Office REITs: No Going Back

Summary

  • Vaccines are here, masks are off, and sports stadiums are full. Office desks around the country remain eerily empty, however, as office utilization rates remain a fraction of pre-COVID levels.
  • For many corporations, there's no going back - at least not to pre-COVID norms. Survey data revealed that office workers would accept pay cuts before returning to the 5-day in-person workweek.
  • While the office isn't going away entirely, hybrid work environments - which require less office space - are increasingly standard. Office market rents have plunged 10-20% as vacancy rates soar.
  • The permanence of WFH trends and the ultimate recovery in office demand will be uneven across regions. Commute times and cost-of-living factors are playing a major role in determining which markets recover faster.
  • Earnings reports confirmed that leasing demand remains depressed with no clear inflection yet, particularly in the dense transit-heavy office markets like New York and San Francisco, which are expected to struggle in the "new normal."
  • This idea was discussed in more depth with members of my private investing community, The REIT Forum. Learn More »

Black stay at home father working on laptop while his kids are demanding his attention.
Drazen Zigic/iStock via Getty Images

REIT Rankings: Office

office REITs

(Hoya Capital Real Estate, Co-Produced with Colorado Wealth Management)

Office REIT Sector Overview

Vaccines are here, masks are off, and sports stadiums are full. Office desks around the country remain eerily empty, however, as office utilization rates remain a fraction of pre-COVID levels with coastal cities facing a particularly slow recovery. The "reopening rotation" has boosted many of the urban office REITs to double-digit percentage gains this year despite weak quarterly results and a muted outlook. Within the Hoya Capital Office REIT Index, we track the 26 office REITs, which account for roughly $10 billion in market value. Office REITs comprise roughly 10% of the broad-based "Core" Equity REIT ETFs.

office REITs 2021

For many corporations, there's no going back - at least not to the pre-COVID norms of a traditional 5-day in-person workweek and evidence suggests that its market forces rather than discrete decisions driving the shift. A recent survey published by Stanford University economists showed that nearly two-thirds of employees would accept a pay reduction to continue to work from home for at least 2-3 days per week. Another recent survey from Blind was able to put a precise dollar figure on the value of WFH, finding that 64% of employees with some of America's biggest companies would turn down a $30,000 pay increase in order to keep working from home indefinitely.

WFH pay cuts 2021

The finding that two-thirds of employees place significant value in working-from-home is remarkably consistent across many similar surveys including from KPMG, which found that only a third of workers wanted to see a return to the five-day in-person work week. Work-from-home isn't just popular among employees. A recent PWC survey showed that the opinion of remote work by employers has actually increased since early in the pandemic as 83% of executives now say the shift to remote work has been successful for their company. While the office isn't going away entirely, hybrid work environments - which require less office space - are increasingly standard. Fewer than one in five executives say they want to return to the office as it was pre-pandemic.

permanent wfh

While it's perhaps easy to discount survey data, the on-the-ground fundamentals confirm the stiff resistance facing the return to the office. According to data from Kastle Systems, office utilization levels have barely budged over the last nine months in the largest U.S. cities. The "shutdown cities" - New York City, Chicago, Washington DC, and San Francisco - have been hit especially hard with office usage rates still below 25% in all of these cities as technology suites including Zoom (ZM), Slack (WORK), Google (GOOG), Microsoft (MSFT), and Amazon (AMZN) have emerged as an unexpected competitive threat to the traditional office model.

office usage 2021

As discussed in our Real Estate Earnings Recap, first-quarter earnings reports from office REITs confirmed that leasing demand remains depressed with no clear inflection yet, particularly in these dense transit-heavy office markets. While many other COVID-sensitive sectors are seeing a bounce-back in activity this year, office leasing volumes remain depressed while deals that are getting done are being signed at leasing spreads that imply a 10-20% decline in market rents relative to pre-COVID levels. Meanwhile, occupancy rates across the office sector continued to decline sharply in Q1 - a trend that we expect to accelerate and eventually flirt with the prior lows from the early 2010s.

office reit leasing

As discussed last quarter, we believe that the permanence of WFH trends and the ultimate recovery in office demand will be uneven across metros, but patterns won't necessarily follow the standard urban vs. suburban dynamic. Instead, one overlooked factor determining how fast - and to what extent - employees return is employee commute times. Data from the American Community Survey show that over the course of a 5-day work week, remote work employees in cities with particularly brutal commutes "save" an average of 6 hours per week and a hundred dollars in transportation costs. Stanford University researchers estimated that the aggregate time savings associated with the pandemic-induced shift to WFH totals more than 9 billion hours.

commute times 2021

The office sector is typically segmented into two categories. Urban CBD ("Central Business District") REITs hold portfolios that are concentrated in the six largest U.S. cities: New York City, Chicago, Boston, Los Angeles, San Francisco, and Washington, D.C., a segment that has been hit especially hard by the pandemic. Secondary/ Suburban REITs, which have generally outperformed in 2020, hold portfolios concentrated in the Sunbelt regions and/or in secondary markets. While we maintain a cautious sector-level outlook on office REITs due to structural headwinds, we see pockets of value in Sunbelt and suburban-focused REITs as well as office REITs that cater more to "non-corporate" tenants that are less impacted by WFH headwinds.

office REITs 101

Office REITs Stock Price Performance

Despite the downbeat quarter of earnings results for office REITs, the vaccine-driven "reopening rotation" across the REIT sector has powered a rebound for many of the hardest-hit REITs from last year, including many of the urban-focused office REITs. Office REITs have gained 25.7% so far in 2021, outpacing the 23.3% returns from the broad-based Vanguard Real Estate ETF (VNQ) and the 12.8% returns from the S&P 500 ETF (SPY).

office REIT stock performance 2021

Office REITs were pummeled early in the pandemic, pressured by these lingering questions over the long-term demand outlook as businesses become more comfortable with the expanded utilization of WFH arrangements. The fourth-worst performing sector last year, office REITs ended 2020 with total returns of -18.4% compared to the -8.0% total return from the FTSE Nareit Equity REITs and the 17.6% gain by the S&P 500 ETF. From 2010-2020, Office REITs delivered average compound annual total returns of 9.1%, trailing the 12.6% average returns from the broader REIT index.

office REITs 2021

Diving deeper into the performance of these individual REITs, we note that all but two office REITs are in positive-territory this year while eight office REITs are higher by at least 30%, led by many of the hardest-hit REITs from 2020. Secondary/Suburban REITs - particularly those focused on the Sunbelt region - generally delivered stronger performance last year, but trends have reversed this year with stock prices of Urban CBD REITs bouncing back.

office REIT investing

Office REIT Fundamental Performance

As noted above, this stock price rebound comes despite an earnings season that we graded a "D+" in our Real Estate Earnings Recap. Even as rent collection rates averaged over 95% throughout the pandemic, Office REITs still reported an average FFO/share decline of 13.9% for full-year 2020, by far the worst year on record, and the FFO forecast for 2021 could be similarly rough. Just 10 of the 26 office REITs are providing full-year FFO guidance, and among this group - which are generally among the stronger REITs in the sector - 7 of these REITs see a worse FFO trend this year than in 2020. Two REITs reduced FFO guidance with their Q1 results - the only two REITs across the sector that lowered their FFO guidance during the quarter.

office REITs march 2021

Office REITs were finally hitting their stride right before the pandemic powered by a seemingly unstoppable streak of job growth. The office REIT sector tends to outperform later in the economic cycle and respond more slowly to economic inflection points given the typically long-term lease structure inherent in office leases, which average 5-10 years for suburban assets and 10-20 years for CBD assets. Same-store NOI growth for office REITs averaged -3.0% in 2020, but while the REIT sector is on pace to deliver NOI growth in the 5-8% range this year, office REITs will likely be in the "basement" of the REIT sector through the end of 2021, and perhaps longer.

office REIT NOI growth 2021

Power to the tenants. More than other REIT sectors, office REITs have a relatively small roster of tenants, and given the significant supply overhang from the combination of weak demand and continued supply growth, landlords will have impaired pricing power for the foreseeable future. Occupancy rates across the office sector have declined more sharply than any other major property sector since the pandemic began. In CBRE's 2021 U.S. Real Estate Market Outlook report, the real estate brokerage firm commented that "office vacancy will persist at a stubbornly high rate and rent increases will be difficult to achieve as market conditions remain decidedly in favor of tenants."real estate occupancy

The supply dynamic hasn't helped, either, as construction spending on office development ramped up again after the 2016 elections, spurred by the passage of corporate tax reform. With the Trump-era acceleration in office development, the office pipeline increased to a new cycle-high in late 2019 right before the start of the pandemic, and supply growth has averaged more than 1.5% per year since 2017. According to NAREIT T-Tracker data, the office development pipeline stands at roughly $13.9 billion, up sharply from the 2012 level of $2 billion, representing 14% of office REIT market value which is by far the highest relative pipeline in the REIT sector.

office reit development pipeline 2021

Ground-up development has been the lone source of external growth for office REITs over the past half-decade as accretive acquisitions have been made quite difficult by the persistent valuation discounts relative to private market valuations. On the private market side, office valuations have generally remained firm with declines of only about 5-10%, on average. As the markets thaw, however, we believe that office valuation in Urban CBD markets will reset lower by 10-15% over the next half-decade, in line with the projected decline in market rents. We believe that private market valuations will be relatively slow to "reset" and see this widening NAV discount as a continued headwind for these office REITs which will make accretive external growth via acquisitions all but impossible.

office reits acquisitions

Even in the best of times, 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. This is particularly true given the ample available supply - a supply overhang that will linger for much of the next decade. 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 negative impacts.

office REIT operating profile

Additionally, it's important to note that the rapid growth of co-working - highlighted by WeWork (WE) - had been one of the more significant demand drivers over the past half-decade, responsible for almost a third of total leasing activity over the past three years. The ongoing struggles of the co-working business model - made far worse by the coronavirus pandemic and resulting recession - potentially remove a significant chunk of incremental office leasing demand. Co-working firms have always been far more "friend than foe" for office REITs, serving as an intermediary to facilitate shorter-term space rentals and create incremental demand that would not otherwise be tenants of these office REITs.

co working

Office REITs Dividend Yields

Office REITs have not traditionally been a sector known for high dividend yields, but office REITs now rank toward the top of the REIT sector, paying an average yield of 3.5% compared to the market-cap-weighted REIT sector average of 3.1%. Office REITs pay out roughly 50% of their available cash flow, towards the lower end of the REIT sector, but the sector has historically produced dividend growth that is below the REIT sector average.

dividend yield reit office

As anticipated, the pace of dividend cuts reversed across most of the REIT sector, but we believe that many office REITs that were able to "hang tough" in 2020 will face potential dividend cuts in 2021 or 2022 as market conditions continue to soften. With a 42% debt ratio, according to NAREIT, office REITs operate with leverage ratios that are above the REIT sector average of around 34%. Eight office REITs currently have debt ratios above 50%, while six REITs are above 60%, which we view as the "danger zone" for potential dividend cuts or other means of deleveraging.

office REITs balance sheets

Seven of the 26 office REITs reduced their dividend last year, but we've seen five REITs increase their distributions this year. There is a wide range of dividend distribution strategies employed by the twenty-six REITs within the sector, with yields ranging from 7.0% from Office Properties (OPI) to a low of 0% from Equity Commonwealth (EQC) and Mack-Cali (CLI).

office REIT dividend yields

Investors looking to take the "preferred route" have several options. Five of the 26 office REITs offer standard cumulative preferred securities including Vornado Realty (VNO.PK, VNO.PL, VNO.PM, VNO.PN), SL Green (SLG.PI), Equity Commonwealth (EQC.PD), Armada Hoffler (AHH.PA), and City Office (CIO.PA). Elsewhere, Office Properties Income (OPINI, OPINL) has a pair of exchange-listed "baby bonds" and CIM Commercial Trust Corp. (CMCTP) has a convertible preferred issue. On average, these securities pay a current yield of 6.02% and trade at a roughly 5% premium to par value.

office REIT preferreds

Office REIT Valuations

Reflecting the secular headwinds facing the sector, Office REITs trade at relative discounts to most other REIT sectors. Office REITs trade at a Forward Price/FFO multiple of 15.6x, which is below the REIT sector average of 22.8x. Despite the rally this year, office REITs still trade at discounts to their private-market-implied asset value, but we believe that private market valuations will be slow to "reset" and see this NAV discount as a headwind to an FFO recovery, making accretive external growth via acquisitions all but impossible.

office REIT valuations

Key Takeaways: No Going Back

For office REITs, fundamentals appear likely to weaken further over the next several quarters, and a full demand recovery to pre-pandemic levels is no guarantee. COVID-19 has simply accelerated - rather than temporarily altered - the pre-existing trends of increased workplace efficiency and technological disruption to the workplace in a magnitude not entirely unlikely the e-commerce disruption to the brick-and-mortar retail format seen throughout the 2010s. That said, Sunbelt and suburban-focused REITs share a far brighter outlook than their urban-focused peers that operate in markets with brutal transit-heavy commutes that will struggle in the "new normal."

office space per worker 2020

Evidence suggests that its market forces rather than discrete decisions driving the shift, underscored by several surveys showing that workers would rather have a pay cut than give up WFH privileges. In an increasingly tight labor market, even otherwise reluctant executives will lean heavily on WFH-related benefits to retain and attract employees. As WFH becomes the norm, the office sector's loss will continue to be the housing market's gain as households look for more living space to adapt and thrive in the new normal.

For an in-depth analysis of all real estate sectors, be sure to check out all of our quarterly reports: Apartments, Homebuilders, Manufactured Housing, Student Housing, Single-Family Rentals, Cell Towers, Casinos, Industrial, Data Center, Malls, Healthcare, Net Lease, Shopping Centers, Hotels, Billboards, Office, Storage, Timber, Prisons, Cannabis, High-Yield ETFs & CEFs, REIT Preferreds.

Disclosure: Hoya Capital Real Estate advises an Exchange-Traded Fund listed on the NYSE. In addition to any long positions listed below, Hoya Capital is long all components in the Hoya Capital Housing 100 Index. Index definitions and a complete list of holdings are available on our website.

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