Written by Sam Kovacs.
Yet here I am, suggesting that the troubles of office real estate investment trusts, or REITs, are just getting started.
Office REITs are a very dangerous industry within the real estate sector.
I don’t believe we’ve seen the worst of it.
During the pandemic, corporate America attempted a mass experiment of work from home… and people liked it.
Fast forward 4 years later, and while a full remote model hasn’t prevailed, the hybrid model (a bit at home a bit in the office) looks like it is here to stay.
This is a problem for commercial real estate. Because if employers realize they don’t need so much office space, then they will want to downsize. Why not? Either spend less for less space, or spend the same for a nicer although smaller space.
Either way it seems like a no-brainer for corporations, and it explains why we’ve seen vacancies rise and overtake the level of vacancies reached in the mid ’80s and ’90s following a bout of overbuilding.
More expirations ahead
Looking at just the second half of the year, we see that a lot of big companies have either let leases expire, or sublease unused space:
- July: Charles Schwab (SCHW) which adopted a hybrid work model, is “hoping to reduce its real estate footprint by ‘closing floors or closing offices’ at its downtown office space (SF). Similar downsizing efforts are planned for… Boston; Chicago; Henderson, Nevada; and Jersey City, while offices in Atlanta, San Antonio, San Diego, St. Louis and Tampa are slated to close completely.”
- September: Johnson & Johnson (JNJ) “is slashing its Tampa office space by more than 60%. It will leave behind nearly 90,000 square feet.”
- October: Dropbox (DBX) “will pay $79 million to give up 165,000 square feet of office space at its San Francisco HQ.”
- October: Microsoft (MSFT) “to vacate 50,000 square feet of office space in San Francisco as tech-exodus continues amid drug and crime ‘doom loop’.”
- November: Phillips 66 (PSX) “has begun vacating floors 10 through 18 of its office building, consolidating all employees to the lower nine floors.”
- November: General Electric’s (GE) “exit from The Bank’s building that once housed nearly 2,000 GE workers and is part of Downtown’s central business district could exacerbate office vacancies.”
And it is only just getting started.
In a survey conducted in June 2023, half of the world’s biggest companies planned on cutting office space by 2026, with a 10% to 20% reduction being the most common.
But why wait until 2026? Why not do it today?
Office leases traditionally spanned 10 years so landlords only get to make a decision concerning their need for office space once per year.
2024 and 2025 will see higher amounts of square feet expire than in 2023, according to data on corporate mortgage backed securities collateral.
In large cities, millions of square feet are expiring in 2024.
This is a problem for office REITs, because the outcome is either:
- Renew at lower rents.
- See the office go vacant.
Enough of number 2, and rents go even lower.
This is affecting everyone, even the so called “premier” and “top” real estate locations.
Boston Properties: Negative 5.6% cash spreads
Boston Properties, Inc. (BXP) is often presented as one of the top office real estate firms.
Digging in the 10-K for second generation leasing, and we can see that in the past quarter, re-leasing activity has led to a 5.6% decrease in net rents (or cash rents).
We can expect to see more of this in 2024, and the higher the overall vacancy rate, the higher the bargaining power of the tenants renewing leases, the lower the rents will go.
BXP’s price action over the past year and a half reflects this.
The worst might not be over. Never underestimate how far a stock can fall.
Kilroy Realty: 24.7% occupancy
Kilroy Realty Corporation (KRC), another “premier” office REIT, does its best in its investor presentation to convince investors that their buildings, because they are younger and of higher quality, are not as impacted by the office crunch.
This might be true, as indicated in the slide below.
But to me, this is like saying that Tyson Fury is better equipped than you are at getting punched in the face by boxer and martial artist Francis Ngannou.
It doesn’t mean getting punched in the face by Ngannou is pleasant or even remotely a good idea.
KRC knows that renewals will be a problem for office REITs in the next couple of years.
So it tries to brace itself by pointing out that they only have 6% of leases expiring annually between 2023 and 2025.
By my estimates, about 8% of leases expired between June 2022 and September 2023.
Over that period of time, Kilroy’s occupancy went from 94% to 87%.
A look at the most recent 10-Q shows that second generation releasing is being executed with on average 5 year leases (tenants no longer want the 10 year leases), but more alarmingly, that only 24.7% of expiring leases have been renewed in the past 9 months.
Cash rents have also declined by 1% over the period.
Once again, KRC’s stock price has come all the way down, but…
…the worst might not be over.
City Office REIT: Troubled, with more trouble ahead
I could not find any information on renewal spreads in either the 10-Q or investor presentations, so I had to dig property by property to find one which was likely released in the past year.
Most of their properties have escalators so rents would increase from one year to the next. In any case, you wouldn’t have a property which would have rent decline over time.
Yet its “Superior Pointe” property in Denver, went from being rented at a $31.78 gross rent per sq ft in November 2022, with 93.8% occupancy, to only being rented at a $31.6 per sq ft with 71.1% occupancy.
That’s negative gross spreads, definitely negative cash spreads, and lower occupancy.
I expect more trouble to come as another 8.4% of leases expire in 2024.
SL Green: More trouble ahead?
SL Green Realty Corp. (SLG) a Manhattan-based Office REIT, cut its dividend in 2023. Now it has done so again in 2024.
For the 3 months ended September 2023, leased office space commenced during the quarter was rented at $79.49 per share vs $87.56 prior rent.
That’s a negative 10% cash spread, among the worst I’ve seen in my brief survey of office REITs.
Once again, the problems have just begun.
Where do we go from here?
There are office REITs whose renewal numbers for some reasons are looking much better than those highlighted in this article, like Cousins Properties Incorporated (CUZ) and Brandywine Realty Trust (BDN).
I’d need to allocate more time to analyzing those to decide whether there is a sliver of hope in certain stocks from the industry.
For the most part, though, mass renewals will lead to higher vacancies, lower cash rents, and more stock price trouble.
2024 is the year of the REIT, so there might be a sector effect that raises all boats, but once the cracks start to show in the office REIT industry, there will be distress, more dividend cuts, and trouble all over.
The yields on these dividend stocks don’t justify the risk, not when there are brilliant REITs trading at magnificent discounts that got beaten down in 2023 when their business was not at all affected.