REIT Rankings: Office
In our REIT Rankings series, we introduce and update readers to each of the commercial and residential 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 for existing readers.
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Office REIT Sector Overview
Within the Hoya Capital Office REIT Index, we track the 18 largest office REITs, which account for roughly $100 billion in market value: Boston Properties (BXP), Vornado (VNO), Kilroy (KRC), Douglas Emmett (DEI), SL Green (SLG), JBG Smith (JBGS), Hudson Pacific (HPP), Cousins (CUZ), Highwoods (HIW), Equity Commonwealth (EQC), Corporate Office (OFC), Paramount Group (PGRE), Brandywine (BDN), Columbia Property Trust (CXP), Piedmont (PDM), Empire State Realty (ESRT), Washington REIT (WRE), and Mack-Cali (CLI). Considered one of the four "major" real estate sectors, office REITs comprise roughly 10-15% of the broad-based REIT ETFs (VNQ and IYR).
The office sector is often viewed as two distinct sub-sectors: central business district (NYSE:CBD) and suburban. Office REITs tend to hold assets in the higher-tiers of the quality spectrum relative to the national average, holding nearly a quarter of all Class-A CBD office buildings in the United States. As a whole, office REITs tend to be concentrated in coastal "gateway" markets, where post-recession job growth has been strongest, but where supply growth has also been most prevalent. Office REITs are classic Growth REITs, exhibiting a lower degree of interest-rate-sensitivity and a higher degree of economic sensitivity than the REIT sector average.
Given the high degree of fixed costs incurred in managing an office property- whether fully occupied or mostly vacant- operating leverage is quite high. Thus, small changes in occupancy and market fundamentals can have significant positive or negative impacts on performance. Leases for high-quality office space tends to be relatively long-term at 5 to 10 years for suburban assets and 10-20 years for CBD assets. As a result, the office REIT sector tends to outperform later in the cycle as below-market leases get reset to higher rents. After nearly a decade of underperformance, same-store NOI growth for the office REIT sector finally outpaced the REIT average beginning in late 2016.
More than other REIT sectors, office REITs have a relatively small roster of tenants and tend to be more geographically concentrated. Office ownership is a tough, capital intensive business with relatively low operating margins and high capital expenditure needs as tenants tend to have quite a bit of negotiating power relative to landlords, particularly given the ample available supply. Vacancy rates across the office sector have consistently averaged more than 10% for most of the post-recession period, but office REITs have seen improved occupancy metrics in recent quarters. As we'll discuss below, however, these occupancy gains may be short-lived as the development pipeline is at cycle-highs with supply growth expected to average more than 2% per year through 2020.
Job growth in the office-using sectors is the key demand driver for office space, but gains in space efficiency per worker have been the most significant headwind for the office REIT industry over the last three decades. Since the 1990s, the amount of square footage per worker has been cut in half, a function of improvements in communications technology, changes in work culture, and more efficient floor layouts. Job-growth in the office-using sectors has been relatively strong over the past three years as strong growth in the professional and business category offset slowing growth in the finance sector.
The rapid growth of co-working – highlighted by industry heavyweight WeWork (WE) – has been one of the more significant demand drivers over the past half-decade, responsible for almost third of total leasing activity over the past three years. As we've discussed in the past, we think that co-working firms are more friend than foe for office REITs, serving as a needed intermediary to facilitate shorter-term space rentals and create incremental demand that would not otherwise be tenants of these offices REITs. While still accounting for less than 2% of the total office market, co-working and other forms of "flexible workspace" is generally expected to grow as a share of total office square footage over the next decade and will likely be a net positive for office owners and lead to lower "natural" occupancy rates in high-quality buildings.
Bull and Bear Thesis for Office REITs
Before diving into the analysis, we outline five reasons that investors are bullish on the office REIT sector. Job growth as historically been the most significant determinate of office market fundamentals, and while there are growing fears of a potential recession, we're still in the midst of the longest consecutive streak of job growth in American history. 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 since 2013, 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.
WeWork Prepares IPO & Possible Reckoning
On Wednesday, WeWork filed its S-1 paperwork with the SEC with plans to go public this September in an offering worth as much as $3.5 billion, which would be the second-largest IPO of the year after Uber (UBER). An ill-timed filing that was released just as recession worries reached a fever pitch, the document received more ridicule and criticism from the financial media and analyst community than any IPO in recent memory. Critics lambasted everything from the firm's core business model - viewed by some as doomed in a recession - to the apparent corporate governance issues, to the primary critique that we've been discussing for several years: the firm's lofty valuation relative to its co-working peers, namely the London-listed International Workplace Group (LSE:IWG), better known as Regus.
As we've discussed previously, while we believe that co-working is a legitimate and potentially profitable business model as illustrated by the relative success of the incumbent co-working firm Regus, we have continued to question the valuation ascribed to WeWork which we believe is many multiples higher than warranted. WeWork’s upcoming IPO could be a moment of reckoning for the highly-valued but fast-growing co-working sector, whose growth has been fueled by a seemingly limitless pool of venture capital funding. While office REITs themselves have minimal direct exposure to co-working firms, a slowdown in co-working leasing activity would come at a bad time as supply growth remains at cycle-highs.
While WeWork has tried to position themselves as a "technology" company that would warrant tech-like valuations, we believe that the public markets will view IWG as the most appropriate comparable. We think it's reasonable to assume that WeWork could achieve similar net margins in the range of 10-15% once the business has matured - a decent business - but short of the 30% projections outlined by the company in their filing. Giving credit to WeWork's growth trajectory, we think an appropriate valuation would be in the range of $10-20B, which would potentially make them the largest office "landlord" in the country.
If indeed this was the valuation that the public markets ascribe to WeWork, which would likely be viewed as disappointing for WeWork and the broader co-working sector, we think it could significantly slow the rate of growth across the co-working space, particularly among smaller firms that have pegged their valuations to WeWork's lofty private market valuations.
Office REIT Fundamentals: Deeper Dive
Reflecting the trends seen in the broader commercial real estate sector, the past four years in the office REIT sector has been a war between high levels of demand and elevated levels of supply growth. While other segments of the real estate sectors - notably residential, industrial, and technology - have seen demand growth overwhelm the negative impacts of supply growth on fundamentals, office REITs have not been as lucky. After tailing-off by the end of 2016, construction spending on office development ramped-up again after the 2016 elections, spurred by the passage of corporate tax reform and the expectation of reaccelerating economic growth. With the recent pick-up in development, the office pipeline increased to a new cycle-high last quarter with supply growth expected to average more than 2% per year through 2020.
The internal development pipeline from REITs themselves illustrates the boom in construction activity that began in 2013 and is expected to continue until at least 2020. Development yields continue to be favorable as private market valuations have continued to tick higher even as the public REIT-implied values remain relatively stagnant. According to T-Tracker data, the office development pipeline stands at roughly $14 billion, up sharply from the 2012 level of $2 billion. Interestingly, the REITs themselves have been responsible for a sizable share off total development this cycle.
Pressured by elevated supply growth and weak pricing power, rent growth has generally cooled across the office sector since peaking in 2015. The bifurcation between the outperforming and underperforming markets has also widened in recent years. 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 and 5% in the Sunbelt market. As noted above, however, given the relatively long lease terms, same-store NOI growth has picked up in recent quarters years despite cooling rents.
On a positive note, powered by strong leasing activity in the technology and co-working sectors, absorption has been solid over the past year-and-a-half. In JLL's Q2 2019 Office Outlook, the firm notes that leasing activity has been above-expectations in recent quarters ahead of a period of elevated supply growth that will likely swing any negotiating power gained by landlords in recent quarters back to the tenants.
The U.S. office market continued its solid expansion in the second quarter, with sustained leasing velocity and broad- based macroeconomic growth leading to 23.3 million square feet of occupancy gains, a healthy 0.8 percent increase in asking rents and further demand for new product, as more than 62.1 million square feet of supply will deliver over the next four quarters alone. Tenants will find a more flexible environment opening up over the short term, although the potential for oversupply remains subdued as a pullback in construction starts will scale back the development pipeline gradually beginning in 2021.
On the private-market side, office valuations generally remain firm, buoyed by the so-called "wall of capital" of private equity and sovereign wealth funds. Capitalization rates have continued to compress in recent quarters even as REIT valuations fail to keep pace. This growing NAV discount has stymied the sector's external growth prospects. Office REITs have been net sellers of assets since the start of 2016 as NAV discounts have widened and persisted into 2019.
Office REIT 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. The combination of disappointing internal growth and a persistent NAV discount has left the sector with a limited toolbox on which to grow the business. REIT investors now also have a greater awareness of the negative impacts of capital expenditure needs that encumber the office sector.
Despite a record 106 consecutive months of job growth, office REIT performance continues to be lackluster and has underperformed the REIT average over essentially every recent measurement period since the end of the recession. Hit especially hard by recession worries, the office REIT sector has been one of the worst-performing sectors this year, climbing just 8% compared to the 21% jump in the REIT sector average, outpacing only the hotel and mall sectors.
The best-performers so far this year have been Corporate Office Properties, Kilroy, Hudson Pacific, and Piedmont. New York City-focused REITs have generally underperformed this year with weak performance from Vornado, SL Green, and Empire State Realty. Washington DC-based REITs including JBG Smith have benefited from Amazon's (AMZN) announced expansion into the region.
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 cash flow metrics. Based on current and forward Free Cash Flow multiples (aka AFFO, FAD, CAD), office REITs are the fourth most expensive REIT sector. When we factor in two-year growth expectations, though, the sector appears equally expensive. As discussed above, office REITs now trade for a 10-20% discount to NAV, still near the widest discount of the post-recession period.
Dividend Yield and Payout Ratio
Based on dividend yield, office REITs rank toward the middle of the sector, paying an average yield of 3.3%. Office REITs payout roughly 70% of their available cash flow, leaving a sufficient buffer for potential external growth if or when the NAV premium is restored.
Within the sector, we note the varying strategies of the eighteen REITs. In general, the smaller and higher-levered REITs pay heftier dividends than the larger REITs.Brandywine, Washington REIT, Piedmont, Highwoods, Vornado, and SL Green are the highest-yielding office REITs.
Office REITs and Interest Rates
As a sector, office REITs are quintessential Growth REITs. Office REITs are one of the most "equity-like" REIT sectors, historically 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 and timber REIT sectors.
Bottom Line: WeWork's IPO Impact On Office REITs
The rapid growth of co-working – highlighted by industry heavyweight WeWork – has been one of the more significant demand drivers over the past half-decade, responsible for a third of leasing activity over the past three years. WeWork’s upcoming IPO could be a moment of reckoning for the highly-valued but fast-growing co-working sector, whose growth has been fueled by a seemingly limitless pool of venture capital funding.
While office REITs themselves have minimal direct exposure to co-working firms, a slowdown in co-working leasing activity would come at a bad time for the sector, as supply growth remains at cycle-highs. We remain negative on the office REIT sector, as we have for several years, noting the persistently elevated valuations and unfavorable fundamental outlook.
Additionally, while we believe that co-working is a legitimate and potentially profitable business model as illustrated by the relative success of Regus, we have continued to question the valuation ascribed to WeWork which we believe is many multiples higher than warranted. We think that a poorly-received IPO could slow the robust growth of co-working sector as a whole, which would be another negative headwind for the persistently underperforming office REIT sector.
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Disclosure: I am/we are long VNQ. 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.
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