Office REITs

Office REITs are Real estate investment trusts that own and operate office properties. Office REITs earn revenue by leasing those properties to office tenants. Many office REITs also operate office buildings owned by third parties, for which they receive a percentage of the buildings' rents called a "management fee". Like all REITs, office REITs are required to pay out 90% of their taxable income in dividends. This increases shareholder return, but it also means that most office REITs are unable to finance expansion from operating income, instead issuing equity and debt. This reliance on debt causes office REITs to be particularly sensitive to changes in interest rates. Fluctuating interest rates can impact debt service payments on variable rate debt, decrease a REITs' stock price as bonds provide greater returns, or increase the cost of issuing new debt, slowing expansion.

Companies Involved

There are fourteen publicly traded U.S. office REITs.^[1] As of May 21, 2008 The largest six U.S. office REITs accounted for 75% of the office REIT market, by market cap.^[2]

• Boston Properties (BXP): BXP owns 138 properties in just five areas of the United States: Midtown Manhattan, Boston, Washington D.C., San Francisco, and Princeton, N.J. The company operates high end class A buildings and its largest tenants are the legal and financial service Industry. BXP also owns two hotels, an industrial center, and a land bank in the Northeast with 10 million square feet of space for development.^[3] As of May 21, 2008 BXP had a market cap of $11.85B.^[4]
• Brookfield Properties (BPO): BPO develops, owns and manages U.S. commercial office properties and develops residential land. The company's commercial property portfolio consists of interests in 109 properties totaling 73 million square feet, primarily located in New York, Boston, Washington D.C., Houston, L.A. and Toronto where its buildings can lease to a tenant base of government, energy and financial companies. As of May 21, 2008 BPO had a market cap of $8.25B.^[5]
• SL Green Realty (SLG): SLG owns and leases office space to corporations in Manhattan. The company owns more than 30 New York City office properties totaling over 22 million square feet.^[6] In 2007, SL Green cemented its position as the Big Apple's largest landlord when it acquired Reckson Associates Realty Corp. The transaction added a total of 9 million square feet to its portfolio, including over 5 million square feet of suburban offices and 4 million additional square feet of prime Manhattan office space.^[7] SLG faces a particular risk from the subprime crisis. By weakening the financial sector, the heart of the New York economy, it threatens to crimp demand for office space in the company's core market. As of May 21, 2008 SLG had a market cap of $5.71B.^[8]
• Alexandria Real Estate Equities (ARE): ARE acquires, owns, operates and selectively develops life science centers. Life science centers lease space to pharmaceutical, biotechnology, medical device, and life science companies, as well as governmental agencies. These buildings contain scientific research and development laboratories in addition to standard office space. ARE owns and operates 166 properties containing approximately 1.6 million rentable square feet of rentable space.^[9] 3.33B
• Liberty Property Trust (LRY): LRY focuses on five varieties of properties, including big box warehouses, multi-tenant industrial facilities, flex/R&D buildings, and office space. As of 2006, the company owned over 65 million rentable square feet across 720 properties. Of these around 41% were offices, while 59% were industrial-use.^[10] In total, LRY owns 649 properties, 353 industrial and 296 office properties.^[11] It has properties throughout the country but in the past couple years has been pursuing a strategy of entering high growth markets like DC and Phoenix.
• Mack-Cali Realty (CLI): CLI develops, owns and manages office buildings. The firm makes money by reselling office properties that it acquires and develops. While its properties appreciate, CLI rents them to tenants to cover the financing costs of the loans used to purchase the property. CLI's holdings are concentrated in the Northeast corridor of the United States, and the company sold its remaining assets in San Francisco and Colorado in 2006 in order to focus on its core business in the Northeast. Mack-Cali's 2,000-plus clients represent over 30 industries, and its largest client makes up only 3% of its annual rent revenues. Portfolio diversity, and the relative stability of the high-end firms that rent CLI's office space, insulates the firm from swings in the business cycle. As of May 21, 2008 CLI had a market cap of $2.53B.^[12]
• Highwoods Properties (HIW): HIW owns or has management interests in office, industrial, retail, and service center properties, including development projects and apartment units. The company is both an owner operator and manages properties for third parties for management fees. The company's core markets are located in the Southeastern and the Midwestern US. As of September 30th, 2007, the company owned or had interests in 378 in-service office, industrial holdings, and retail properties, with an aggregate of 33.6 million square feet of gross leasable space. HIW also owned 662 acres of developable land. As of May 21, 2008 HIW had a market cap of $2.06B.^[13]
• Corporate Office Properties Trust (OFC) OFC develops, acquires owns and operates suburban office buildings. It specializes in leasing to multi-location tenants and industries. OFC owns 228 operating properties in Maryland, Virginia, Colorado, Texas, Pennsylvania and New Jersey containing 17.8 million rentable square feet. As of May 21, 2008 OFC had a market cap of $1.82B.^[14]
• HRPT Properties Trust (HRP): HRPT acquires, owns and manages office buildings and industrial properties. HRPT operates both security and growth properties. Security properties are properties with stabilized occupancy leased to high credit quality tenants under long term leases. Growth properties are under-performing buildings with redevelopment potential. HRPT owns and operates over 500 properties with over 50% of the companies rents coming from their top five markets (Philadelphia, Washington DC, Oahu (Hawaii), Boston, and Southern California). As of May 21, 2008 HRP had a market cap of $1.74B.^[15]
• Kilroy Realty (KRC) KRC develops owns and operates class A office buildings and industrial buildings. The firm makes money by developing properties, leasing them to tenants and selling stabilized properties at a profit. KRC leases office space to tenants in the healthcare, legal and financial services industries with its top ten tenants representing only 37% of the company's total rental revenue.^[16] KRC operates 129 properties (86 office and 43 industrial buildings) all in Southern California, primarily in Los Angeles County, Orange County and San Diego County. These are high growth areas and high land costs and form a barrier to entry for competitors. As of May 21, 2008 KRC had a market cap of $1.73B.^[17]
• Brandywine Realty Trust (BDN): BDN is a diversified office and industrial real estate investment trust. The company develops and operates commercial properties in the largely suburban areas of western and northern Pennsylvania, New Jersey, California, Virginia, and Texas. BDN received almost all of its California, Virginia and Texas properties when it acquired Prentiss Properties Trust in 2006. As of 2006, Brandywine operated a total of 28.2 million square feet across its 284 office and industrial properties.^[18] As of May 21, 2008 BDN had a market cap of $1.67B.^[19]

As of May 21, 2008 the following office REITs had market cap at or below $1.0B.

Cole REIT: Cole, a non-traded REIT, invests primarily in income-producing, single-tenant commercial real estate leased to high-quality, creditworthy tenants under long-term, net leases. They are also conservative to moderate in their use of financing. Cole currently owns and manages more than 1,100 properties valued at nearly $7 billion. This information is current as of February 2011.

^[20]

• Franklin Street Properties (FSP)
• Maguire Properties (MPG)
• Parkway Properties (PKY)

Industry Overview

Office space is generally classified as one of the following three grades.

1. Class A Office Buildings: Typically around 150,00 square feet these are buildings with excellent location and access, in city centers or other very prestigious and desirable locations.^[21] The buildings are top quality and are managed by professionals. In practical terms, the buildings you see in the city centers of major metropolitan areas like New York, San Francisco or Washington D.C. with large, expensive lobby's and lots of brass and glass fixtures are class A office buildings. These buildings typically have rents in line with newly constructed office buildings.^[22]
2. Class B Office Buildings: These are buildings with good locations, either just outside the city center or in desirable suburban markets. They are usually older, wood framed office buildings with no functional obsolescence or former Class A office buildings that due to age and wear can no longer command the same rents. Class B office usually also lack covered parking.^[23] Wood framed office buildings are usually three stories or less.^[24]
3. Class C Office Buildings: Class C office buildings are typically 15-25 year old buildings that continue to maintain steady occupancy. They are primarily located in areas outside a city's central business district or in less desirable suburban markets. Many Class C office buildings are not actually dedicated office buildings, but spaces above retail stores or service businesses the owner has converted into office space.^[25]

Though most office REITs occupy properties that can be classified by the list above, there are exceptions. For example Alexandria Real Estate Equities (ARE) owns and operates life science centers. These are office buildings for scientific and pharmaceutical companies that contain lab space and research facilities in addition to standard office space.

Office REITs are particularly sensitive to changes in the U.S. economy because they lease space to other companies. During economic boom times, many companies grow and expand, increasing the demand for office space. During economic contractions many companies cut down operations to save money, decreasing the demand for office space. This has been a particularly relevant issue as the U.S. economy began to slump in 2008.^[26] In April the U.S. labor department released a report estimating that the U.S. had cut jobs by 232,000 in the first three months of 2008, the first time the economy had lost jobs three times in a row since 2003.^[27] One of the areas hardest hit by the slump has been the financial sector. Office REITs like Boston Properties (BXP) that lease a high percentage of space to the financial services industry or that operate in financial centers like New York or San Francisco are likely to see a lowered demand for their properties.

A struggling economy can also impact firms’ decisions about what type of buildings to locate in. During a recession many companies attempt to conserve cash by moving to less expensive office space. This is especially true for companies with low amounts of client interaction. Financial services and legal companies are likely to locate in high profile buildings even during economic downturns, conserving cash by leasing less space or negotiating lower rates. However, companies in the technology or internet industry, engineering firms or energy companies have less of an incentive to locate in top quality buildings.

Trends and Forces

Demand for Office Properties Lags Behind Changes in the U.S. Economy

The demand for office space is closely tied with the performance of the economy. During a boom economy employment rises and firms expand, leasing more square footage in higher quality buildings. Similarly, during economic contractions when employment falls companies no longer need as much office space and so cut back on the amount of space leased. The effect can take some time to have an effect on an office REIT's rents however, as leases typically last for several years before they can be renegotiated. This poses a significant risk for office REITs as the U.S. economy has been entering a recession in 2008.^[28] In April the U.S. labor department released a report estimating that the U.S. had cut jobs by 232,000 in the first three months of 2008, the first time the economy had lost jobs three times in a row since 2003.^[29] This is particularly bad for office REITs with short lease terms, or those that have a large percentage of leases coming due in 2008 or 2009.^[30] It is likely that when those leases expire, fewer companies will choose to release, increasing vacancy, and those that do release will do so at lower rates, decreasing revenues. If firms do lease for lower rates the effect will last over the entire life of the lease, lowering the REITs revenues for the next several years.

Changes in Interest Rates Affect an Office REIT's Income and Stock Price

In order to expand operations, office REITs must increase the size of their portfolio through acquisition or development. Because REITs must pay out 90% of their taxable income in dividends, most REITs finance expansion with debt, exposing the company to interest rate risk. For example, most property developers finance development using short term variable rate loans, and when a project reaches stabilization refinances to a low, fixed rate mortgage. Increasing interest rates increase the REITs debt service payments on its variable rate loans, decreasing net income. They also increase the rate at which the REIT must issue new variable or fixed rate debt. In the case of fixed rate debt, high interest rates when the debt is issued leads to large debt service payments over the life of the loan. Interest rate fluctuations also affect a REITs stock price. Because of government regulation that requires REITs to pay out 90% of their taxable income as dividends, most retail REITs pay out large and stable dividends. These consistent dividends mimic bond coupon payments. As interest rates rise, bonds provide a greater Return on investment (ROI) relative to a REITs stock. Since investors are able to earn a higher risk-adjusted return on fixed income instruments, they shift their investment out of REIT stock and into bonds. When the number of people wishing to hold a REIT's stock decreases, the stock price falls.

Rising Construction Costs Are Increasing the Price of Developing Properties, Lowering Developers Return on investment (ROI)

Construction prices in the U.S. have grown dramatically in the past three and a half years, rising an average of 3-5% each year and far outstripping inflation.^[31] A depressed dollar and the rising cost of fuel both contribute to increase the price of imported construction materials while a declining pool of specialized construction workers has led to a sharp 4.7% increase in wages from July 2006 to July 2007.^[32] Rising construction costs decrease an office REIT's return on its development projects. They also slow the company's growth and increase their expenses on existing projects. This decreases earnings, leading to a potential decrease in company stock price. One benefit of high construction costs to many REITs is that it leads to decreased new supply. When construction costs rise developers cut back expansion as they are unable to earn as high of a return on their projects. This is beneficial as too many new office buildings can lead to over-supply, increasing vacancy and lowering rental rates in a market. Increasing construction costs can also increase the sale price of office buildings as it becomes cheaper for property owners to acquire existing buildings rather than develop new ones.

A Credit Crunch Makes it Difficult for Office REITs to Fund Expansion

REITs are required to pay out 90% of their taxable income in dividends. This requirement makes it unlikely they can fund all their growth from operating income. To finance growth the companies also rely on debt or equity capital. If these companies are unable to obtain financing at favorable rates, they will not be able to fund expansion. REITs also face the risk they will be unable to refinance maturing debt. For example Kilroy Realty (KRC) has $34% of its maturing in or before 2010.^[33] If KRC is unable to refinance maturing debt, it will be forced to issue equity or enter joint ventures at unfavorable terms, diluting stockholders interest in the company. This would harm shareholders by requiring all future cash flows to be paid out among a larger pool of investors. Alternatively the company will be forced to sell assets at unfavorable terms. This would lose value for investors, as KRC will fail to realize the full economic potential of these assets. If the company is unable to issue more equity, and is unable to sell properties due to the Credit Crunch it will find itself insolvent as it will be unable to meet debt obligations.

Market Share

Market share is listed by 2007 revenues.^[34] There are 14 U.S. exchange traded REITs focusing on office properties.^[35] Of those, the top three Boston Properties (BXP), Brookfield Properties (BPO) and SL Green Realty (SLG) accounted for just over half of Market Share by 2007 revenues.