REIT Rankings: Office
In our REIT Rankings series, we analyze one of the fifteen real estate sectors. We rank REITs within the sectors based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives. We update these rankings every quarter with new developments.
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Office Sector Overview
Office REITs comprise roughly 15% of the REIT Indexes (VNQ and IYR). Within the Hoya Capital Office REIT Index, we track the 18 largest office REITs within the sector, which account for roughly $110 billion in market value: Boston Properties (BXP), Vornado (VNO), Alexandria (ARE), SL Green (SLG), Kilroy (KRC), Douglas Emmett (DEI), Hudson Pacific (HPP), Highwoods (HIW), JBG Smith (JBGS), Cousins (CUZ), Equity Commonwealth (EQC), Paramount Group (PGRE), Brandywine (BDN), Empire State Realty Trust (ESRT), Corporate Office (OFC), Piedmont Office (PDM), Washington REIT (WRE), and Mack-Cali (CLI).
Above, we show the size, geographical focus, quality focus, and leverage profile of these REITs. Quality is a function of the average rent per square foot for the portfolio. REITs tend to hold assets in the higher-tiers of this quality spectrum relative to the national average. As a whole, office REITs tend to be concentrated in coastal "gateway" markets, where post-recession job growth has been strongest. While this has been a good strategic decision for the past decade, tax reform threatens to upend these dynamics and could result in a migration of high-income office-using jobs into lower tax markets over the next decade.
Bull and Bear Thesis for Office REITs
The ‘bull’ thesis for office REITs tends to center around their status as a late-cycle outperformer. Because of their long lease terms, office NOI growth tends to lag the broader economy and outperform later in the real estate cycle. NOI accelerates late in the cycle as leases are reset to market rates, captured by a leasing spread that can exceed 30%. As a result, office REITs are finally beginning to feel the full effects of the post-recession period of strong job growth. Demand for office space has been strong over recent quarters, a result of the solid employment growth in the US, particularly in the office-using services sectors.
The ‘bear’ thesis for office REITs tends to focus on high-levels of recent supply growth, the sector’s historical underperformance, and idiosyncratic issues that are specific to the sector. Construction of new office assets essentially shut down in the aftermath of the recession but has come roaring back since 2014. Supply growth is expected to peak between 2017 and 2018 and should average 2% of existing supply per year. Unfortunately for office REITs, oversupply has emerged as a significant issue in recent quarters as a sizable percentage of this new supply is specifically concentrated in the coastal gateway markets. Efficiencies in office layouts and the increased use of remote working have also decreased the average space leased per worker.
Recent Stock Performance
The post-recession period has been unkind to the office REIT sector, which has outperformed the REIT index in only one year since 2009. Since the start of 2007, only the shopping center sector has produced a lower total return. Office REITs produced a total return of 5% in 2017, matching the return of the REIT index.
Despite a record 92 consecutive months of job growth, office REIT performance continues to be lackluster. The sector, which theoretically should outperform other real estate sectors during periods of rising rates, has barely topped the performance of the broader REIT average.
The top performer within the sector has been JBG Smith, which benefited from speculation that Amazon (AMZN) will choose the DC region as their home for their "HQ2." Empire State Realty, Mack-Cali, and Vornado have been the underperformers this year.
Quarterly Earnings & Recent Developments
1Q18 earnings were generally in line with expectations. Overall, same-store NOI growth and leasing spreads continue to moderate after peaking in 2016 as supply growth has put upward pressure on vacancy. Bucking the national trends in the office markets, however, same-store occupancy stayed firm at 93%. Tech-focused West Coast markets continue to outperform, producing SSNOI growth 6.6% compared to the East Coast/Midwest at 3.4% and the Sunbelt at 3.6%. Despite recent improvement, DC and NYC fundamentals continue to be soft due to the supply overhang.
A result of longer-than-average lease terms, the later stages of the economic cycle is typically the time in which office REITs outperform. Seven years into the recovery, office REITs are finally showing mild NOI outperformance over the REIT average. Per the NAREIT T-Tracker, same-store NOI growth averaged 3.9% in 2017, slowing from the 5.3% rate in 2016. On a GAAP basis, NOI growth in the office sector should remain firmly ahead of the broader average for several more years as older leases are marked-to-market at higher market rents.
On a cash basis, however, we have already begun to see the slowing in same-store NOI growth after peaking in 2015. Historical SSNOI growth trends show the outperformance of the West Coast and Sunbelt-focused REITs. Over the last seven years, West Coast and tech-focused REITs have averaged nearly 6% SSNOI growth compared to 2.2% in the East Coast and Midwest markets.
Trends & Topics of Discussion
1) Jobs, Jobs, And More Jobs
Demand has been powered by strength in the US labor markets, as job growth continues to exceed even the most optimistic of economists' projections. The "white-collar economy" has outpaced the broader economy in terms of employment growth over the past five years. Employment in the "professional and business services" category has increased nearly 20% since the start of 2012 and "financial activities" has increased more than 10%.
2) Private Values Remain Firm
Office REITs are a prime example of the dangers of "too much of a good thing." The substantial private market demand for high-quality office assets in gateway markets led to continued cap rate compression from 2010-2017. Private market valuations of office REITs more than doubled from the depths of the recession to 2017, and the rate of appreciation was far higher in NYC and DC markets. Naturally, "trophy fever" prompted a wave of development in these coastal markets where the development yield was simply too juicy to pass up.
Rising Treasury yields and moderating fundamentals, however, have slowed further cap rate compression. Cap rates are roughly flat year over year and there appears to be an expectation that we've seen the bottom of cap rates for this cycle.
3) Supply Growth Remains Elevated
While demand has been solid, relentless supply growth over the past several years has weakened fundamentals. According to JLL's Q4 2017 Office Outlook, new supply will outpace incremental demand from 2016 until at least 2019. More than 60 million square feet of space will be delivered in 2017 and 2018, the highest quantity of supply growth on record. Developers are finally pulling back from new projects, however. In 2017, new starts were 30% lower than the prior year, which indicates that supply growth should begin to tail-off by 2020.
4) Development Continues to Drive Growth
The internal development pipeline from REITs themselves illustrate the boom in construction activity that began in 2013 and is expected to continue until at least 2019. Development yields continue to be favorable as private market valuations have remained steady despite the significant selloff in the REIT markets.
According to T-Tracker data, the office development pipeline stands at nearly $12 billion, up sharply from the 2012 level of $2 billion. As same-store fundamentals moderate, development yields will be an increasingly important source of AFFO growth for many REITs as these projects reach completion in 2018 and 2019.
5) Acquisition Pipeline Cools Amid NAV Discount
Buoyed by the so-called "wall of capital" of private equity and sovereign wealth funds, private market valuations of office assets in gateway markets remain firm despite the selloff in REIT markets. Office REITs have been net sellers of assets since the start of 2016 as NAV discounts have widened. Office REITs may become attractive M&A targets if NAV discounts persist.
Valuation of Office REITs
As has been the case for most of the past five years, Office REITs are one of most expensive sectors across most metrics. Based on current and forward Free Cash Flow multiples (aka AFFO, FAD, CAD), office REITs are the second most expensive REIT sector. When we factor in two-year growth expectations, though, the sector appears slightly more attractive. As discussed above, office REITs now trade for a 10-20% discount to NAV, still near the widest discount of the post-recession period.
Sensitivities to Equities and Interest Rates
As a sector, office REITs are quintessential Growth REITs. Office REITs are one of the most equity-like REIT sectors, exhibiting very limited interest rate sensitivity and responding instead to movements in the broader equity markets. This level of pro-cyclicality is fairly unique within the REIT sector, shared by the hotel, single-family rental, and mall sectors.
13 of the 18 fall into the Growth REIT category, while Highwoods, Equity Commonwealth, Piedmont, Washington REIT, and Mack-Cali fall into the Hybrid REIT category.
Dividend Yield and Payout Ratio
Based on dividend yield, office REITs rank towards the bottom, paying an average yield of 2.5%. Office REITs pay out 76% of their available cash flow.
Within the sector, we note the varying strategies of the 18 REITs. In general, the smaller REITs pay heftier dividends than the larger REITs. Piedmont, Washington REIT, Mack-Cali, and Brandywine are the only REITs paying a yield higher than the broader REIT average.
Despite a record 92 consecutive months of job growth, office REITs have yet to fully recover from the previous recession. The sector has been a perennial underperformer since 2007. Led by US labor markets, the global economy is growing at the strongest rate in decades. Even with robust growth in the office-using employment sectors, office fundamentals continue to be unimpressive.
Supply growth has become an issue in the coastal markets as rent growth peaked in 2015. Spurred by sky-high valuations, developers have added supply at a frenetic pace since 2013. While developers are beginning to pull back on new projects, supply growth is likely to outpace incremental demand from 2016 through 2019. Net absorption appears to have peaked in 2015.
Tax reform added a new twist to office markets. Office REITs tend to be concentrated in the high-tax coastal markets that are likely to be negatively impacted by tax reform. We currently view the Sunbelt-focused office REITs as the most attractively-valued names in the space. We remain cautious on coastal REITs that will be hit by a one-two punch of supply growth and long-term demand weakness from tax reform.
To see where office REITs fit into a diversified REIT portfolio, be sure to check out our other REIT Rankings: Net Lease, Malls, Industrial, Data Center, Apartments, Shopping Center, Hotel, Healthcare, Industrial, Single Family Rental, Cell Tower, Manufactured Housing, Storage, Homebuilders, and Student Housing.
Please add your comments if you have additional insight or opinions. Again, we encourage readers to follow our Seeking Alpha page (click "Follow" at the top) to continue to stay up to date on our REIT rankings, weekly recaps, and analysis on the REIT and broader real estate sector.
Disclosure: I am/we are long VNQ, SPY, AMZN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: All of our research is for educational purposes only, always provided free of charge exclusively on Seeking Alpha. Recommendations and commentary are purely theoretical and not intended as investment advice. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. For investment advice, consult your financial advisor.