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REITs 101: Office REITs
Office buildings are widely considered the roughest sector of the real estate market in which to operate. Gone are the small timers, the moonlighters, and the mom-and-pop operators that are commonplace in residential real estate. Also absent are the low-key profile of community shopping malls and suburban retail centers, where properties are often hard to distinguish from one another. In the world of high-quality office buildings—especially the shark-infested waters of top-tier markets such as New York, San Francisco, Boston, and Washington, DC—professional management is the norm, not the exception. This stratum of the industry demands deep pockets and access to capital markets, a well-stocked rolodex of contacts and leads, and, most important, a wealth of relevant experience.
Even more so than other property types, asset valuation in the office sector is highly dependent on location. Specifically, desirability is a function of local business activity, tenant proximity to clients and peers, and the broader growth prospects of the region. Office buildings generally break down into three categories: Class A, B, and C space. Newer, trophy properties with prominent, well-established tenants are typically considered Class A, offering high-end amenities and building materials, and access to the most desirable parts of town. In many cases, naming or signage rights are paid for by one of the property’s larger tenants, generating additional revenue for the building owner and cache for the tenant.
Class B space is characterized by older buildings that have undergone a modest renovations, but offer amenities and features a notch or two below Class A properties. This category typically appeals to smaller, younger firms looking to strike a balance between location and price. On the other hand, Class C buildings usually represent a significant step down, since most are older, oftentimes obsolete, and generally located in less-pricey neighborhoods.
Of the six stocks that comprise Value Line’s office REIT sub-segment, two stand apart as the 800-pound gorillas in the room: Vornado Realty Trust (VNO) and Boston Properties (BXP). The market capitalization of either company exceeds that of the four other participants combined, a testament to their well-positioned asset base and formidable resources.
One of the world’s largest publicly traded real estate firms, Vornado has a long and colorful history dating back to 1947 and a small appliance store in Harrison, New Jersey. Indeed, the company operated as a retailer until 1980 when current chairman Steven Roth gained control of the firm and began to position it as a developer of real estate. Today, Vornado is a power player in two of the country’s most competitive markets, New York and Washington, D.C., owning more than 110 office properties and nearly 40 million square feet of space. The Big Apple remains Vornado’s core market and home to roughly half its office assets including Penn Plaza, 1290 Avenue of the Americas at Rockefeller Center, and the Manhattan Mall.
Formed in 1997 by publishing magnate Mort Zuckerman, Boston Properties has become one of the largest office landlords in the country and a bellwether of broader real estate market fundamentals. The company’s vast office portfolio includes over 140 properties and just under 40 million square feet of space, with the lion’s share concentrated in New York, Boston, San Francisco, and D.C. Fittingly, the stocks of these twin goliaths seem to move in lock step with one another, rising and falling in tandem through the ups and downs of the market.
Rounding out the group are Duke Realty (DRE), Liberty Property Trust (LRY), Mack-Cali (CLI), and Washington Real Estate Investment Trust (WRE). With the exception of Washington REIT, which has substantially all of its assets in the Capital, these smaller operators are primarily located in second-tier markets across the Midwest and South.
Although operating conditions have started to stabilize, the national office market will likely remain under pressure for the next year or so. Employers—eager to stay in the black and maintain margins—seem content to squeeze more productivity out of their existing workforce, which is liable to keep the jobless rate perilously high and sap demand for office space. Historically, premier markets have fared better during downturns, owing to their high barriers to entry and a dearth of land available for development. But even the stalwarts have not been immune. Office vacancy rates in New York, Boston, San Francisco, and DC have shown signs of improvement, but remain at their highest levels in recent memory.
Meanwhile, fundamentals in secondary cities such as Atlanta, Cincinnati, Indianapolis, and Phoenix remain mixed. In most cases, employment growth has stalled, though the fact that many of those markets did not experience a building boom partially mitigates some of the pressure. In all, it will probably require several years and a meaningful economic and job market recovery to reinvigorate demand for office space.
From an investment perspective, none of the stocks we’ve covered here stand out for either short- or long-term relative price performance. However, Duke, Liberty, Mack-Cali, and Washington REIT offer above-average dividend yields, which should appeal to income-minded investors.
At the time of this article’s writing, the author did not have any positions in any of the companies mentioned.