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Wild Ride for Office REITs

After four years of incredible growth — topped off with a 45% spike in total returns in 2006 — office REITs looked unstoppable at the beginning of the year. Remember all the excitement generated by the Blackstone Group's $39 billion purchase of Equity Office Properties? But the convergence of the subprime mortgage meltdown, widespread apprehension of a slowing economy and other market forces has transformed a bull run for the ages into a wild ride that has bruised the portfolios of office REIT investors.

The events conspired to drive down total returns for office REITs to a negative 14% for the year by the end of July, making office the worst-performing REIT property sector over that period. As of Oct. 24, total returns for office REITs were still off about 10% for the year compared with a 5.07% drop for all equity REITs.

“The public market is pessimistic about office fundamentals going forward,” says Keith Pauley, a managing director of Chicago-based LaSalle Investment Management. “We're less positive about overall fundamentals, too. But we think office REITs are trading at more attractive values than other [REIT] sectors.”

Against that backdrop, most office REITs are taking one of two approaches. Some are positioning themselves to take advantage of potential buying opportunities in the event highly leveraged office owners tumble into distress. Others are rushing to pay off debt and strengthen balance sheets in the face of flagging fundamentals in their markets.

Foremost on the mind of office investors is whether a slowing economy will eat into the rent growth needed to justify historic high prices that buyers have paid for office buildings. On average, 122,000 jobs have been created each month this year, down from 188,600 last year, reports the Bureau of Labor Statistics. Moody's predicts an average of only 70,000 jobs will be created monthly in the fourth quarter.

“Office properties are more vulnerable to an economic slowdown, and offices have more risk of rising cap rates,” says Pauley, whose firm manages public real estate securities and private real estate assets valued at $44 billion. “The market has become more leery about whether [rent growth] will be achieved and whether it will be as robust as had been expected.”

Stalling growth

A high degree of volatility in the debt and equity markets has driven away leveraged private buyers who drove up office valuations — and office REIT share prices — over the past few years prior to the current market turbulence. Fewer buyers ultimately means that office capitalization rates will rise by 75 basis points versus a rise of 40 points across other property sectors, predict Banc of America Securities REIT analysts, who have lowered their office REIT price targets by 13%.

While office fundamentals remain relatively healthy, there are indications that growth is slowing. Effective rents grew 9.9% nationally year-over-year in the third quarter. But upon closer review, the rate of increase tapered to 2.4% in the third quarter from 3.1% in the second quarter, according to real estate research firm Reis Inc.

Office vacancy in central business districts (CBDs) declined 20 basis points to 10.9% in the third quarter while suburban office vacancy remained flat at 14%, according to Chicago-based real estate brokerage Grubb & Ellis. Development remains subdued in most markets, but it's still something of a wild card (see sidebar p. 30).

Mitchell Hersh, CEO of Edison, N.J.-based office REIT Mack-Cali Realty, suggests that doubts over continued strong fundamentals have escalated given the swift deterioration of the subprime mortgage industry.

A rise of subprime loan defaults earlier this year has all but bottled up the residential and commercial debt markets. Subprime residential mortgages more than 90 days delinquent or in the foreclosure process, for example, hit 9.27% in the second quarter, a year-over-year increase of 304 basis points, according to the latest delinquency survey by the Mortgage Bankers Association.

“We're in a rapidly changing environment,” says Hersh, whose company owns 35 million sq. ft. of office space primarily in the Northeast and Mid-Atlantic. “The cost of capital is increasing, and that [has created] uncertainty as to how high rents can go.”

Divergent strategies

The mortgage meltdown is having a decided influence on REITs. While some are gearing up for possible defaults among private office owners, other REITs are confronting the fallout directly in their markets and portfolios.

Maguire Properties, a Los Angeles-based office REIT that owns 21 million sq. ft., primarily in Southern California, has slashed its year-end occupancy expectations to 89% from 94%. The culprit: a heavy concentration of prime and subprime mortgage lenders in Orange County. The industries announced some 30,000 job cuts in California for the year through September, according to Chicago-based outplacement firm Challenger Gray & Christmas.

In particular, subprime lender New Century Financial Corp.'s Chapter 11 bankruptcy in April left Maguire in the lurch. New Century, which early this year employed 7,200 workers, vacated some 267,000 sq. ft. it leased from Maguire. The subprime lender also is walking away from 190,000 sq. ft. it agreed to lease in the REIT's new 530,000 sq. ft. office tower completed in September. New Century, which has gone out of business and is liquidating assets, faces investigations for accounting errors and other possible misconduct.

The subprime mess coincided with Maguire's $3 billion acquisition of 24 Equity Office buildings and 10 development sites in Southern California — a deal that stemmed from the Blackstone and Equity Office transaction. Maguire and other office developers also are in the process of adding nearly 2 million sq. ft. of speculative office space to Orange County.

William Flaherty, executive vice president of marketing for Maguire, acknowledges that increasing vacancies in the company's portfolio and in Orange County will slow earnings growth. But, he adds, Maguire has likely seen the worst of the subprime fallout.

“The fact is that we got a dose of reality quicker and harsher than we would have wished,” Flaherty says. “We're going to come through 2007 with some bumps and bruises, but overall in pretty good shape.”

Righting the ship

Maguire is pushing to dispose of $2 billion in assets by the end of the year and is using the proceeds to build cash reserves and pay down its big debt load. At roughly 75% of its $6.2 billion enterprise value, the debt ratio is the heaviest among any office REIT, according to analysts.

The company had sold about $1.2 billion of properties as of late October, and it is considering spinning its 9.1 million sq. ft. downtown Los Angeles portfolio into a joint venture. Additionally, as of late October, Maguire executives were rumored to be exploring a management-led buyout of the REIT.

Analysts remain unconvinced of the company's strategy, especially since leveraged buyers have vanished as a result of the tightened credit market and as leasing activity slows. Those forces will put further downward pressure on Maguire's valuation, wrote Banc of America analysts in an October research note.

In fact, Orange County experienced negative absorption of about 1.4 million sq. ft. for the year through the end of the third quarter, and office vacancy shot up more than 300 basis points to 11.5%, according to Grubb & Ellis. While effective rents grew by 14% over 12 months ended June 30, the rate of growth slowed to less than 1% in the second quarter from 3% in the first quarter, according to the most recent report from Reis.

“Orange County is a market where there's some concern,” acknowledges Steve Shigekawa, associate portfolio manager for the $121 million Neuberger Berman Real Estate Fund. “The rent-growth levels we've seen in the past will not be possible until the market can absorb some supply.” But, Shigekawa adds, the county's long-term growth prospects remain attractive to institutional real estate investors.

Other fund managers suggest the situation might be overblown. LaSalle Investment Management owned nearly 7% of Maguire as of June 30, according to the firm's most recent filings with the Securities and Exchange Commission.

Pauley views the REIT as a value play. “We think the public market has been overly pessimistic about Orange County, and there's a lot of skepticism about [Maguire's] management to execute its plan to sell assets,” he says. “But we think the stock is at a point where all that and then some is priced in.”

Preparing for a shakeout

REITs in markets unaffected by the subprime mess — at least thus far — are strengthening their portfolios and are gearing up for potential acquisition opportunities. Highwoods Properties, based in Raleigh, N.C., has pre-leased some 66% of its $464 million office development pipeline.

The company, which now owns some 34 million sq. ft. of office, industrial and retail space predominantly in the Southeast also has sold non-core properties and land for $108 million year-to-date. Additionally, Highwoods has redeemed $40 million in preferred stock and has paid off $80 million in high-interest debt. Highwoods expects to achieve an occupancy rate of between 91% and 92.5% by the end of the year, up from about 90% at mid-year.

But the company has begun hoarding cash rather than using it to buy back more preferred stock. Why? It's preparing for buying opportunities stemming from potential distress in the office sector.

“The big question going forward is what's going to happen in reality versus the assumptions [that leveraged buyers] made to underwrite so many acquisitions,” says Highwoods Properties CEO Ed Fritsch. “If they were dead-on and conservative, then life goes on. If not, there will be some properties that need to be sold.”

Mack-Cali's Hersh has the same designs. The REIT has suffered from lackluster leasing in suburban markets. Yet it sold non-core assets for $90 million and recently extended a credit facility by $175 million to a total of $775 million. In June, Mack-Cali paid $273 million for a nearly 40% interest in 125 Broad Street in New York — its first acquisition in the market and part of a larger strategy to move into the city.

Mack-Cali's Hersh is scouting other Midtown and Downtown properties in Manhattan, although he's patiently waiting for re-pricing to become more definitive before he pulls the trigger. “I think to be well-capitalized in this kind of environment is going to prove very advantageous,” he says. “And that's frankly where I want my company to be.”

Fragile footing

Still, Fritsch and Hersh acknowledge that whether distress actually occurs remains unclear. Meanwhile, office REIT investors should remain strapped in for more potential wild swings before the ride calms.

Economic indicators likely will keep analysts and investors off balance. In September, the U.S. Department of Labor reported a net job loss of 4,000 in August, prompting howls of recession warnings. Then in October, the department announced 88,000 jobs were actually created in August in addition to 110,000 in September.

The rapid subprime collapse gives investors pause, too, making them rethink REITs operating in supposedly bulletproof strongholds such as Manhattan. That market received some good news recently. Vacancy in Manhattan fell 40 basis points to 6.2% in the third quarter and no substantial supply is due to come online until after 2010, Reis reports.

But financial services firms have announced more than 42,000 job cuts in New York through late October this year, according to Challenger Gray & Christmas. That's a 320% increase in job cuts over the same period in 2006.

Kenneth Heebner, manager of the $1.7 billion CGM Realty Fund, has cut the fund's REIT holdings to 25% from 75%. That included the disposition of its 4.5% ownership stake in New York-based SL Green Realty, the biggest office landlord in Manhattan.

Joseph Smith, a portfolio manager with ING Clarion Real Estate Securities in Radnor, Pa., remains bullish on New York and SL Green. But he's keeping his eye on weakness that could erupt from additional financial services layoffs, new supply or the rising cost of doing business in the city.

“What you worry about [in Manhattan] is a mini-version of the perfect storm,” says Smith, whose firm manages some $21 billion in real estate assets. “Significant financial distress could have negative implications for large users of office space — financial services firms and hedge funds. The harder issue to figure is how many support firms will be giving back space at the same time.”

Small growth in office supply likely to soften the blow

Joe Gose is a Kansas City-based writer.

Fears of an economic slowdown amid stagnating office occupancy nationwide have given office REITs major headaches in 2007. Year-to-date as of Oct. 24, office REITs posted total returns of negative 9.9% compared with negative 5.07% for all equity REITs, according to the FTSE NAREIT U.S. Real Estate Index.

But limited new construction over the last few years in most markets should help office landlords and investors sidestep the pain they suffered earlier this decade, when new office building completions following the dot-com bust and the terrorist attacks on 9-11 eventually drove up vacancies nationwide to 17% in 2003.

“We see the office vacancy rate climbing toward the end of the year, which is something we've been anticipating as job creation slows,” says Sam Chandan, chief economist for Reis, a New York-based commercial real estate research firm. “Fortunately, big increases in labor and material costs cut out opportunistic and speculative developers over the last couple of years.”

Still, Reis projects that some 58 million sq. ft. of new office space will be built this year, a roughly 1% increase over 2006 and the most office construction since 2002. As the economy slows, however, so does the value of development pipelines within REITs, says Paul Curbo, a portfolio manager for the $1.7 billion AIM Real Estate Fund.

Investors and analysts sharpened their skills at valuing potential development as REITs consolidated and went private over the last couple of years. But the subprime mortgage meltdown, slowing job growth and uncertainty surrounding layoffs have created a dramatically more bearish outlook today compared with a year ago.

“Fully valuing office REIT pipelines is a little bit risky,” Curbo says. “In a slower economic environment, the ability of a company to lease up speculative development becomes less attractive.”

That puts more of a premium on REITs operating in markets with high barriers to entry — typically found in coastal markets — that have tenants paying below-market rents on leases made during the last recession. Those REITs will enjoy big rent increases as tenants renew leases or execute new agreements.

Ultimately, fears of a slowing economy could help keep office markets stable. While such a climate likely will impede rent growth, speculative developers will have less incentive to build, suggests Keith Pauley, a managing director with Chicago-based LaSalle Investment Management.

“New supply already looks like it's at reasonable levels,” Pauley says. “So it's going to be harder for spec projects to move forward.”
— Joe Gose

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