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As we mentioned in a previous article about SunBelt REITs and the rise of the 18-hour city, the increase in prices in so-called 24-hour cities has resulted in cap rate compression, and a renewed focus on opportunities in secondary or tertiary markets--particularly in the Sun Belt, where there are still good supply-demand dynamics, high occupancy, and rent growth. Lower cap rate compression in these markets also means potentially higher yields for investors.
In the previous article, we talked about REITs in general and touched on some of the specific subsectors that looked most promising in light of some of the demographic factors in these markets. We focused some of our analysis on Apartment REITs and Office REITs and how demographic trends should be a tailwind for some of the apartment and office landlords in the area.
In this article, we will take a closer look at Office REITs and some of the specific drivers to watch for that we believe will drive future price and dividend increases within the sector.
The outlook for office REITs
The U.S. economy is operating near full capacity and the search for talent is becoming increasingly difficult given the scarcity of available qualified workers. Metros such as Austin, Dallas, Houston and Portland are, according to DWS, expected to lead in office-using job growth over the five-year forecast, while growth in the gateway markets such as New York, Washington D.C. and Chicago is expected to moderate and lag the nation.
Vacancy rates have stayed stable, falling below their 20-year historical norms in most markets with San Francisco, Seattle and Austin posting some of the lowest office vacancy rates across the nation.
Exhibit 1: Office net absorption and completions as % of inventory and vacancy rate (1999-2023)
Construction is highly concentrated in a few high-demand tech markets, notably San Jose, San Francisco and Seattle, and in the large, gateway markets such as Washington, D.C. and New York City. As developers and lenders stay cautious, speculative construction is expected to slow in 2019, limiting supply concerns and keeping vacancy rates in balance.
Exhibit 2: Office rent growth
With low cap rates, rising expenses and tepid demand, total return performance in core-gateway central business district (CBD) markets has been moderating. Going forward, low housing affordability in gateway markets may limit the urban demographic growth, with workers likely to look for housing in the inner suburbs that offers both affordability and access to an urban living style. Moreover, recent NPI office returns show that suburban markets have outperformed those in the CBDs, driven by both appreciation and income growth.
Exhibit 3: Suburban office returns beat CBD returns
According to DWS, high rent growth across tech and gateway markets is expected to moderate, with regional metros, particularly in the high-growth Sunbelt markets, continuing to outperform. These are metros with strong demographic and office-using employment prospects, as well as affordable business and housing costs.
Sun Belt office sector
More and more companies are domiciled in the Sun Belt. A pro-business culture, largely enabled by fewer and less onerous taxes and regulations, has spurred significant private sector growth. Today, Texas, Florida, and California boast the most Fortune 500 Companies (outside of New York, Illinois, and Ohio). Over the past decade, total employment in the Sun Belt region grew by 12 million (+20%) versus 9 million (+12%) in the non-Sun Belt.
Exhibit 4: Sun Belt office job growth
The tremendous business expansion has led to faster job, GDP, and wage growth in most metro areas, well above the U.S. and non-Sun Belt averages. Recent and forecasted office-using job growth is highest in Austin, Orlando, Dallas, Houston, Raleigh, Fort Worth, Phoenix, Las Vegas, Tampa, West Palm Beach, Jacksonville, and Charlotte. Muted economic growth, high housing costs, congestion, and dated infrastructure also may worsen outside the Sun Belt.
About half of the total nonfarm and office-using jobs (a respective 150 million and 32 million) are already located in the Sun Belt. Also, 50% of millennials currently live in the region. With millennials expected to be about 75% of the workforce by 2030, Sun Belt markets will continue to capture more jobs as their younger populations continue to grow.
In recent years, Sun Belt markets have greatly outperformed in effective rent growth relative to outside markets. The built environment in the region is largely composed of lower-density suburbs and exurbs. Much of the real estate is newer and low-rise construction. Given the higher level of sprawl, the trends toward densification and live-work-play are going strong.
Exhibit 5: Sun Belt vs. Non-Sun Belt Rent Growth History (5-Year)
The Sun Belt has seen a surge in population growth for decades from an influx of people seeking growing economic opportunity, a lower cost of living, and retirement in a warm and sunny climate. Clarion Partners believes that the investment outlook for the West and South is now especially attractive. The Sun Belt markets within the NCREIF Property Index (NPI) returns have performed extremely well over the past 20 years.
Exhibit 6: Sun Belt outperformance
Many Sun Belt areas will become increasingly popular destinations for professionals, families and retirees. Most importantly, the expanding new economy in the West and South may become more important than that in the Northeast and Midwest and will continue to attract top talent. These dynamics should greatly improve and catalyze cultural, institutional, leisure, and intellectual property growth in urban areas, as well as household wealth, which will likely drive outsized commercial real estate appreciation.
Over a long period, oversupply could be a risk in these markets, but given the near-term supply-and-demand balance, this is not an issue right now.
Exhibit 7: Office supply
All-in-all the Sun Belt office market still enjoys good supply-demand dynamics, high occupancy, and rent growth.
Sun Belt office REITs
Earlier this year, Cousins Properties agreed to acquire Tier REIT (TIER) in an all-stock transaction, creating a Class A office REIT with a combined portfolio of more than 21million square feet across the Sun Belt.
Exhibit 8: Cousins Properties and Tier REIT merger
Highwoods Properties (NYSE:HIW)is a member of the S&P MidCap 400 Index. HIW is a fully-integrated office REIT that owns, develops, acquires, leases and manages properties primarily in the best business districts of Atlanta, Greensboro, Memphis, Nashville, Orlando, Pittsburgh, Raleigh, Richmond and Tampa. The portfolio totals almost 30 million square feet.
Franklin Street Properties is focused on infill and central business district (CBD) office properties in the U.S. Sunbelt and Mountain West, as well as select opportunistic markets. Franklin Street Properties seeks value-oriented investments with an eye towards long-term growth and appreciation, as well as current income. Franklin Street Properties has 32 operating properties with almost 10 million rentable square feet.
In the hierarchy of property types from Trophy to Class C, Class A comprises fairly new, high quality buildings in prime locations, that have luxurious amenities and highly professional property management services. In the hierarchy of property types, Class A properties are just below what are called Trophy properties, the newest, best-looking, and most technologically up-to-date buildings in the most upscale neighborhoods. Like Class A, these have abundant amenities and are professionally managed.
Class B properties are of lower quality than Class A. They are usually aged buildings that are still of good quality and have the potential to be renovated to look like “Class A,” but offer fewer amenities and services. They are also more prevalent in less prominent locations.
Finally, Class C properties are those in less desirable areas and are likely to have outdated infrastructure and technology, requiring extensive renovation to remain functionally up-to-date, and are typically targeted for redevelopment.
Cousins Properties and Highwoods Properties focus on Class A Sun Belt office properties, while Franklin Street Properties’ portfolio is more mixed.
What growth figures can we expect in the future for the Sun Belt office REITs? The premium or discount at which REITs trade can give us an indication of expected growth.
The equity markets have a strong preference for higher levels of NAV growth, and, at times when this exists, price REITs at premiums to NAV. When real estate value growth is more muted, short-term focused equity investors look elsewhere leading to REITs trading at a discount.
Over the long term, U.S. REITs have, on average, traded at the value of their underlying real estate.
A premium to NAV does not mean a sector is overpriced, however. Over the long term, the REIT premiums and discounts to NAV by sector are predictive of future changes in private market values.
If REIT stocks trade at big discounts to the value of their assets, private market asset values tend to fall.
If REITs trade at large premiums, private market asset values tend to rise which has a positive impact on the NAV growth of REITs.
Exhibit 9: NAV Premium/Discount
On average, Sun Belt office REITs trade at a 17% discount to NAV compared to an average 18% discount for US office REITs. This suggests that we can expect a slightly higher growth from Sun Belt office REITs.
A low payout ratio and low debt ratios lead to a higher dividend safety. When we compare office REITs that focus on the Sun Belt with the average US office REITs, we can only conclude that the Sun Belt office REITs have stronger balance sheets and lower payout ratios and, hence, a lower risk of a dividend cut.
Exhibit 10: Balance sheet strength
Is the higher historic and expected growth of Sun Belt office REITs reflected in a higher valuation?
Is the higher balance sheet strength of Sun Belt office REITs reflected in a higher valuation?
The answer is no!
The Sun Belt office REITs trade at a cheaper valuation than the average US office REITs.
The Sun Belt Office REITs trade at a P/FFO of only 11.3 while the average US office REITs trade at a 17.4 multiple. A huge discount given the aforementioned balance sheet strength and dividend safety.
The cheapest one, Franklin Street Properties, is also the most indebted one.
Cousins Properties’ low pay-out ratio results in a fairly low dividend yield of 3.3%, which drags down the average Sun Belt office REIT dividend yield to 4.1%. This still compares favorably to the 3.8% yield for the average US office REITs.
In a late-cycle environment, in which growth opportunities are scarcer, a focus on markets with stronger demographic trends can help identify opportunities with attractive total return potential. The Sun Belt is such a market.
Sun Belt focused REITs in the office sector combine higher growth, a cheap valuation and balance sheet strength and hence a high dividend safety.
We are fiduciaries by nature and are required by CFA charter to provide advice in the best interest of clients. We are not always right but we take a prudent approach to finding income producing ideas for members. Our research covers REITs, Dividend Stocks, MLPs, Preferreds, Bonds, BDCs, ETFs, and Closed End Funds.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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: This article is meant to identify an idea for further research and analysis and should not be taken as a recommendation to invest. It does not provide individualized advice or recommendations for any specific reader. Also note that we may not cover all relevant risks related to the ideas presented in this article. Readers should conduct their own due diligence and carefully consider their own investment objectives, risk tolerance, time horizon, tax situation, liquidity needs, and concentration levels, or contact their advisor to determine if any ideas presented here are appropriate for their unique circumstances. Furthermore, none of the ideas presented here are necessarily related to NFG Wealth Advisors or any portfolio managed by NFG.