Post-pandemic, E&O risks rising in commercial real estate

Commercial real estate is evolving as businesses continue to cope with the effects of the COVID-19 pandemic. While the pandemic dramatically accelerated a work-from-home movement for many industries, more employees are returning to the workplace, at least for portions of the work week. As a result, the outlook for commercial office space is positive, but risks remain for commercial real estate professionals.

The “New Way of Working” (NWOW) is becoming a hybrid model, with traditional 9-to-5 shifts disappearing for many companies. Instead, employers are offering flexible and alternating office schedules. With fewer employees in commercial buildings every day, companies in some cases are opting to scale down their office footprints. Most companies, however, are not looking to expand their office space.

Even as employers seek to maintain or reduce their spaces, buildings in prime locations remain in demand. As competition for talent continues, more employers are renovating their spaces and/or offering flexible policies that appeal to workers. This is causing some former employees to rejoin their prior employer, a phenomenon observers call the “boomerang effect.” Similarly, commercial property owners are investing in features that tenants value, such as shared gyms, daycare facilities, and other amenities.

According to the VTS Office Demand Index (VODI), which tracks new demand for office space in seven major cities across the United States, nationwide demand has stabilized at half to two-thirds of pre-pandemic levels. In July 2022, VTS reported the VODI dropped 6% nationally to 63; the index‘s baseline was 100 in 2018 and 2019, before the impact of the pandemic. VTS notes that the index‘s overall stability since October 2021 is positive for office space demand, as the labor market remains active.

One of the continuing risks in the commercial real estate sector is reduced occupancy. Property managers and property owners rely on revenue based on occupancy. Lower occupancy results in less revenue, and replacing tenants who can no longer continue their leases is difficult due to economic pressures including inflation and higher interest rates.

In addition, there is a trickle-down effect from NWOW, which is reflected not only in real estate organizations, but also in the businesses that serve office employees — for example, restaurants, coffee shops, dry cleaners, and retail stores adjacent to or within office complexes. With fewer workers, foot traffic has fallen precipitously, which in turn reduced those businesses‘ revenue. Property owners and managers may have been forced to cut staff, leaving fewer people available to maintain and administer properties, which can contribute to their level of service and may affect their ability to keep tenants or attract new ones. Sooner or later, these issues will impact property values.

In these challenging conditions, risks arise. Will businesses feel compelled to cut corners to make revenue? That could lead to Errors & Omissions Liability claims. For example, a franchise company that leased space in a densely populated area before the pandemic could see its revenue plummet, with little hope of recovery to pre-pandemic levels. Such a business might seek to recoup its lost revenue, which could lead to an E&O Liability claim.

At Munich Re Specialty Insurance (MRSI), we rely on our knowledgeable underwriters, who have vast experience in underwriting commercial real estate risks. We recognize this sector, like the broader economy, is a wave with peaks and troughs. As a risk management organization committed to our broker partners and our clients, we are willing to “ride the wave” with them and be there for them in the long term.

One of the ways our team is adapting to the market shifts in commercial real estate is to take a closer look at our insureds‘ financial statements as well as their clients. If occupancy falls where it threatens its profitability, a commercial real estate organization might be tempted to lower its standards for tenants. By looking at property locations, clients, the insured's financial health, and other data, our experienced underwriters can make better-informed decisions. Some cities will experience higher “New Way of Working” effects, which can influence the risk profile of insureds with a presence there.

MRSI understands that losses are going to happen. We are in the risk business, after all. What‘s important for us to know is how our insureds learn from losses. What corrective actions have they implemented to mitigate future losses? Risk-aware businesses in the commercial real estate sector are looking for true partnerships, and MRSI can offer that collaboration.

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