- Many companies and workers are not only embracing work from home, but they’re also wondering why they live and work in the core of places like San Francisco in the first place.
- The shift to work from home and away from the office already is underway as stay-at-home orders slowly ease on the West Coast.
- While nobody knows how big the impact will be, office REITs need to prepare for possible Armageddon.
- Long, airtight leases, fancy HVAC systems, sanitary practices, and new space configurations aren't long-term solutions to what could be a systemic problem.
- One thing is for certain: We're going to live in a world of uncertainty for the foreseeable future. Even so, office REITs must prepare for a very different future.
- Looking for a helping hand in the market? Members of The REIT Forum get exclusive ideas and guidance to navigate any climate. Get started today »
Do you know the way to... Hollywood? Source: Author's Image
Boston Properties (BXP) and Hudson Pacific Properties (HPP) are two of the nation's largest office REITs with concentrations in major cities, particularly the San Francisco Bay Area and Southern California, especially Los Angeles. Even though we don't cover office REITs due, in part, to their high capital expenditures, we think it's equally interesting and important to consider how they might fare in the forthcoming post-quarantine environment.
Because we do not have a history of covering these REITs, we'll focus our discussion on the broader question - will Coronavirus change places such as San Francisco and Los Angeles forever? If the future of work renders central business districts somewhere between obsolete or less important, this will certainly impact firms such as BXP and HPP.
To begin our investigation, let's play a little game.
The Matching Game
We'll run through some quotes and excerpts on this subject. Match the blurb with the source. Don't cheat by clicking on the source links until after you have read through the blurbs and guessed.
Note: Some of the source links might lead you to a pesky paywall and the answer key is included after the blurbs (don't scroll too far before guessing).
You can select from the following sources:
- Box (BOX) CEO Aaron Levie
- Real estate investment banking firm Eastdill Secured LLC managing director, Will Silverman
- HPP CEO Victor Coleman
- BXP CEO Owen Thomas
- Morgan Stanley (MS) CEO James Gorman
...much is being written and speculated about the future use and need for office space as a result of the pandemic. Several business leaders have commented on their success and operating remotely and claimed to be reevaluating their future office space needs. Further urbanization as well as office densification have been questioned, given the imperative of spacing during a viral pandemic. Though no one including myself knows the answers to these longer term questions, it's instructive to focus on what we know today.
The biggest impact to the office market near term is recession, which as I discussed previously will adjust rent and capital value. Low interest rates definitely help. Second, our customers with dense layouts… are removing workstation and will return to work in a less dense environment. Some of these users will have a portion of their workforce continue to work remotely and some will require more space.
Third, modern healthy and well-managed building with state-of-the-art health security will be at a premium like never before.
You strip out a commute and you strip out having to get on an airplane for business meetings and you kind of remove a lot of these other things that crept into the work that you had to do.
I mean, if you'd said three months ago that 90% of our employees will be working from home and the firm would be functioning fine, I'd say that is a test I'm not prepared to take because the downside of being wrong on that is massive.
One of the most important aspects of American business over the last couple of decades has been the establishment of firmwide cultures-the idea that having the right firmwide culture can make your company successful. I just don't know how you establish a culture among people who are only together a few days a week.
Our team has been reached out by virtually every production company saying we need office space and we need studio space. The demand for production right now is at the height-this is effectively like it's a strike. And so, writers are writing. They're doing virtual table reads. They can't wait to start filming.
They've already come out and said - Amazon (AMZN) said, all their domestic filming is moving into Los Angeles. Netflix (NFLX) is saying all of their location shoots are now going to move to studio shoots. They're going from three to four days a week, trying to get the unions to approve and SAG to approve seven days a week filming.
The demand is going to be voracious.
Emphasis added in all cases.
- Blurb #1 - BXP CEO Owen Thomas
- Blurb #2 - Box CEO Aaron Levie
- Blurb #3 - Morgan Stanley CEO James Gorman
- Blurb #4 - Eastdill Secured LLC managing director, Will Silverman
- Blurb #5 - HPP CEO Victor Coleman
Office REITs Can't Resist This Trend
As is often the case, sentiment and predictions on how things will shake out vary based on who you talk to. Certainly, we can all agree that, as BXP's Thomas says, no one has the answers to these longer-term questions (right now).
While this is true, what we're seeing is all too familiar. It's the age-old epidemic of old school stakeholders saying things they want to be true. They say them even in the face of plausible alternative realities presented by forward-looking tech workers. Instead of truly grasping these potential realities they effectively attempt to wish them away.
The executives with a vested interest in keeping downtown real estate alive and kicking say things like:
- How can you build culture remotely?
- Let's focus on what we know today.
If you're long office REITs, these types of statements should be red flags. They're tantamount to putting your head in the sand. As a reminder, these are some of the most talented executives in the sector.
This response reminds me of terrestrial radio and broadcast television's response to the threats posed by Napster, Spotify (SPOT), Pandora (SIRI), YouTube, and Netflix back in the day. We don't have to review the history. If you were alive around the turn of the century, you remember the feeble reaction from the old guard as new technologies prepared to take over audio and visual entertainment. It was no different in retail with brick and mortar entities (who are literally going bankrupt now) doing absolutely nothing in response to Amazon. Physical retail could have responded from what was a position of strength, taking the threat seriously. But it didn't.
I hope that's not what's happening among office REITs and their supporters, but it sure smells like it.
The idea that you can't create culture with people working remotely full time or part time is absurd. It shows a lack of understanding and appreciation for the way people in tech - many of whom are in the millennial generation - function in the day-to-day.
It also ignores the words of tech executives who have made it clear that they will not abandon face-to-face interaction. Instead, they tweak how they foster it. They'll make it sync with remote work lifestyles. They'll make it fun and spontaneous just as they did with over-the-top cafeterias, ping pong tables, and other amenities when tech positioned extravagant offices as the focal point of work.
In other words, tech will adapt and pivot, as it always does. Will office REITs and their stakeholders stand idle?
Consider this thought from Joseph Flaherty, a director at the VC firm Founder Collective, in a recent Buzzfeed article:
Flaherty tweeted that local governments outside of the Bay Area might take advantage of tech workers' newfound ability to work from anywhere: "If I were a mayor of an up and coming, mid-sized city I'd offer $500K housing credits to the top 10 VPs at Twitter," he said. "If Twitter is just the first domino, imagine the power of being able to kickstart a regional talent hub?"
Note: In my opinion, there are massive ethical issues with a local government offering incentives to VPs, rather than to a company. I would consider this bribery.
This is in response to the very real notion that tech workers might abandon the San Francisco Bay Area to work remotely in less expensive but still culturally-relevant cities. We will discuss the concept in more detail in an update on housing. There's research on both sides of the issue. We still find several attractive valuations among the housing REITs. However, we want to focus on the office REIT impacts in this article.
Office REITs shouldn't be deriding the idea of creating culture in remote work environments or focusing only on what we know today. Instead, they may want to be on the phone with government officials in cities from Spokane to Salt Lake City, from Denver to Minneapolis, and from Detroit to Buffalo.
They might ask:
- How can we partner to gobble up your relatively cheap office space?
- How can we make it attractive to tech workers and companies?
- How can we incentivize them to move to your city, if they flee soon-to-be former and still very expensive hubs such as San Francisco?
- Can we create a whole bunch of WeWorks that actually work?
- How can we encourage tech workers to buy a home in a city where they can actually afford one?
- How can we thrive in a world where digital nomad isn't simply a thing a millennial calls him or herself on Instagram?
Alternatively, the office REITs may be best served by selling assets and reducing debt to shrink leverage. I'm not convinced that office space in lower-cost cities will perform better. The office landlords may take a substantial hit to rental rates, which reduces the incentives for a tenant to move. Telecommuting already has reduced traffic (at least temporarily reduced), making the major cities even more appealing for those with sufficient income.
Will companies really offer the same level of pay to workers who choose to telecommute from lower-cost cities? What forces the employer to offer those wages? Many employers have a "cost of living" adjustment. If someone isn't going to live in San Francisco, why would the employer continue to offer the same pay? If employers are genuinely interested in the welfare of their employees in 2020, that would be front-page news. I see employers offering to let workers continue telecommuting because it serves three purposes:
- Retain any members of the work-from-home crowd the company values.
- Save money on office space by renting less of it.
- Save money on labor expenses by eventually recruiting at lower wages and potentially reclassifying roles as "independent contractors" to eliminate benefits.
When the worker is not physically on ground owned or rented by the company and not using assets owned by the company, it's much easier to classify them as independent contractors.
In this scenario, owning office space in smaller cities won't protect the landlord. The only path to "safety" would be a dramatic reduction in debt.
The market has become quite concerned about office REITs, as demonstrated by many trading at substantial discounts to NAV:
|(ARE)||Alexandria Real Estate Equities Inc||0.89|
|(BXP)||Boston Properties, Inc.||0.55|
|(CUZ)||Cousins Properties Inc||0.69|
|(DEI)||Douglas Emmett, Inc.||0.65|
|(ESRT)||Empire State Realty Trust Inc||0.41|
|(HIW)||Highwoods Properties Inc||0.7|
|(BDN)||Brandywine Realty Trust||0.52|
|(OFC)||Corporate Office Properties Trust||0.75|
|(PDM)||Piedmont Office Realty Trust, Inc.||0.63|
|(PGRE)||Paramount Group Inc||0.38|
|(SLG)||SL Green Realty Corp||0.38|
|(CIO)||City Office REIT Inc||0.61|
|(CLI)||Mack Cali Realty Corp||0.56|
|(CXP)||Columbia Property Trust||0.47|
|(DEA)||Easterly Government Properties Inc||1.27|
|(FSP)||Franklin Street Properties Corp.||0.59|
|(HPP)||Hudson Pacific Properties Inc||0.48|
|(KRC)||Kilroy Realty Corp||0.65|
In chart format:
Source: The REIT Forum
One of the most effective things an equity REIT can do when it trades at a large discount to NAV is:
- Sell assets (at market value)
- Reduce debts
- If the price remains low, continue selling assets and mix debt reduction with buybacks
This is a good time to highlight two office REITs where we believe leverage is too high: CIO and FSP. While both trade at substantial discounts to NAV, they trade at smaller discounts to gross asset values. If office values across the country plunged, higher leverage would be devastating. We've checked consensus NAV estimates and they have hardly changed throughout the sector. In essence, analysts are not significantly reducing the value they apply to the real estate - yet. We believe that could happen over the next few quarters and the leveraged impact of declining asset values could be a disaster. When the market puts BXP and HPP at large discounts (essentially predicting a large drop in asset values), CIO and FSP are incredibly dangerous.
Since equity REITs aren't hedging the value of their assets, higher leverage can result in dramatically faster plunges in asset values. Examples from another sector include CBL Properties (CBL), Washington Prime Group (WPG), and PREIT (PEI). Each had significantly too much leverage and the drop in asset values created a leveraged drop in net asset value.
Don't Rely Too Heavily on FFO
Some investors will argue that FFO multiples are very low. That's very true. However, we would caution investors about putting too much emphasis on "FFO" for office REITs. Due to high capitalized expenditures, the office REITs may have far less cash available for dividends than investors think. The following chart contrasts the dividend rate, the "Recurring FFO" and the "Analyst AFFO":
Source: The REIT Forum with data from REITbase.com
The "Analyst AFFO" metric is designed to strip out all recurring capital expenditures related to keeping the portfolio appealing to tenants. You may notice that it eats a very large portion of the total "Recurring FFO" per share.
We put together some simplified charts and descriptions to help investors understand the difference in those terms. It helps us communicate if we have the same definitions. Consequently, we put together charts to help investors understand several equity REIT terms:
Source: The REIT Forum
Note: Our definitions and calculations shown here are simplified. We've eliminated tiny adjustments that are usually immaterial.
You'll see Analyst AFFO is near the very bottom of the chart. If we want to start from revenue, it takes quite a while to get there. You don't need to memorize this table, but it could help you as a REIT investor.
Each line provides the formula to reach the value listed on the right. You'll notice that "Normalized FFO" and "Standard AFFO" are the same. This is the value that most management teams report as "AFFO." However, we also have "Analyst AFFO" which adjusts for recurring capitalized expenses.
Note: To be even more precise, there are a handful of other non-cash adjustments going into Analyst AFFO. However, in most cases, the other non-cash adjustments have a fairly small cumulative impact. We didn't think it was worth adding several other boxes to represent a very small adjustment.
The next two tables dive deeper into the definitions:
Source: The REIT Forum
For office REITs, the values for Normalized FFO and Analyst AFFO should be quite different. Capitalized expenditures can be quite high, so the value for "FFO per share" can materially overstate the amount available for shareholders.
The New Classes Of Digital Nomads
Maybe the millennial idea of being a digital nomad isn't going to be so millennial - in spirit and practice - after all.
Digital nomads work, often in tech and related industries, but they don't have a fixed location. Some have a home base, but they get work done from all over the world. It's a way to see the world, build a career, and make money at the same time. Digital nomads traverse the globe living and working in the world's coolest and most hip places from Los Angeles to Lisbon and San Francisco to Stockholm.
As it's defined today, you have to be single and without kids to be a digital nomad. Or you need a very understanding spouse and family. But what if different degrees of digital nomad emerge in the new normal?
You might have the full-fledged or closer to part-time digital nomad as we know them today. Going forward, you might have groups of white-collar workers who take more working vacations. Maybe they want to see how it would feel to live in, say, Boise, Idaho, for two weeks. Trying out a new city or going to a central location for a company retreat takes the place of what used to be business travel from one huge downtown to another.
There are a million ways, shapes, and forms this could develop, but the bottom line is office REITs need to visualize the possibilities as much as, if not more than, the tech companies who have and will continue to call the shots for the foreseeable future. Like it or not, tech companies will ultimately dictate the direction office REITs (and other industries) must take. Will office REITs go kicking and screaming or will they actually help lead the way?
Resting on the laurels of a long-term, airtight lease is a band-aid and somewhat arrogant approach to change. It might help keep your business afloat for the time being, but it's akin to the short-sighted approaches that sunk radio, television, and brick and mortar retail when tech came to change their worlds.
Los Angeles Better Off Than San Francisco?
In blurb #5, HPP's Coleman made a valid point about the health of his REIT's studio business. HPP owns more than 15.7 million square feet of office space throughout Los Angeles (including Hollywood, Santa Monica, and parts of Los Angeles's cores), San Francisco (The City, The Peninsula, and Silicon Valley), and Seattle (with a building in Vancouver, British Columbia as well), but it also owns and operates three very important studios in Hollywood (Sunset-Bronson, Sunset-Gower, and Sunset-Las Palmas). These three studios account for:
1.2 million square feet of facilities;
41 acres of space; and
roughly 800,000 square feet of development rights.
Coleman chose to focus on the studio business on his company's recent earnings call (see blurb No. 5). And it does make sense. Netflix, Amazon, and others want to get back to creating content. As they do this, they'll likely utilize studio shoots over location shoots for a while. So HPP may hold steady or see a boost to its studio revenue. This might put Los Angeles in a slightly-to-much better position than San Francisco.
That said, if you look at the bigger picture, studio revenue makes up a tiny fraction of the company's total revenue, which it divides between office and studio. Have a look at the numbers for yourself from HPP's most recent quarterly report:
The studio business accounts for $19,800,000 in revenue, down 8% from the same quarter last year. As a whole, HPP's studio segment represents just 9.6% of total revenue, as of the most recent quarter. Hardly something to hang your hat on. And there's a very real possibility that decreases in office revenue will offset (or worse) the anticipated increase for studio business.
All of this to say, there's a bright spot for HPP. That's what HPP, using BXP's words, can safely say it "knows today." But going on what you know today isn't enough. Listening to what your clients are saying - not merely to you - but in the press via their chief executives and employees matters now more than ever. Not only so you can better serve them, but so you can innovate on your own accord before they leave you in the dust without an innovative and visionary plan.
The last thing you want if you're a BXP or HPP shareholder is to watch either REIT cling to the status quo and let tech companies, solely, dictate the terms of what the future holds for them. Now is the time to embrace new ways of thinking, being, and organizing your business, even if it's uncomfortable and bears little or no resemblance to what you have always done.
Ratings: Bearish on FSP and CIO
This article was written by
You’ll find several reports on The REIT Forum that don’t get posted to the public side of Seeking Alpha. Many of our public reports are dramatically reduced versions of subscriber articles. If you enjoy our public articles, you’ll love the content we keep for subscribers.
Analyst’s 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.
If I was long any office REITs, that would be a pretty funny disclosure. We're favoring industrial/housing as an alternative to office.
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