Office REITs at bargain prices

  • By Lawrence C. Strauss,
  • Barron's
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The U.S. economy continues to grow steadily, shutdown or no, buoyed by strong job numbers and an unemployment rate below 4%.

Some of those jobs are housed in office buildings owned by real estate investment trusts across the country, from New York to San Francisco. Yet office REITs have been perennial underperformers in recent years and now typically trade at a 20% or wider discounts to their net asset values.

Investors may be tempted to hunt for bargains in the sector. But they need to be selective.

Office REITs have perked up a bit lately, having gained 7.2% year to date, though they have lagged behind the broader REIT market over one-, three-, and five-year periods. Over the past 12 months, office REITs have returned minus 3.5%, compared with a 6.4% gain for the broader industry, which includes hotel, mall, and apartment REITs.

All REITs are required to distribute most of their profits to shareholders, making them especially attractive to income-seeking investors.

Why the disconnect between a strong, durable economy and office REIT performance? For one thing, there are worries that the U.S. economic expansion has finally started to deteriorate.

The sector "will continue to be challenged" this year, and office employment "growth in most major markets doesn't seem to be enough to push pricing power," says Danny Ismail, an analyst at Green Street Advisors who focuses on office REITs. "It's a tough business. Capex is high, and fundamental growth is tough to come by."

A recent Green Street report cited high concessions for office tenants and "sluggish rent growth."

In a practice known as densification, many companies have tried to be more efficient with floor space as they situate individual workers in smaller workstations. The trend has meant that many companies need less office space.

"You can't just focus on the underlying NAVs" of office REITs, says Vikram Malhotra, a real estate equity analyst at Morgan Stanley. "You have to focus on the direction of rents. If market rents are not moving up, it's very hard for these names to work."

Green Street suggests that many office REITs, owing to the big discounts to their NAVs, should consider shrinking by selling assets in the private market, where prices are generally higher. The proceeds could be used to buy back stock or pay down debt. But few REITs are doing that, and most plan on growing externally by developing more properties this year, the report adds.

One bright spot is that there isn't a glut of new office supply, though it varies among markets. As of Dec. 31, the vacancy rate was at 12.6%, its lowest since the fourth quarter of 2007, according to CBRE.

Much depends on individual market conditions. Gateway cities such as Washington, D.C., and New York are more challenged due to factors such as weaker rent growth.

Although New York's overall office supply growth doesn't appear to be out of control—analyst John Kim of BMO estimates it will be 1.4% this year and 0.3% next year—worries persist about the underlying health of the market.

"Since 2017, we have been concerned about NYC fundamentals, as rent growth has been under pressure," Morgan Stanley wrote in its 2019 outlook on REITs. "NYC financials job growth has been decelerating, and tenant incentives remain at elevated levels."

Some landlords in New York have had to offer concessions, including free rent at the beginning of leases, to attract tenants. And many Manhattan buildings are at least 50 to 60 years old and require steep capital expenditures.

Office development is strongest in the planned Hudson Yards on Manhattan's far West Side, where the asset-management behemoth BlackRock plans to move its headquarters in 2022, and in Midtown south and downtown.

In November, Amazon.com (AMZN) announced that it had selected New York, specifically Long Island City in Queens, and Arlington, Va., near Washington, as the locations for its second and third headquarters. But Green Street's Ismail doesn't expect these events to have a big impact on the office market in those two cities.

In Virginia, he says, Amazon "should help lift up" the area where it's situated, but "it's hard to see it moving the needle for the entire market, given the high levels of existing vacancy and low supply barriers."

New York is a much bigger office market, he says, and the new headquarters is "likely too small to be needle-moving on its own."

The outlook is better for real-estate firms that own properties in the Sunbelt or on the West Coast, Green Street says, with technology firms providing plenty of ballast.

West Coast REITs generally sport higher capitalization rates than New York–based ones do. A cap rate takes a REIT's net operating income and divides it by its market value minus its liabilities. The lower the cap rate, the higher the valuation, and vice versa. It's akin to a dividend yield.

One is Kilroy Realty (KRC), which has properties in Seattle, San Francisco, Los Angeles, and elsewhere on the West Coast. Last November, it announced a deal in which Netflix (NFLX) will lease 355,000 square feet of a mixed-use project under construction in Hollywood.

The stock, which yields 2.7%, is off about 9% over the past six months. Analysts estimate that the REIT will generate some $2.62 a share in adjusted funds from operations this year, up from $2.39 in 2018.

Last year, Kilroy Realty added five million common shares in a public offering, a dilutive move, says Green Street, adding, however, that its "development pipeline looks attractive," including the long-term lease with Netflix.

The stock was recently trading at $68 and change, some 20% below its consensus NAV of nearly $82 a share, according to FactSet.

"They benefit a lot from growth in tech companies," says BMO's Kim. He rates the stock Overweight with a price target of $79. The company was "very astute about entering San Francisco at the right time"—specifically, 2009—and it is well positioned in a market that "is very land-constrained."

Malhotra of Morgan Stanley has an Overweight on Vornado Realty Trust (VNO). The REIT has a big office and retail presence in Manhattan, in particular around Penn Station and other Midtown locations, as well as big properties in San Francisco and Chicago.

At a little above $65, the stock is off about 8% over the past year.

Malhotra characterizes the REIT, on which he has an Outperform rating, as "more of a long-term value play." He has a price target of $76.

The company, led by real estate mogul Steve Roth, gets about 30% of its net operating income from retail leases, also known as street retail.

"While rental declines are not done, they are close to bottoming," says Malhotra. "Second, there is a lot of long-term value in their assets around 34th Street/Penn Station."

An overhang for Vornado's shares is succession planning for Roth, who turned 77 last year.

On a conference call nearly a year ago, Roth was very terse about the succession issue, saying, "I'm clearly on the back nine. I'm clearly not going to go forever, and I may be on the back half of the back nine. So with respect to me, our board focuses on that every meeting. We have a succession plan in place, if I were to be hit by a truck or whatever. And so that's enough about me."

The stock was recently trading at about a 30% discount to its NAV, based on Kim's analysis—a discount that he doesn't think is fully justified. "New York real estate, office in particular, is a very liquid asset," he says, with many transactions that provide timely clues about the market. But "there's a big dislocation between that and where Vornado trades."

Analysts expect the company to generate $3.35 a share of adjusted funds from operations this year, up from $2.70 last year, and it yields nearly 4%.

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