Office REIT Outlook Still Bleak

| About: Vornado Realty (VNO)

According to new data from commercial real estate services company Cushman and Wakefield, US office market vacancies jumped in 1Q09. The overall US office vacancy rate was 12.5% in 1Q09, 130 bps higher than year-end 2008. Only one market of the 31 CBDs (central business districts) that Cushman tracks reported occupancy increases -- Dallas, with a 1Q09 vacancy rate of 27.2%, 40 bps better than the previous quarter.

Two markets -- Atlanta and Orlando -- held steady, and the rest declined. Year over year (1Q09 vs. 1Q08), vacancy rates declined in six markets that the company tracks: Atlanta, Dallas, Ft. Lauderdale, Silicon Valley, Oakland, and Minneapolis, while increasing in the rest. According to the report, the three US markets with the lowest office vacancy rates are New Haven, Conn (9.2%), Washington (D.C), New York (9.6%) and Portland (10.2%), although each market reported large y/y vacancy jumps.

Additionally, asking rents fell 2.2% from 4Q08, but increased nearly 5% from 1Q08. Office occupancy is to some extent a trailing indicator of a city's economic health. As such, we expect continued job losses to increase vacancies in most markets going forward. Asking rents will drop, and it will be a tenants market though at least the end of this year.

On the bright side, the credit squeeze and economic slump has caused new starts to decrease, and many large office projects have been cancelled over the past year. As such, there will be less supply a couple of years down the road when things get better.

If you are buying office REITs now, it should be a longer term play, at least over a year. Absent job growth, office fundamentals have nowhere to go but down. Near term, earnings growth in the sector will be negative and more dividend cuts will come as 2009 progresses.

When looking in the sector, we favor the larger, well capitalized players who can better withstand the loss of a couple large tenants. Vornado (NYSE:VNO) is our favorite pick in the sector and currently our only Buy recommendation.

The company has lots of cash and a good mix office and retail holdings. VNO’s office properties are concentrated in two good long-term markets, D.C. and New York, which should hold up comparatively well during the recession.

--Greg Sukenik