(Hoya Capital Real Estate, Co-Produced with Colorado WMF)
The future of work is here, and nearly everyone besides office landlords are quite content about it. For office REITs, the "new normal" of hybrid work environments brings new challenges, but also new opportunities as expectations and valuations have been reset sharply lower. A "new normal" on several levels, office REITs - which historically traded at persistent premiums to their REIT peers - have become relative "value plays" in the post-pandemic era while dividend yields have swelled. Within the Hoya Capital Office REIT Index, we track the 26 office REITs, which account for roughly $100 billion in market value and comprise 6-10% of the market-cap-weighted REIT Indexes.
Eighteen months after "two weeks to slow the spread," office utilization rates have recovered only a fraction of pre-COVID levels, particularly in dense coastal markets with longer and more transit-heavy commutes. According to recent data from Kastle Systems, office utilization levels have barely budged over the last year in the largest U.S. cities and showed only modest improvement following the long-anticipated "return to school" in early September. The "shutdown cities" - New York City, Chicago, Washington DC, and San Francisco - have been hit especially hard with office usage rates still below 35% in all of these cities as technology suites including Zoom (ZM), Slack (WORK), Google (GOOG) (GOOGL), Microsoft (MSFT), and Amazon (AMZN) have emerged as an unexpected competitive threat to the traditional office model.
For many employees and 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 it's market forces rather than discrete decisions driving the shift. Fresh data from Hogan Assessments found that more than 80% of employees look for employers to offer remote work at least two days per week while nearly 90% reported that they are at-least as productive at home as they are in a traditional office setting. A similar survey published by Stanford University economists showed that nearly two-thirds of employees would accept a pay cut to continue to work from home for at least 2-3 days per week, while another survey found that employees would turn down a $30,000 pay increase in order to keep working from home indefinitely.
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. However, perhaps equally as important as it relates to the long-term outlook for office REITs, a consistently small share of employees want to do away with the office entirely - averaging 10-20% across most surveys. In the recent Hogan survey, employees cited challenges with collaboration (36%), distractions at home (25%), and difficulty with motivation (16%) as the top challenges of the fully-remote environment.
While we see Work-From-Home headwinds persisting in this "New Normal," the office REIT outlook has brightened in recent months - particularly those focused on more business-friendly Sunbelt regions - following solid earnings results and favorable private-market pricing. As discussed in our REIT Earnings Recap, led by strong results from Sunbelt-focused REITs, rents and leasing volumes exhibited a positive inflection in Q2 as 7 office REITs boosted their full-year FFO outlook. Fundamentals in many Sunbelt markets are as-strong or stronger than pre-pandemic conditions while in urban metros, robust demand for life-sciences space and from mega-cap technology companies has partially offset soft demand from financial services firms.
Consistent with office REIT leasing trends, Jones Lang LaSalle (JLL) noted in their recent Office Outlook, "The U.S. office market is stabilizing and slowly capitalizing on the macroeconomic recovery. Although subdued by delayed office re-entry and uncertain long-term space planning, leasing improved meaningfully for the first time since the onset of the pandemic, while occupancy losses slowed and many tenants elected to withdraw space previously placed on the sublease market." Per JLL, gross leasing activity rose by 28.7% over the quarter to 34.7 million square feet in Q2, the first time that it has surpassed 30 million square feet since on the onset of COVID-19.
So while the office isn't going away entirely, hybrid work environments - which will typically result in less office space per employee - are increasingly standard and we continue to believe that COVID-19 has simply accelerated - rather than temporarily altered - the pre-existing trends of increased workplace efficiency and technological disruption. 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.
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.
Despite the better-than-expected quarter of earnings results for office REITs, the "fourth wave" of the coronavirus pandemic - and the resulting delayed return-to-the-office plans announced by several major corporations - has pressured office REITs in recent months. Sliding about 10% over the past quarter, office REITs are now higher by 14.8% so far in 2021, lagging the 23.4% returns from the market-cap-weighted Vanguard Real Estate ETF (VNQ) and the 18.7% returns from the S&P 500 ETF (SPY).
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.
Diving deeper into the performance of these individual REITs, we note that all but five office REITs are in positive-territory this year while seven office REITs are higher by at least 20%, 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 more significantly. Interestingly, small-cap CIM Commercial (CMCT) has dipped this year after being the lone office REIT with positive total returns in 2020.
Small-cap City Office (CIO) has nearly doubled this year after a large asset sale of its entire Sorrento Mesa portfolio which suggested that CIO - along with the majority of office REITs - are trading at substantial discounts to their private-market-implied Net Asset Value. Consistent with that theme, Columbia Property Trust (CXP) has gained over 30% this year after announcing that it has agreed to be acquired by funds managed by PIMCO at a healthy premium. Importantly, these transactions underscore our belief that opportunities for value-creation are plentiful for executive teams and REIT Boards that put shareholders first and we think that investors would benefit from a long-overdue wave of office REIT M&A and consolidation.
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 throughout the pandemic, hold portfolios concentrated in the Sunbelt regions and/or in secondary markets. We continue to see 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.
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.
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 - have removed 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.
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 bounced back into positive territory in Q2 with 3.3% growth, however this was still shy of the nearly 6% average same-store growth across the REIT sector.
Power to the tenants. More than other REIT sectors, office REITs have a relatively small roster of tenants, and given the ongoing supply overhang from the combination of weak demand and continued supply growth, we project that most landlords will have soft 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, but bounced back slightly last quarter. 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."
The supply dynamic hasn't helped, either, as construction spending on office development ramped up after the 2016 elections, spurred by the passage of corporate tax reform and strong job growth of key office-using sectors. The office pipeline increased to a new cycle-high in late 2019 right before the start of the pandemic, and after a slight pullback during the pandemic, the office REIT pipeline is yet again at fresh record highs. According to NAREIT T-Tracker data, the office development pipeline stands at $15.53 billion, up sharply from the 2012 level of $2 billion, representing 15% of office REIT market value which is by far the highest relative pipeline in the REIT sector.
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. As noted above, private market pricing has remained notably firm in recent quarters, underscored by several major transactions including Google's $2.1 billion deal to buy a Manhattan office building, consistent with recent data from CBRE (CBRE) which showed that cap rates have "remained stable or compressed across most of the top 25 markets" since the start of the pandemic.
Office REITs - which traded at premium multiples throughout the post-GFC period - have become relative "value plays" in the post-pandemic period, trading at similar valuations as retail REITs. Private market pricing suggests that office REITs currently trade at a 20-30% discount to Net Asset Value ("NAV"), the widest NAV discount in the REIT sector. Unlike other heavily-discounted REIT sectors like prisons and malls, there is an active transactions market for office assets, indicating that many office REITs can and should be seeking opportunities to create shareholder value through asset sales.
While the growth outlook remains muted, office REIT dividend yields have swelled this year amid this post-pandemic pullback and as nine REITs have boosted their payout in 2021 and current payout ratios suggest that these distribution levels are quite sustainable, as a whole. Office REITs now rank toward the top of the REIT sector, paying an average yield of 3.73% compared to the market-cap-weighted REIT sector average of 2.80%.
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. There is a wide range of dividend distribution strategies employed by the twenty-six REITs within the sector, with yields ranging from 8.58% from Office Properties (OPI) to a low of 0% from Equity Commonwealth (EQC) and Mack-Cali (CLI).
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.PL, VNO.PM, VNO.PN, and VNO.PO), 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.
The future of work is here, and nearly everyone besides office landlords are quite content. For office REITs, the "new normal" of hybrid work environments brings both new challenges and opportunities. Eighteen months after "two weeks to slow the spread," office utilization rates have recovered only a fraction of pre-COVID levels, particularly in dense coastal markets with longer and more transit-heavy commutes. Surveys suggest that it's market forces rather than discrete decisions driving the shift, underscored by data showing that workers would rather have a pay cut than give up WFH privileges.
A "new normal" on several levels, office REITs - which historically traded at persistent premiums - have become relative "value plays" in the post-pandemic period, while dividend yields have swelled. Trading at steep discounts to private-market-implied pricing based on recent comparable transactions, investors would benefit from a long-overdue wave of consolidations and asset sales to capture these value-creation opportunities. While WFH headwinds will persist, the office REIT outlook has brightened in recent months - particularly those focused on more business-friendly Sunbelt regions - following solid earnings results and favorable private-market pricing.
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