By Arlene Issacs-Lowes

Office properties have staged a remarkable turnaround since the last real estate recession of the late 1980s and early 1990s saw operating performance plummet and property values deteriorate. Still, fundamentals for this sector suggest that office buildings tend to have volatile cash flows, above-average risk of capital loss and longer market downturns than some other property types. Office buildings are increasingly management and capital intensive due in part to rapidly shifting tenant space format and technology needs. The weakening economy and problems in the technology industry lead us to wonder if the office market is poised for a repeat of the last downturn. And if so, what will the effects be on office property values?

We don't think a downturn is imminent, in part because real estate markets now have greater stability because of increased public scrutiny. However, the softer economy will pinch office property values—some more than others—raising caution as we monitor the credit quality of office REITs. Emerging trends such as mergers, consolidations and third-party fee business will also shape the credit outlook for these companies.

Credit Analysis and Office Characteristics

The underlying cash flow volatility of the office sector is due in part to long development lead times that impair owners' ability to react quickly to supply and demand imbalances. The development cycle for an office project is often 24 to 48 months or longer, which means a building could be completed in a drastically different economic climate than when the project began. The long cycle also makes predicting tenant demand quite challenging. Furthermore, the financing environment during development could be vastly different from that originally used when the project was underwritten, resulting in material revisions to the project's return. Office projects also tend to be large, which can narrow the universe of potential purchasers and financing sources. Disposition and permanent financing strategies are best firmly planned in advance.

For these reasons, evaluating investment strategies for office REITs is important to a credit assessment. Positive credit signs include a sound investment strategy based on product and economic research, the controlled use of development and a diversified regional asset and tenant base.

Office REITs need greater financial flexibility to meet the capital requirements of maintaining and operating projects because leasing to office tenants typically involves up-front cash outlays for leasing commissions and tenant improvements. Tenants no longer are just looking for a building to meet their space needs. They want an infrastructure that can handle future technological needs, and they want to be provided with the highest level of service available. Tenants sometimes make occupancy selections based solely on these factors, and landlords are wise to differentiate their properties from competing products. It's not just the rent per foot, but what you are getting for it in toto. All this means increased capital expenditures for landlords. Prudent firms address these factors through more modest dividend payouts, long average and staggered debt maturities and ample, long-term flexible bank facilities.

Office Sector # of REITs 19 Market Cap. $28,775,747* Industry Market Cap. $149,466,469* % of Industry 19.3% Average Dividend Yield 6.7% YTD Total Return 3.5% 1-year Total Return 14.6% 3-year Total Return 10.0% 5-year Total Return 16.6% Weighted Daily Volume (shares) 489,923,019 Weighted FFO Growth (2001–2002) 11.4% *These figures represented in thousands. Data as of July 20, 2001. Source: NAREIT

How Will Office REITs Fare in Softening Markets?

We believe that the increased scrutiny that has accompanied the publicly traded real estate market will continue to dampen the peaks and valleys of the real estate cycle. Since the beginning of 2001, market fundamentals, measured by space absorption and the growth rates of rents, have either stagnated or, in some technology dominated markets, rapidly deteriorated. However, to keep things in perspective, it is important to note that 2000 was perhaps one of the strongest years in recent memory for space absorption, with declining vacancies and soaring rents. Furthermore, as a result of embedded rent growth as leases roll to market, office REITs should continue to achieve some revenue growth. This, combined with lower interest rates, should help to support coverages. Those office REITs that can continue to demonstrate financial flexibility with solid bank line capacity, healthy levels of self-funding for their capital needs, manageable refinancing risk, and modest, planned development activity should be well positioned to maintain their credit profile and capitalize on opportunities as the markets stabilize.

We are concerned about those companies that have substantial development projects and will be forced to deliver and lease buildings in a weaker market environment. Even those projects that are pre-leased or build-to-suit could pose liquidity challenges as capital sources adjust.

Caution is also warranted for those REITs concentrated in technology based markets such as Austin, Seattle, San Francisco and Boston. The collapse of the capital markets for much of the technology sector has led to a rapid decline in tech companies' demand for space and ultimately the rent growth in these markets. We are also concerned about reduced space demands for their vendors and service providers. Although some of these markets are relatively strong by historical standards, we will remain concerned until the sublease situation plays out. The surviving technology companies will likely make more prudent location decisions. We expect that they not only will be concerned about occupancy cost, but also will be more sensitive to the cost of housing for employees. This could again buoy demand in suburban office markets, albeit from weaker credit tenants.

What's Next for the Office REIT Sector?

The recent industry consolidation has been noteworthy and may continue. For the office sector, the recently completed $7.3 billion Equity Office Properties Trust and Spieker Properties, Inc. deal set the current pace. One wonders whether another deal will be announced, and what effect that will have on privately held offices. A recent tax ruling could make it easier for some corporations to monetize their owner-occupied offices through REIT spin-offs, which could eventually become parts of other REITs.

Expansion into fee businesses has to be carefully executed so as not to conflict with, or divert attention from, the core business.

It is our view that consolidation makes particular sense for the office sector. Larger, more strategically diversified portfolios not only stabilize cash flow that consolidation makes particular sense for the office sector. Larger, more strategically diversified portfolios not only stabilize cash flow but also improve a REIT's ability to meet the space needs of national tenants in different markets, further cementing tenant relationships. Still, an office REIT that is dominant in a few economically diversified markets and has demonstrated an expertise of ferreting out opportunities to enhance value may represent an attractive niche investment opportunity. There is a greater need to be a leader in some facet than simply having a nice assortment of properties.

With the passage of the REIT Modernization Act and fewer core growth opportunities, we expect some office REITs to zealously pursue third-party fee business. Aside from their core competencies of providing property management, leasing and development services, the success several firms have had with pension fund joint venture partners may encourage more firms to follow suit. One advantage of engaging in fee businesses is the ability to earn additional revenues by leveraging in-house expertise, especially during less robust markets.

Aside from being profitable, fee businesses allow companies to keep certain functional expertise in place until market conditions are more receptive to apply that discipline to their own portfolio. It also would provide greater investor visibility as REITs interact with new subsets of the institutional investor market. Larger, national office REITs can further reinforce tenant relationships by providing not only leased space but also by developing owner-occupied buildings. Expansion into fee businesses has to be carefully executed so as not to conflict with, or divert attention from, the core business. Additionally, some of these revenues are non-recurring and while they may boost the bottom line for a while, they do not necessarily improve cash flow quality. The worry here is that management, or investors, could place undue reliance on the cash flows from these activities, and therefore be more receptive to incremental leverage.