crystal ball 2018

Office REITs Plan to Focus on Development in 2018, and Stay Away from Acquisitions

Rising interest rates are to blame for an anticipated decrease in acquisitions by office REITs in 2018.

No one has a crystal ball that can offer a precise forecast for the office REIT market in 2018. But the sector’s insiders foresee a year ruled by property development and redevelopment rather than asset purchases.

Rising interest rates are to blame for an anticipated decrease in acquisitions by office REITs in 2018 and a greater focus on development/redevelopment projects, according to Chris Wimmer, vice president of REITs at Chicago-based Morningstar Credit Ratings LLC. Even then, Wimmer envisions a “moderation” in development and redevelopment activity by office REITs, especially in certain central business district (CBD) markets where supply is eclipsing demand.

In a November call with Wall Street analysts, Owen Thomas, CEO of Boston-based office REIT Boston Properties Inc., said the company’s “core competency” is development, with the current development pipeline totaling $3.1 billion.

In terms of asset purchases and sales, Boston Properties executives signaled less upcoming activity. Thomas cited the decreased availability of high quality assets as a factor, given that more office properties are now held by long-term institutional investors.

Michael DeMarco, CEO of Jersey City, N.J.-based REIT Mack-Cali Realty Corp., says any office acquisitions his company makes in 2018 will be “sharply tailored” to its investment criteria. For example, Jersey City will be a “big focus” for the office side of Mack-Cali’s business. “After all, it’s where we are based, and it’s the vantage point from which we observe the market,” DeMarco says.

In addition, Mack-Cali will proceed with its strategy of redeveloping suburban office properties in transit-oriented locations to equip them with urban-style amenities, DeMarco says. “Our goal there is to create a sense of energy and community, while completely overhauling and activating lobbies and other common areas.”

As office REITs like Boston Properties and Mack-Cali concentrate on development and redevelopment, the sector as a whole will also continue with asset dispositions, Wimmer predicts. Pasadena, Calif.-based office REIT Alexandria Real Estate Equities Inc., for instance, is forecasting about $400 million in asset sales this year, which is on par with its disposition levels of the past several years.

“Office REITs, as recyclers of capital, will always be disposing of older assets that are more expensive to maintain and redeploying the capital into higher quality, often newer, assets,” Wimmer says. “As long as the debt markets remain robust, especially the CMBS markets, there will be a healthy bid for these types of assets from real estate investors outside the office REIT space.”

In November, Donald Miller, president and CEO of Johns Creek, Ga.-based Piedmont Realty Trust Inc., said the REIT hadn’t identified any reasonably priced acquisition targets that fit the company’s investment model. He added, however, that some attractive acquisition opportunities were about to pop up in and around key submarkets.

“Having said that, I want to be clear that we don’t feel pressured to put money out the door. Any acquisition will be highly strategic to our business model,” Miller said. “We are comfortable paying down debt and waiting for the right opportunities and finding other uses for such capital, such as repurchasing our own stock when appropriate.”

Bobby Bowers, CFO of Piedmont, added that the REIT’s executives believe the REIT being more of a seller than a buyer “is the right thing to do at this point in the cycle.”

Of course, the recently enacted federal tax overhaul could disrupt the current cycle.

The new tax law will help dictate investment activity in the office REIT sector in 2018 and beyond, says Alex Pettee, president and portfolio manager of Norwalk, Conn.-based Hoya Capital Real Estate LLC. He expects some REITs to begin de-emphasizing coastal gateway markets—many of which are in high tax states that are set to experience diminished state and local tax deductions—and to pivot toward lower tax Sunbelt markets.

“REIT executives in the coastal markets will continue to outwardly express confidence, but I think behind the scenes they will be looking to reposition their portfolios as quickly as possible,” Pettee says.

He adds: “While I don’t envision a sudden exodus out of [coastal gateway] markets, I do believe that businesses will begin to seriously reconsider their geographical footprint during the next round of leasing negotiations, and this will affect market rents pretty quickly.”

Amazon.com’s much-anticipated decision on where it will locate its second headquarters will be the first major indication of how much the tax law’s weakening of state and local tax deductions will reshape the office landscape, Pettee notes.

“Amazon has historically gone to pretty extreme lengths to avoid taxes, and I wouldn’t be surprised to see the company choose a low tax locality that surprises many in the industry,” he says. “That may be the shockwave that really wakes everyone up to the new reality.”

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