Documeent title on one or two Creative lines in destruction:

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1 March 2014 TIAA-CREF Asset Management Documeent title on one or two Creative lines in destruction: Gustan Book 24pt Generational shift in the U.S. office sector TIAA-CREF Global Real Estate Strategy & Research Martha Peyton, Ph.D. Managing Director Edward F. Pierzak, Ph.D. Managing Director Office demand is shifting toward creative space which is designed to appeal to the tastes of young millennials, especially those with tech skills. The shift in demand is creating opportunity that offsets some of the drag associated with slow office employment growth, densification in use of office space, and the overhang of space in less desirable locations. Investing in creative office space is challenging because it requires an understanding of the technological, generational and locational forces that drive it. Our assessment of those forces is summarized here. The investment strategies that we are pursuing for the near term act on the shifts we identify. They include rebalancing of our office holdings to weed out properties that are losing competitiveness in favor of those that are better positioned to withstand the creative destruction now underway. Others are well advised to follow suit. In a pickle Office property investments have been the weakest sector in the commercial real estate recovery that began in Total returns for the NCREIF Property Index show that apartment, industrial and retail property types have all outperformed office over the last four years. This situation has left office investors in a pickle. To date, the slow recovery in the office sector nationally has been driven by a variety of largely negative forces. The most significant is the weakening in the importance of both finance and law. Employment in both sectors has grown little since 1990, as compared to growth in business and professional services. Additionally, all office tenants are squeezing employees into less space by eliminating libraries, file cabinets and excess equipment. On a macro-economic level, employers are also squeezing maximum productivity out of existing staff before adding to it. None of these forces appear to be easing. Office developers are reacting to these weak prospects by limiting the flow of new office construction. That parsimony is welcomed by office investors, but it is not enough to revitalize investment returns in the sector. The more powerful force will come from a slow weeding out of noncompetitive properties from the institutional-quality office stock.

2 Separating the winners from the losers At the same time, some positive forces are emerging within the office sector that will affect the competitiveness of properties. These uplifting forces are associated with the demographic shift as Gen Y (also called millennials ) steadily increases as a proportion of both the workforce and consumers. The shift to Gen Y is associated with (1) the strong growth in technology- related jobs since the bottom of the recession, (2) the demand for creative office space designed to appeal to Gen Y techie employees who fill those jobs, (3) the economies associated with that kind of space design because it requires less space per employee, (4) the concentration of growth in tech jobs and creative office space on locations that are more urban and amenity rich, and (5) the increasing technology content of almost everything which further enhances the importance of tech-related activities and those with techie skills. These are the forces pushing the economy and office property forward. The key for office investors is to identify properties where these positive forces dominate. In the sections that follow, we attempt to untangle the positive and negative forces to help investors identify office opportunities with better prospects for attractive returns. Generational shift Technology today is focused on a combination of new industries such as social media, new devices such as smartphones and tablets, and new ways of doing things such as mobile shopping and streaming media. All these elements, in turn, are driven by young people who are the strongest users of technology, and, an increasingly important segment of the workforce that produces it. These younger workers are part of the generation referred to as millennials or Gen Y. It is the largest cohort since the baby boom and includes those born in the years leading up to the millennium who are now between 15 and 34 years old. The 84 million millennials outnumber even the massive boomer cohort which totals 82 million. Millennials now constitute 35% of the U.S. labor force and 52% of the population over 16 which is defined as eligible for the labor force. As younger millennials mature and older boomers retire, millennials will become an increasingly larger portion of the labor force. Exhibit 1: U.S. population by age cohort Thousands Under 15 Millennials Gen X Boomers Source: U.S. Census Bureau 2

3 Tech s turf In 2008, nine U.S. metro areas were identified as having at least 80,000 jobs each in occupations in the computer and mathematical science category which contains the bulk of tech sector activities. At that time, these occupations accounted for 4.5% of the nonagricultural jobs in these tech-heavy metro areas. Within these metros, the most recent occupational survey shows an 8.4% jump in this job category between 2008 and 2012 despite the Great Recession. This increase brought the concentration of tech to 4.9% in 2012 in the nine metros. It is likely that the 2013 update due for release later this year will show a further increase in tech concentration. Exhibit 2: Metro area concentrations of computer and math jobs 300 W 2008 W 2012 Thousands New York Washington, Los D.C. Angeles Chicago Boston Dallas Seattle San Francisco San Jose Source: Bureau of Labor Statistics Not only has tech been growing in these nine metro areas, but overall employment growth there has outpaced the remainder of the nation. The most recent employment data for November 2013 shows that the job total for these nine metros is slightly above its January 2008 level, indicating that the negative effects of the Great Recession have been more than made up. The remainder of the U.S. has not fully recovered and remains 1.45 million jobs beneath the January 2008 level. The strength of the tech sector can be seen in the office sector. According to a CBRE Econometric Advisors special report, 1 the tech sector accounted for the largest volume of office leasing in 2Q2013 at 13% of the total. Leasing activity in tech outpaced the more traditional leaders, finance and law, which accounted for 11% and 6% of leasing, respectively. This activity has not been limited to downtown CBDs, but rather tracked the pattern of urban-suburban tech concentrations within the nine metros. Furthermore, the tech-heavy metros are also leading the way with respect to price performance. According to the Moody s/rca CPPI index, 2 six of the nine tech-heavy metros identified above are deemed major markets; Seattle, Dallas, and San Jose are the exceptions. In the major markets, the index shows that downtown office property values recovered more than their entire property value decline suffered during the Great Recession as of November Values are on average 8.2% above their prior peaks, the best performance across all of the CPPI segments except for major market apartments. Outside the major markets, downtown office values have restored only 57.5% of the prior peak values. 3

4 What s in it for me? For office investors, it is important to understand the needs and preferences of the rising tech workforce who populate office space and their employers who sign the leases on that space. For employers, the boom in tech is very much about finding and keeping skilled employees. Fifty-eight percent of corporate CEOs are either somewhat or extremely concerned with the availability of employees with key skills according to a recent survey. 3 Young techies are in high demand from both emerging industries and traditional industries, along with the attraction of entrepreneurship. Supply of skilled techies is perceived to be tight with some analysts projecting a talent gap. 4 On top of strong demand and tight supply, young employees with sought-after skills are footloose. A recent Gallup survey reports that 47% of them expressed interest in switching jobs over the coming year, the highest percent among all age cohorts. 5 Employers are noticing; PwC reports that their youngest generation of professionals were leaving in growing numbers after just a few years. 6 In light of their concern with finding and keeping skilled millennial employees, employers are taking note of the workplace environment that is most satisfying to millennials. Their preferences lean toward office space that is quite different from traditional design and configuration. Some are calling it creative space. The value proposition in creative space Creative space is not simply about taking down the partitions surrounding cubicles. It is more complex than just open space with a patina of grunge. Creative space is best defined as a part of a flexible work environment that offers employees a variety of spaces to accommodate various activities. The design firm Gensler defines these activities as focus, collaborate, learn, and socialize. 7 Focus work and individual learning are commonly done in an open space environment with benches, tables, or low-walled cubes. Employees often listen to music through ear buds to encourage focus, loud talking is discouraged. Conference rooms are readily available for collaboration and group learning which are also encouraged by availability of attractive common spaces including kitchens, dining areas and recreation spaces. Small private spaces are available for conversation and telephone calls. Academic research supports this multi-use configuration showing that people communicate three times more often in a multi-space area 8 The final characteristic of creative space is its design esthetic which is reminiscent of converted urban industrial lofts. Big windows, abundant natural light, high ceilings, big open space, and rather raw-looking finish complete the look. Millennials grew up with abundant fast-changing technology: video games, computers, cell phones, smartphones, tablets, etc. As a result, creative space suits millennials because it facilitates the way they use technology. Their smartphones, tablets and lightweight laptops allow them to move around while they work. They are not tied down to a single desk and chair. They use paper minimally which also facilitates mobility. They eschew hierarchy which is symbolized by work environments where space equals rank. They use technology to communicate. A 2013 survey shows that 66% of younger millennials (16 to 24 years old) said they send texts instead of making phone calls, because it s easier. Millennials are said to view telephone calls as an interruption and are anecdotally referred to as phone-phobic. They also appear to favor texting over face-to-face communication. This style of communication accommodates open-space offices and minimizes the need for the small private spaces used for conversation and phone calls. 4

5 The appetite for creative office space is most pronounced in the metro areas with concentrations of tech employment. Leading-edge tech companies and smaller tech startups were the first adopters. They prefer edgier sub-market locations such as SOMA in San Francisco, the seaport in Boston, and Midtown South in Manhattan. These submarkets offer abundant older office and industrial properties with potential for conversion into creative space. More traditional companies are nibbling at creative space for their tech-heavy activities in order to attract and retain staff. Their efforts involve renovation of more traditional office space to incorporate elements of creative design. The secret sauce of creative space is that it actually economizes on the use of space. CBRE data show that office space per employee has been dropping since 2009 when it peaked at 196 square feet per employee to 182 in Gensler predicts that such densification could reach as low as 100 square feet per employee as creative design spreads. 10 The opportunity to use less space is an enormous quantifiable benefit of creative design than will likely encourage adoption even for employers with less interest in satisfying the design esthetic of millennials. Exhibit 3: Occupied office space per employee Square feet Source: CBRE-EA as of 4Q 2013 Bottom line There is solid evidence of a generational shift underway with huge implications for the investment performance of office property. The components of the shift include the increasing role of tech in economic growth, the increasing role of millennials in manning that sector and as a proportion of the labor force generally, the perceived shortage of skilled workers and sensitivity of employers to retention, and the preference of skilled millennials for a creative space office environment. Over and beyond the generational shift, creative space design squeezes more employees into less space which is a quantifiable benefit for employers. These opportunities will be especially precious because other forces are shrinking prospects for office investors. The bottom line for investors is that the shift toward creative space is creating opportunities to offset some of the drag associated with slow office employment growth, densification in use of office space, and the overhang of space in less desirable locations, both in CBDs and suburbs. Investing in creative office space is challenging because it requires an understanding of technological, generational and locational forces that drive it. Over the long term, addressing the challenge should prove to be worthwhile. 5

6 We are acting on the emerging generational shift toward creative space by adjusting the investment strategy for the office portion of our portfolios. The first step is restructuring portfolios away from office properties that are in locations that do not appeal to millennials. Out-of-favor locations are likely to include more isolated neighborhoods that lack access to public transportation and cool amenities. Some will be in downtowns, others suburban. The second step is adding investment in office properties that can benefit from the generational shift. These will include properties in submarkets with relatively strong job growth especially jobs requiring tech skills that will draw millennials. But, the characteristics of these properties might be off-putting to some. Older buildings that would be shunned in the past can be particularly attractive and amenable to creative office retrofitting. The third step is to embrace leasing opportunities that transform space through creative design and use that space to demonstrate expertise to prospective tenants. This will likely require higher tenant allowances than traditional space design but should be worth it. The efficacy of this strategy is supported by the pattern of investment performance in the tech-heavy metro areas. Those markets are leading the way; investors are well advised to take notice and take action. 1 CBRE, Econometric Advisors, U.S. Tech Sector Dominates Office Leasing, September 9, Moody s/rca CPPI, January PwC, The Talent Challenge McKinsey Global Institute, Big Data: The Next Frontier for innovation, competition, and productivity, June Gallup Inc., State of the American Workplace, PwC, NextGen: A Global Generational Study, Gensler, 2013 U.S. Workplace Survey, Key Findings. 8 R. Boutellier, et. al., Impact of Office Layout on Communication in a Science-Driven Business, R&D Management, September CBRE EA, Is The Demand for U.S. Office Space Shifting, October 28, Gensler, 2013 U.S. Workplace Survey, Key Findings. Real estate securities are subject to various risks, including fluctuations in property values, higher expenses or lower income than expected, and potential environmental problems and liability. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. Past performance does not guarantee future results. TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association (TIAA ). Teachers Advisors, Inc., is a registered investment adviser and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA). TIAA, TIAA-CREF, Teachers Insurance and Annuity Association, TIAA-CREF Asset Management and FINANCIAL SERVICES FOR THE GREATER GOOD are registered trademarks of Teachers Insurance and Annuity Association Teachers Insurance and Annuity Association of America-College Retirement Equities Fund (TIAA-CREF), 730 Third Avenue, New York, NY C _ (03/14)