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Capital Crunch

The move by Equity Office Properties (EOP) to chop its 2006 dividend by 34% generated little shock among REIT observers since the nation's largest office landlord has not covered its dividend through cash flow since 2002. Even so, the reduction poses a broader question for large office landlords: As properties routinely sell at record prices, can owners achieve rent increases to cover rising costs and dividend commitments this year?

A REIT cash flow analysis by Boston-based Property & Portfolio Research (PPR) suggests that EOP won't be alone in its struggle to generate sufficient net operating income to cover its costs. While national vacancy rates have modestly improved, only in powerhouse markets like Manhattan and Los Angeles are landlords demanding — and achieving — rent increases above the inflation rate.

The coastal markets tell a different story than much of the nation, according to PPR analyst Hans Nordby. Since most office tenants sign five-year leases, many landlords will see their 1999 and 2000 leases expire this year.

“Many office landlords are signing new tenants at lower lease rates today,” says Nordby. Nationwide, office rents increased by 0.5% in 2005. PPR expects rents to grow by 4.3% in 2006, and 5.1% in 2007. The increase is due to tight coastal markets like Manhattan, where vacancy is at about 10%.

Five years ago, the lease rates were much stronger than they are today, says Bob Bach, national director of market research at Oakbrook, Ill.-based Grubb & Ellis. He believes that the Midwest will lag the broader recovery as auto industry layoffs and coastal migration patterns ripple through the markets. As a result, coastal properties are in great demand. Last year, in fact, EOP spent $505 million to buy the midtown Manhattan Verizon Building.

Prudential Equity Group analysts expect earnings growth at Indianapolis-based Duke Realty, with its heavy concentration of Midwestern office properties, to come under pressure this year given market weakness in the region.

Not only is Duke paring its holdings, but it recently spent $194.6 million to buy a 5.1 million sq. ft. industrial portfolio in Savannah, Ga.

The acquisition makes Duke the largest industrial owner in Savannah, the fifth busiest port in the nation for Asian imports. As strategic as that sounds, Prudential analyst James Feldman believes that Duke will have the dubious honor of being the only industrial REIT that does not cover its dividend by cash flow this year.

Aside from buying stability along the coast, asset sales will clearly help many office owners cover costs. In 2005, for example, EOP sold $2.6 billion worth of assets, and analysts expect the REIT to be a seller through the first half of 2006.

But the company has warned that it doesn't expect to post a huge sales volume this year. “We do not anticipate the same level of capital gains in 2006 that we expect in 2005,” remarked Richard Kincaid, president and chief executive officer of EOP, during a late December conference call alerting investors to the dividend cut.

Lehman Brothers analyst David Harris believes that EOP's underlying cash flow will only modestly improve in 2006 as occupancy gains are offset by downward pressure on rents. He isn't convinced that EOP has ended its disposition campaign.

In early January, Harris was telling clients to underweight shares of EOP with a 12-month price target of $28. “They may sell some more properties this year, but they have to bear in mind that they're selling cash flow after a certain point.”


As leases signed in 2000 and 2001 roll over, many office landlords arechallenged to fetch the lofty asking prices of five years ago. Although rental growth is expected to accelerate over the next two years, average asking rents will still trail the peak of 2001.

Year Rent Growth % Average asking rent/sq. ft. Vacancy %
2001 0.1 $27.86 14.7
2002 -8.6 $25.48 17.3
2003 -7.8 $23.48 18
2004 -2.4 $22.91 17.6
2005 0.5 $23.04 16.8
2006* 4.3 $24.02 16.2
2007* 5.1 $25.25 16
2008* 3.7 $26.17 15.6
Source: Property & Portfolio Research

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