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.
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.
Office space is generally classified as one of the following three grades.
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. 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. 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.
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. 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. 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. 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.
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.
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. 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. 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.
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. 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 is listed by 2007 revenues. There are 14 U.S. exchange traded REITs focusing on office properties. 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.