KBWY - Office REITs: Work-From-Home's Recession Reckoning

Summary

• Pressured by the painfully slow “return to the office” with daily utilization rates still 50% below pre-pandemic norms, Office REITs are among the worst-performing property sectors this year.
• Office leasing activity and REIT earnings results have been surprisingly resilient, but corporations won't pay for half-empty space indefinitely and have been leveraging softening market conditions to extract generous concessions.
• With labor markets still historically tight, employees are still dictating the terms of the "Work from Home" dynamic, especially in coastal markets with long commutes where WFH benefits outweigh costs.
• Don't get overly comfortable at the home office: Counterintuitively, a recession could be a net positive for the typically pro-cyclical office sector as firms increasingly utilize office mandates as part of a workforce reduction strategy, driving utilization rates closer to pre-pandemic levels.
• We’ve been bearish on the sector since early in the pandemic – especially on REITs focused on urban markets with long, transit-heavy commutes citing a “New Normal” of remote work environments – but we see the consensus swinging too far in the negative direction.

REIT Rankings: Office

This is an abridged version of the full report published on Hoya Capital Income Builder Marketplace on November 1st.

Pressured by the painfully slow "return to the office" with daily utilization rates still 50% below pre-pandemic norms, Office REITs are among the worst-performing major property sectors this year with declines of nearly 40%. Office leasing activity and REIT earnings results have been surprisingly resilient in recent quarters, but corporations won't pay for half-empty space indefinitely and have been leveraging softening market conditions to extract generous concession packages to "upgrade" into higher-quality space while downsizing their overall footprint. Within the Hoya Capital Office REIT Index , we track the 23 office REITs, which account for roughly $50 billion in market value and comprise 5-7% of the market-cap-weighted REIT Indexes.

The office sector is typically segmented into two categories. Urban CBD ("Central Business District") or ' Gateway' REITs hold portfolios that are concentrated in the six largest U.S. cities: New York City, Chicago, Boston, Los Angeles, San Francisco, and Washington, D.C., a segment that has been hit especially hard by the pandemic. Secondary/ Suburban REITs , which have generally outperformed throughout the pandemic, hold portfolios concentrated in the Sunbelt regions and/or in secondary markets. As we'll discuss throughout this report, we believe that the longer-term outlook remains far "sunnier" in the Sunbelt and in secondary markets with net population growth, shorter commute times, and a more favorable industry mix, but we're also beginning to see compelling value in some Coastal-focused REITs where the consensus appears to have swung too far in the negative direction.

Since early in the pandemic, we've held the view that the Work-From-Home era is truly a "new normal" - a catalyst that accelerated a pre-destined trend of lower office utilization rates - and that the return to the office would be particularly slow in cities with longer average commute times and heavier reliance on public transit. Consistent with that expectation, utilization rates have recovered only a fraction of pre-COVID levels, particularly in dense coastal markets with longer and more transit-heavy commutes. According to recent data from Kastle Systems, office utilization levels remain at 50% or less in seven of the ten largest office markets including New York, Chicago, San Francisco, and Los Angeles. Sunbelt and secondary markets, however, have seen far higher utilization rates throughout the pandemic with Austin, Houston, and Dallas recovering to around 60% while rates are closer to 75% in several Sunbelt markets including Raleigh, Charlotte, Atlanta, and Phoenix.

Still, there remains a sizable spread between the number of days that employers would prefer their employees to be in the office - around 4 days per week - and the desired office time of employees - around 2 days per week - and with labor markets still historically tight, employees are still dictating the terms of the "Work from Home" dynamic. Counterintuitively, a recession could be a net positive for the typically pro-cyclical office sector as firms increasingly utilize office mandates as part of a workforce reduction strategy - with Tesla ( TSLA ) being a notable recent example - driving utilization rates closer to pre-pandemic levels. While unlikely to ever recover to pre-pandemic levels given the proliferation of remote work technologies, if we do begin to see weakening labor market conditions, we could see utilization rates improving to ~75% nationally and up to 80-90% in some Sunbelt and Suburban markets, implying ~3-4 days of in-person attendance per week and level of demand for office space that isn't nearly as bleak as valuations suggest.

Sunnier In The Sunbelt & Suburbs

Importantly, data continues to show that the office isn't necessarily the problem - it's the commute - and there's a growing consensus that there are quantifiable "costs" of remote work which can accumulate over time if not at least augmented by some non-virtual between employees and clients. A recent Hogan survey noted that employees cited challenges with collaboration (36%), distractions at home (25%), and difficulty with motivation (16%) as the top challenges of the fully-remote environment and a consistently small share of employees want to do away with the office entirely - averaging 10-20% across most surveys - with younger people itching to get back to the office at rates nearly twice that of older cohorts. A recent survey from KPMG found that less than one in five workers would prefer to be fully remote.

Recently-updated data from the American Community Survey show that over the course of a 5-day work week, remote work employees in cities with particularly brutal commutes "save" an average of 6.5 hours per week and a hundred dollars in transportation costs. Recent surveys from WFH Research confirmed that the lack of a commute is far and away the top benefit of working from home. The survey found that WFH saved office workers an average of 70 minutes per day, of which 40% was reallocated toward work. That "bonus" time allocated towards work seems to explain all of the reported productivity gains of WFH found across most surveys - offsetting the drag from a generally less productive home environment compared to the office.

Consistent with this framework, in markets with shorter average commutes, the productivity and social benefit of the office environment is "worth" the commute time. In fact, Work From Home adoption remains primarily a 'Big City' trend with a near-linear correlation between the size of the market and the WFH rates. Industry and tenant mix has also become an increasingly important factor that explains the variance in office utilization rates and also captures some of the effects of commute times. Certain industries are far more WFH-friendly than others, particularly the technology and financial services industries, where WFH Research finds that employers expect just 2.2 to 2.5 office days per employee per week under their post-COVID plans. These office utilization rates are roughly half that of other office-using industries that expect their employees to report to the office 3-4 times per week.

Flight To Quality & Office Industry Trends

Consistent with a recent "Flight to Quality" trend across the industry, while the top-tier "trophy" assets in these dense coastal markets will continue to see demand from top-tier tenants, older and lower-quality properties in these markets will likely face persistently elevated vacancy rates. We expect a 15-20% decline in office space per employee by the end of 2030 as many corporate tenants in low-utilization markets significantly reduce their footprint in these regions and adopt more formalized "hybrid" work dynamics. Even before the pandemic, utilization rates and space per employee were on a downward decline, consistent with the theory the pandemic simply accelerated - rather than temporarily altered - the pre-existing trends of increased workplace efficiency and technological disruption powered by Zoom ( ZM ), Slack ( WORK ), Alphabet ( GOOG ), Microsoft ( MSFT ), and Amazon ( AMZN ).

That said, corporate decision-makers have, so far, been hesitant to make major strategic decisions to dramatically reduce their office footprints, but have been leveraging softening market conditions to extract generous concessions. JLL ( JLL ) Research noted in their recent Office Report that leasing activity remained within 25% of pre-pandemic norms despite the far-steeper 50%+ decline in utilization rates, reporting that gross leasing activity totaled 45.5 million square feet - roughly 75% of pre-pandemic norms - as "a record volume of lease expirations occurring in 2022 and into 2023 is putting upward pressure on leasing activity, but renewal rates are declining significantly, and tenants are frequently opting to downsize while upgrading to higher-quality space rather than renew in place."

The recently quarterly US Office Marketbeat from Cushman & Wakefield further highlighted the "highly uneven" recovery. The firm noted several bright spots, seeing strong demand in life sciences markets buoyed by demand for both lab and office space - San Jose, San Diego, Boston, Northern New Jersey, and San Mateo County - and also seeing strong demand in large Sunbelt markets with strong job growth and appeal for growing tech firms - Dallas, Atlanta, Austin and Miami - and in recovering secondary markets in the Northeast - notably Fairfield County. At the national level, JLL reports that while asking rents are roughly flat since the start of the pandemic, effective market rents have declined by 6.2% as concessions continue to be on the rise.

These trends have been consistent with office REIT earnings results over the past several quarters which have been defined by

significant outperformance from Sunbelt and secondary-market-focused REITs and coastal REITs with significant specialty lab space assets. Sunbelt-focused Highwoods ( HIW ) has been an upside standout this earnings season, raising its full-year FFO growth target to 4.4% - up 180 basis points from its prior outlook while noting that it leased 518k SF of space in Q3 - its highest volume of new leases since 2014 with rents that were 20% above its prior five-quarter average. Cousins ( CUZ ) and Brandywine ( BDN ) also reported notable strength in their Sunbelt markets. Results from coastal-focused REITs have been shakier - with the exception of the lab space segment which has seen continued robust leasing demand with Kilroy ( KRC ) boosting its full-year FFO growth target.

For REITs, the average occupancy rate has remained roughly flat at around 90% since early 2021 while asking rent spreads have managed to remain slightly positive, on average, with Sunbelt strength offsetting Coastal weakness. NYC-focused SL Green ( SLG ), for instance, reported that rental rates were about 10% lower on renewed leases this year while Vornado ( VNO ) reported that tenant improvement and leasing commissions represented 18.2% of initial rent on its NYC office space - one of the highest in the company's history. Boston Properties ( BXP ) slightly raised its full-year FFO outlook but noted that it expects its FFO to be about 4% lower in 2023 at the midpoint of its range. Easterly Government ( DEA ) was the lone REIT to reduce its FFO outlook in the third quarter - a revision primarily attributable to a newly-announced deal to sell 10 properties for $205M.

Office REITs were finally hitting their stride right before the pandemic, powered by a seemingly unstoppable streak of job growth that reached over 115 consecutive months. The office REIT sector tends to outperform later in the economic cycle and respond more slowly to economic inflection points given the typically long-term lease structure inherent in office leases, which average 5-10 years for suburban assets and 10-20 years for CBD assets. Same-store NOI growth for office REITs averaged -0.2% in 2020 but bounced back into positive territory in 2021 with 3.9% growth and is now 6.5% above pre-pandemic levels despite the broader industry pressure.

Office REITs Stock Price Performance

After riding the 'reopening rotation' and inflation trade to strong gains in early 2022, higher interest rates, recession concerns, and the sluggish "return to the office" have weighed heavily on the office REIT sector in recent months. After leading the gains in the REIT sector through the first quarter, office REITs are the third-worst-performing property sector over the past quarter. The Hoya Capital Office REIT Index is lower by roughly 36% for the year - underperforming the 28.5% decline from the market-cap-weighted Vanguard Real Estate ETF ( VNQ ) and the 18.7% decline from the S&P 500 ETF ( SPY ).

The underperformance this year comes after an equally disappointing 2021 in which office REITs gained 23.3% for the year, significantly lagging the 41.3% total returns from the All Equity REIT Index. Diving deeper into the performance of these individual REITs, every office REIT is lower for the year while five REITs are off by 50% or more including Hudson Pacific ( HPP ), Franklin Street ( FSP ), Brandywine ( BDN ), and Orion Office ( ONL ) - which spun out from Realty Income ( O ) following their merger with Vereit. Despite the bifurcating fundamentals between Sunbelt-focused office REITs and coastal-focused REITs, the stock performance trends haven't necessarily reflected these trends, and we see compelling value in several of the Sunbelt-heavy REITs that trade at historically deep discounts across most metrics.

Several office REITs have taken advantage of the steep NAV discounts to create significant shareholder value. Last year, Columbia Property Trust was acquired by PIMCO at a healthy premium, underscoring our belief that the sector is long overdue for a wave of consolidation and asset sales. Elsewhere, Mack-Cali Realty rebranded itself as Veris Residential ( VRE ), reflecting the company's exit from the office sector through a series of asset sales as it transitions into a pure-play multifamily REIT and received an unsolicited takeover bid last month from Kushner Companies. This move follows a similar strategic shift from Washington REIT , which sold its office portfolio to Brookfield ( BAM ) for $766M as WRE shifted its focus to multifamily and last month rebranded as Elme Communities ( ELME ).

Office REITs Dividend Yields

While the growth outlook remains muted, office REIT dividend yields have swelled over the past year amid this post-pandemic pullback. Eleven office REITs boosted their payouts in 2021 - part of a historic wave of more than 120 dividend hikes across the REIT sector in 2021 - and we've seen an additional seven hikes this year, offset by one dividend cut. Current payout ratios suggest that these distribution levels are quite sustainable, as a whole, but several REITs with weaker balance sheets are at higher risk for a potential dividend cut if fundamentals weaken further. Office REITs now rank toward the top of the REIT sector, paying an average yield of 6.3% compared to the market-cap-weighted REIT sector average of 3.9%, while paying out just 50% of their available Funds from Operations.

There is a wide range of dividend distribution strategies employed by the 23 REITs within the sector, with yields ranging from 14.4% from Office Properties ( OPI ) to a low of 0% from Equity Commonwealth ( EQC ). As noted, seven office REITs have hiked their dividends this year including Kilroy ( KRC ), Cousins ( CUZ ), Paramount ( PGRE ), and City Office ( CIO ) - while one office REIT - Franklin Street ( FSP ) - cut its dividend, changing its distribution policy to a variable quarterly dividend - replacing its previous regular quarterly dividend policy - which the company notes "better aligns with the transactional nature of our 2022 objectives" which include the sale of properties and use of proceeds for debt reduction.

Takeaways: Power To The Workers, For Now

We've been bearish on the office REIT sector since early in the pandemic - especially on REITs focused on urban markets with long, transit-heavy commutes citing a "New Normal" of remote work environments - but we see the consensus swinging too far in the negative direction with office REIT valuations below that of even more structurally-troubled sectors including Class B and C malls. We continue to see better overall value in the Sunbelt and in secondary markets, but even a handful of Coastal REITs now appear attractively valued. Counterintuitively, a recession could be a net positive for the typically pro-cyclical office sector as firms increasingly utilize office mandates as part of a workforce reduction strategy, driving utilization rates closer to pre-pandemic levels. We're seeing some potential early evidence of this shift in one of the most WFH-heavy markets - New York City - which has seen improved ridership in its commuter rail system as labor markets soften.

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