Outlook for office REITs murky as concern builds around CRE debt, market weakness
Between a weaker office market since the pandemic, a continued prediction for a recession, higher interest rates and the collapse of regional banks this spring, the office-focused commercial real estate market is under a microscope.
By Ashley Fahey
With a weaker office market since the pandemic, a continued prediction for a recession, higher interest rates and the collapse of regional banks this spring, the office-focused commercial real estate market is under a microscope.
Across the U.S., there's a wide range of office owner types, but among the most closely tracked are publicly traded REITs, many of which will soon report first-quarter earnings. Some analysts have modified their outlook on office-focused REITs, thanks to a continued slow return to the office, less demand for space and rising vacancy and interest rates.
S&P Global Ratings, for example, last month took various rating actions on eight U.S. office REITs, with five of them — Boston Properties Inc. (NYSE: BXP), Brandywine Realty Trust (NYSE: BDN), Office Properties Income Trust (Nasdaq: OPI), Piedmont Office Realty Trust Inc. (NYSE: PDM) and Vornado Realty Trust (NYSE: VNO) — facing a negative outlook.
"Demand is really slowing (for office), with the secular headwinds coming from remote working and also more cyclical pressure with the outlook being weaker and potentially a softer job picture," said Ana Lai, senior director of real estate at S&P Global. "Office is cyclical, and it lags a bit to economic performance."
It's expected pressure will remain on the office sector for at least the next one to two years, she said.
Some REITs with heavy concentrations in office space are continuing to diversify their portfolio, such as Boston-based Boston Properties' growth in life sciences. Others may be looking to offload properties but transaction activity, in office and other commercial real estate sectors, has slowed dramatically as pricing expectations have changed.
In fact, higher capitalization rates have shaved cumulatively about 25% of Class A office values since before the pandemic, analysts with Newport Beach, California-based Green Street found in a recent report, while values have been slashed on average by about 40% among Class B and B-plus assets since pre-pandemic.
Despite some of the hand-wringing over financial pressures facing the office market, liquidity isn't a big concern right now for office REITs specifically, Lai said. By S&P Global's estimates, aggregated debt maturities for its rated office REITs are $4.1 billion in 2023 and $3.7 billion in 2024, as of Dec. 31, 2022, or 6.9% and 6.4% of office debt maturities, respectively.
"The REITs, like other real estate companies, have taken advantage of the low interest-rate environments and proactively refinanced debt at lower rates," Lai said. "It’s something we see as manageable but it really depends on market conditions as well."
Because REITs have unencumbered balance sheets, secured debt is an option, but the real question for any office owner, REITs or otherwise, is loan-to-value ratios. Coverage ratios are expected to decline as borrowers refinance maturing debt at higher rates, S&P Global predicts.
There's also pressure on valuations right now, Lai added. But some REITs are choosing to refinance with secured debt when the credit market is expensive on the unsecured side.
Last year, REITs saw their share prices fall dramatically, which is now starting to trickle into the private market, said Jim Costello, chief economist at MSCI Inc. Total returns among office REITs fell 37.6% in 2022, according to an index by Nareit, a Washington, D.C.-based association for the REIT industry. It was the largest decline of any REIT sector tracked by Nareit.
Returns for office REITs are down so far this year by about 15.9%, as of March's Nareit index. Public REITs aren't always a leading indicator of what'll happen in the private market, Costello added. But an argument could be made now that pricing observed among REITs within the past year or so will be an indication of where the private market goes.
"There’s withdrawal support in terms of the shrinking of the Fed balance sheet," he said. "This time, I think the REITs are probably a good indicator of where the rest of the market will go."
Much can also depend on the types of tenants office REITs are exposed to. Technology companies, for example, have aggressively pulled back on their office leasing activity — either by signing fewer new deals, consolidating their offices, putting space on the sublease market or exiting deals entirely.
West Coast REITs like Hudson Pacific Properties Inc. (NYSE: HPP) and Kilroy Realty Corp. (NYSE: KRC) tend to have more exposure to the tech market, Green Street analysts noted recently. REITs based in New York, meanwhile, generally lease more to tenants in industries like finance, insurance, real estate and law, which have seen a less muted withdrawal from the office market.
John Worth, executive vice president for research and investor outreach at Nareit, wasn't available for a phone interview by deadline but in an email said, despite a great deal of uncertainty in the office market, the group believes office REITs have the balance-sheet flexibility, operational strength and portfolios to navigate the current uncertain environment.
He cited Nareit's fourth quarter 2022 tracker data for office REITs, which found unsecured debt accounted for 64% of total debt, the weighted interest rate on total debt was 3.8% and the weighted average term to maturity was a little more than seven years.
Green Street analysts have also noted most office REITs have well-laddered maturity schedules and mostly fixed rate debt but also say unsecured spreads for office REITs have widened more than other sectors.
Worth added there's "a clear quality divide" emerging in the office sector, and office REITs tend to be on the higher side of that quality divide — something analysts at S&P Global and Green Street also noted.