of 0.48. And the city’s employers, many of which are in the technology industries, may have been more likely to adopt remote work technology when the pandemic began.
Paris’s business mix shows why the pandemic has affected real estate demand less strongly than in San Francisco. Unlike San Francisco, which is heavily dependent on tech firms and the knowledge economy, Paris is home to companies that are global leaders in a wide variety of industries ranging from cosmetics to hospitality. But the city’s urban structure has features that push residents away as well as those that pull them in. On the one hand, home prices are twice as high in Paris’s urban core as in its suburbs and four times higher than the national average. On the other, Paris has a great deal of mixed-use development.
Finally, consider Tokyo, where real estate demand has been affected less than in most cities we studied. Most of Tokyo’s workers are in wholesale and retail trade, in contrast with technology-dependent San Francisco. Like Paris, Japan has a culture built around small and medium-sized businesses that value office presence. In our survey, respondents in Tokyo said that they expected to be required to be in the office 3.7 days per week, significantly higher than Paris’s 3.3 days.
Furthermore, online spending as a share of retail spending was lower in Japan than in any other country we studied. That probably con- tributed to higher office attendance and continued in-person retail shopping. Consider, too, that Tokyo home prices in the urban core are 2.1 times higher than the national average – a starkly smaller number than Paris’s 4.1 and San Francisco’s 5.0.
Thriving in Hybrid Places
Superstar cities are facing a new reality in which hybrid work worsens vacancy rates, threatens the vibrancy of neighborhoods, and thus makes urban cores less attractive to employers, employees, retailers and residents. To adapt to that new reality, urban stakeholders should consider adopting more hybrid approaches themselves. At the neighborhood and building levels, and even in the design of the floors of buildings, choosing diversity, adaptability and flexibility rather than homogeneity can help cities thrive.
Mixed-Use Neighborhoods
One way cities could adapt is by encouraging mixed-use neighborhoods – that is, neighborhoods not dominated by a single type of real estate (especially offices). Such hybrid neighborhoods were becoming more popular even before the pandemic. And now that the pandemic has reduced demand for offices, cities have been left with vacant space that could be converted. Furthermore, our research shows that mixed-use neighborhoods have suffered less during the pandemic than office-dense neighborhoods. That resilience gives investors, developers and cities still more reason to engage in placemaking.
Redeveloping neighborhoods is an enormous undertaking, of course, so mobilizing the many stakeholders is important. Governments may be key here, since change typically requires a loosening of zoning. Investors would be needed to finance redevelopment. And of course, developers would be the ones to turn mixed-use visions into realities. Suburbs could benefit from hybridization as well. City dwellers, untethered from their daily commutes and thus less concerned about living far from urban cores, are increasingly seeking larger homes in greener areas. More housing and retail in the suburbs could help satisfy their preferences.
More multifamily housing could be particularly beneficial because it would accommodate more people at lower price points than single-family homes. So long as the apartments are larger and more comfortable than apartments in urban cores, they could attract urbanites seeking space. Policymakers could consider encouraging multifamily development by offering incentives to developers and reexamining restrictive regulations such as those governing minimum dwelling sizes and parking requirements.
Adaptable, Flexible Buildings
The key to adapting to declining demand for traditional office and retail space, we believe, is hybrid buildings. The most ambitious vision is a universal “neutral-use” building whose design, infrastructure and technology could be easily modified to changing demand. Imagine a medical building that could be converted into, say, a hotel or apartments. More modestly, buildings could be designed to accommodate different degrees of collaborative and individual work, or different arrangements of open and closed office space. They could also include technology that promotes flexibility, such as sensors to track patterns of usage that could inform an employer’s approach to hybrid work.
Hybrid buildings would bring at least two advantages. They would protect owners from shifts in preferences that are hard to predict. And they would soften the blow of the trend toward shorter leases in the office sector.
Developers could also convert existing offices into the kinds of space for which there is more demand. Conversions are very hard, however, since they face obstacles ranging from zoning to accommodating legacy tenants during transitions. Furthermore, in the cities we studied, even if all the office space left vacant by pandemic-triggered dislocation were converted into housing, the amount of residential space in each city would grow by less than 3 percent. Still, for owners facing the prospect of lower occupancy and lower rents in their office buildings, the opportunity cost of conversion has fallen and the number of successful conversions may grow.
Developers of retail space, too, could keep adaptability in mind. Of late, retail tenants have been evaluating their footprints with a stricter eye, moving to smaller spaces or simply shutting down stores. If developers built more adaptable spaces, they would be likelier to remain relevant to tenants’ shifting needs. Developers might also offer new store formats, such as spaces intended for delivery and fulfillment or for logistics rather than traditional retail. Or they might design buildings that are more integrated with their environments – for example, with dining spaces that extend onto sidewalks.
Modular, Multi-use Floors
Commercial tenants in urban cores may have to start “earning the commute” from office workers and shoppers who would otherwise visit less often. Here too, thinking flexibly and adaptably can help. For example, the office does not have to be just a place to work. It can also be a place where employees genuinely enjoy spending time or where they can take part in compelling events and activities.
Retailers, too, may have to earn the commute by designing spaces that cater to multiple uses. A prime example is stores that easily accommodate omni-channel retail – a single, seamless experience for customers, whether they shop online or in person. Similarly, stores can provide experiential retail. For example, one department store brand is launching smaller stores where customers can pick up products bought online, get clothes al- tered, obtain fashion advice and patronize a beauty salon.
Indeed, it is not hard to imagine more “hybrid floors” in which offices, residences and stores exist side by side. For floors – as for buildings and neighborhoods – turning empty spaces into hybrid places may not simply be a way to counter the damage wrought by the pandemic. It could be a way to prepare super-star cities for a dynamic, prosperous future.
This article originally appeared in Milken Institute Review.