The commercial real estate market, particularly the office-focused sector, is facing increased scrutiny in the wake of the pandemic-induced economic slowdown, predictions of a recession, and the collapse of regional banks this spring. Among the office owners being closely monitored are publicly traded real estate investment trusts (REITs), which are expected to report first-quarter earnings soon. Some analysts have revised their outlook on office-focused REITs, with remote work, reduced demand, rising vacancy, and interest rates weighing on the sector, according to a recent report by the National Observer.
S&P Global Ratings recently downgraded the outlook for five office REITs, namely Boston Properties Inc., Brandywine Realty Trust, Office Properties Income Trust, Piedmont Office Realty Trust Inc., and Vornado Realty Trust, citing a continued slowdown in demand and weaker job prospects. Ana Lai, Senior Director of Real Estate at S&P Global, said the office sector is cyclical and lags behind the economic performance, meaning that it could take up to two years for the pressure on the office sector to ease.
Some office REITs are diversifying their portfolios, such as Boston Properties, which is expanding its life sciences business. Meanwhile, others may be considering divesting properties, but transaction activity has slowed due to changes in pricing expectations. Green Street analysts found that higher capitalization rates have caused a cumulative 25 percent reduction in Class A office values since the pandemic, and Class B and B-plus assets have seen an average 40 percent reduction.
Despite the challenges facing the office market, liquidity isn’t currently a big concern for office REITs, said Lai. S&P Global estimates that office REITs’ aggregated debt maturities are $4.1 billion in 2023 and $3.7 billion in 2024, respectively, accounting for 6.9 percent and 6.4 percent of total office debt maturities.
According to Jim Costello, Chief Economist at MSCI, REITs saw a significant drop in their share prices last year, and this is starting to affect the private market. While public REITs don’t always indicate what will happen in the private market, Costello believes that the pricing observed among REITs in the past year will be an indication of where the private market is headed.
The office REITs’ exposure to different tenants can also affect their performance. For instance, technology companies have significantly reduced their office leasing activities, which has affected West Coast REITs like Hudson Pacific Properties Inc. and Kilroy Realty Corp. in particular. However, REITs based in New York that lease more to tenants in industries like finance, insurance, real estate, and law have seen a more muted withdrawal from the office market.
Despite the uncertainty in the office market, John Worth, executive vice president for research and investor outreach at Nareit, believes that office REITs have the balance-sheet flexibility, operational strength, and portfolios to navigate the current environment. Nareit’s fourth quarter 2022 tracker data for office REITs found that unsecured debt accounted for 64 percent of total debt, the weighted interest rate on total debt was 3.8 percent, and the weighted average term to maturity was a little over seven years. Green Street analysts noted that most office REITs have well-laddered maturity schedules and mostly fixed-rate debt, but unsecured spreads for office REITs have widened more than other sectors.
