2023-07-30 07:00:00 ET
Summary
- Many, if not most, corporate American CEOs are still very much about encouraging office culture.
- They can accept a hybrid schedule, with employees working from home sometimes.
- But they still ultimately want an office for everyone to commune in several times a week.
I promised a few articles ago that I’d cover the topic of office space sometime soon. And I have to admit that it’s probably a long time overdue.
This has been a big issue almost the entirety of this decade so far. Moreover, it’s not going away. I’m guessing it’s going to remain on investor minds for a while to come.
That’s partially because, as we keep viciously flirting with recession – always blowing kisses its way while ultimately keeping it at arm’s length – shareholders want to hear a certain term: Cost cutting.
It’s why so many companies have been reporting such solid earnings so far for the second quarter, resulting in headlines like:
- “General Motors Raises Full-Year Guidance, Announces Deeper Cost-Cutting”
- Biogen to Cut 1,000 Jobs to Save Costs as Company Prepares for Leqembi Launch”
- GE HealthCare Plans Cost Cuts, Raises Earnings Forecast.
Or how about “ Alphabet Reports Better-Than-Expected Quarterly Results Driven by Growth in Cloud .” It mentions how:
“For the fourth straight quarter, Google’s parent company reported growth in the single digits as it reckons with a pullback in digital ad spending that reflects concerns about the economy…
“Along with Microsoft, Alphabet kicked off earnings season for the mega-cap tech companies. Across the industry, investors will be looking for updates on cost-cutting measures implemented earlier in the year and the impact of artificial intelligence investments on profitability.”
And reducing office space can cut costs immensely.
Which, of course, is bad for office real estate investment trusts (REITs).
The Office Space Case Isn’t So Simple
Before I continue, let me give credit where credit is due.
On July 19, I published “ My Top 5 Favorite REIT CEOs (And 3 Bonus Picks) .” It was a good article in and of itself if I do say so myself. But that’s not what I want to highlight here.
I got this understandable (though not exactly topical) comment at the end from BobWass:
“I would really like to hear your assessment of the office real estate outlook, medium-term and long-term. High-rise, low-rise, office park… need your advice. I’ve been a longtime subscriber, and I remember I used to be able to email you! Times change, congratulations on your growth.”
I want to say a big thank you so much to BobWass not just for submitting that question but also for reading my articles for so long! Your time and commitment are very much appreciated.
Growing or not, I do still try to address all the questions I get on each comment.
With that said, I do think this particular question deserves an entire article response, not just a comment on a comment or even an email. It’s too complex for anything so simple.
We’re talking about an entire industry – one that’s been deeply entrenched in western society for decades.
The Office Isn’t Dead, but It Has Definitely Changed
The history of corporate office space, according to Morgan Lovell (the U.K.’s self-described “leading office interior design and fit out specialist”), goes back easily to the early 18th Century. Apparently, the Royal Navy and East India House was built in London in 1729 to accommodate thousands of employees.
The practice grew in popularity until it became the status quo. Three decades ago, I can’t think of anyone who anticipated that corporate America wouldn’t go to the office.
Even two decades ago, as Internet capabilities and dependency took giant leap after giant leap, remote work wasn’t really on anyone’s radar. Not in a this-could-kill-the-office kind of way, that is.
Yet here we are, post-pandemic, and so very, very much has changed.
However, change doesn’t mean death in this case. For one thing, many, if not most, corporate American CEOs are still very much about encouraging office culture.
They can accept a hybrid schedule, with employees working from home sometimes. But they still ultimately want an office for everyone to commune in several times a week.
Here’s another fact : Office REITs are on far less shaky ground in the Sunbelt vs. traditional business hotspots . And that’s not just because the people there have different preferences about work-life balances. It’s also because those big cities are becoming less business friendly due to rising taxes and rising crime.
I don’t mean to be controversial, but I was in San Francisco last year. It’s really struggling.
This isn’t to say REITs with properties there or NYC are automatically doomed. Only that they have more of an uphill struggle, while REITs in secondary cities around the nation have a much sunnier situation on their hands.
To explore this topic on a deeper level though, let’s look at a few different office REITs and how they’re faring.
Three Flavors of Office REITS: HIW, ARE, BXP
Highwoods Properties ( HIW )
Highwood Properties is a sunbelt focused office REIT that develops, acquires, and leases office properties that are primarily located in the best business districts of Charlotte, Atlanta, Orlando, Nashville, Raleigh, Tampa, Richmond, and Dallas.
HIW’s sunbelt exposure cannot be understated as 95% of their net operating income (“NOI”) is derived from sunbelt markets .
They increased their sunbelt exposure in 2022 when they entered the Dallas market through several joint ventures with Granite Properties. They entered two joint ventures to develop Granite Park Six and 23Springs and another joint venture to acquire McKinney & Olive.
As of June 30, HIW owned or had an ownership interest in 28.5 million rentable square feet of operational properties, 1.6 million square feet of properties under development, and land held for development that is expected to add roughly 5.2 million rentable square feet of potential office space.
Occupancy in their office properties came in at 88.9% as of June 30, 2023, down from 91.0% as of Dec. 31, 2022. HIW expects average occupancy to range roughly between 88.5% to 89.5% for the remainder of 2023.
On July 25, Highwood released second quarter results and reported funds from operations (“FFO”) of $101.0 million, or $0.94 per share, compared to FFO of $108.1 million, or $1.00 per share for the same period in the previous year.
HIW updated their full-year 2023 FFO outlook to come in between $3.69 to $3.81 per share, which at the midpoint would represent a 6.9% decline in FFO when compared to 2022’s full year FFO of $4.03 per share.
HIW reported strong leasing activity in the second quarter with second generation leasing totaling 917,630 square feet which consisted of 221,943 square feet of new leases and 695,687 square feet of renewal leases.
Executed leases in the second quarter had a weighted average term of 5.5 years and a weighted average base rent of $36.39 per square foot.
As a point of comparison, second generation leasing totaled 682,523 square feet in the second quarter of 2022 with a weighted average term of 5.3 years and a weighted average base rent of $32.43 per square foot.
HIW is investment grade with a BBB credit rating from S&P Global. They have reasonable debt metrics with a long-term debt to capital ratio of 56.58%, a net debt to EBITDAre of 5.9x, and an interest coverage ratio of 3.97x.
Their debt has a weighted average interest rate of 4.3%, and as of their most recent update, they have approximately $22.0 million of cash and roughly $565.0 million available to them under their revolving credit facility with no debt maturities until the fourth quarter of 2025.
Since 2013, HIW has had an average adjusted funds from operations (“AFFO”) annual growth rate of 2.10% and a compound dividend growth rate of 1.64%. They pay a 7.84% dividend yield that is well covered with an AFFO payout ratio of 76.74%.
Analysts project AFFO to fall by 3% in 2023, to $2.53 per share which would put the 2023 AFFO payout ratio at 79.05%, but this would still comfortably cover the dividend of $2.00.
The stock is trading at a P/AFFO of 9.95x which is a steep discount to their 10-year normal AFFO multiple of 21.69x. Additionally, the stock is trading at a significant discount to their net asset value with a P/NAV ratio of 0.59x.
We rate Highwoods Properties a Strong Buy.
Note: Since purchasing shares in HIW shares are -13%.
Alexandria Real Estate ( ARE )
Alexandria stands out among its office REIT peers as it invests primarily in life science properties. While several other office REITs have recently been moving into the life science space, ARE is the pioneer of this real estate niche and has been investing in life science properties since its founding in 1994.
ARE develops and owns collaborative life science properties that are located in AAA innovation clusters with properties located in Maryland, Seattle, San Diego, New York City, San Francisco, Boston and the Research Triangle.
Their portfolio consists of 41.1 million rentable square feet of operating properties, 5.3 million rentable square feet of properties undergoing construction, 9.4 million rentable square feet of development projects, and 19.1 million square feet for future development projects.
In total they have an asset base that covers 74.9 million square feet in North America.
Due to the nature of ARE’s properties, their tenant base includes multinational pharmaceutical companies, biotechnology companies, life science products and medical device companies as well as U.S. government research agencies and medical and academic research institutions.
While ARE is not completely immune from the work-from-home movement, they are in a much better position than most, if not all, of their office REIT peers due to the fact that many of the tasks performed in their laboratories cannot be done from home.
They have approximately 825 tenants with a weighted average lease term (‘WALT’) of 7.2 years and their operating properties have a 93.6% occupancy rate as of June 30, 2023.
Additionally, 49% of their annual rental revenue is derived from tenants that are investment-grade or are large cap publicly traded companies.
Alexandria released its second quarter operating results and reported total revenues for the period of $713.9 million compared to $643.8 million in the second quarter of 2022 for an increase of 10.9%.
Funds from operations for the second quarter were reported at $382.4 million, or $2.24 per share vs $338.8 million, or $2.10 per share for the same period in the previous year. On a per share basis, the change in FFO represents a 6.7% increase.
Same property net operating income for the second quarter increased 4.9% on a cash basis when compared to the same period in 2022 and increased by 6.5% when comparing the first half of 2023 to the first half of 2022.
Additionally, they reported strong leasing activity with leasing volume totaling 1.3 million rentable square feet in the second quarter. For the first half of 2023, ARE leasing volume totaled approximately 2.5 million rentable square feet, which when annualized is in line with their pre-COVID leasing volume.
ARE has a BBB+ credit rating and excellent debt metrics with a net debt and preferred stock to adjusted EBITDA of 5.2x, a long-term debt to capital ratio of 38.85%, and a fixed charge coverage ratio of 4.7x.
The debt is 99.2% fixed rate with a weighted average interest rate of 3.69% and a weighted average remaining term of 13.4 years. They have no debt maturities prior to 2025 and have a total of $6.3 billion of liquidity.
Over the past 10 years ARE has delivered an average AFFO growth rate of 5.47% and an average dividend growth rate of 8.62% . Analysts expect AFFO to increase by 8% in 2023 and by 7% and 10% in the years 2024 and 2025, respectively.
ARE pays a 3.89% dividend yield that is well covered with an AFFO payout ratio of 72.17% and is trading at a P/AFFO of 18.66x which is a significant discount to their normal AFFO multiple of 24.21x.
Additionally, the stock is trading approximately 25% under its estimated net asset value with a P/NAV ratio of 0.75x.
We rate Alexandria Real Estate a Buy.
Note: Since Land & Buildings disclosed its short thesis (June 16, 2023) on ARE, shares are +5%.
Also, I plan to interview ARE's CEO this week.
Boston Properties ( BXP )
Boston Properties is one of the largest REITs in the office sector with a market capitalization of around $10 billion. They develop, own, and manage a portfolio of office properties that are concentrated in six gateway markets that includes Boston, San Francisco, Washington D.C., Los Angeles, New York, and Seattle.
Based on net operating income (“NOI”) their largest market is in Boston which contributes 35.5% of their NOI, followed by New York and San Francisco which contributes 25.2% and 19.7%, respectively.
BXP owns or has an ownership interest in 171 office and life science properties, 14 retail properties, six residential properties, and one hotel. In total their portfolio consists of 192 properties that cover approximately 54.5 million rentable square feet and are 91.0% leased with a weighted average lease term of 7.6 years.
BXP has not yet released their second quarter operating results, but during the first quarter they signed 660,000 square feet of leases that had a weighted average lease term of 7.7 years and signed leases totaling 5.2 million square feet over the last four quarters.
During their first quarter earnings release they provided FFO guidance for the second quarter of $1.79 to $1.81 per share and full year 2023 FFO guidance of $7.14 to $7.20 per share. BXP is set to report second quarter results on Aug. 1, 2023.
BXP - IR
Boston Properties has an investment-grade BBB+ credit rating and plenty of capital with $3.2 billion in total liquidity but their debt metrics could be better.
BXP has a net debt to EBITDAre of 7.8x, a fixed charge coverage ratio of 2.7x, and a long-term debt to capital ratio of 69.08%. The debt is 91.88% fixed rate with a weighted average term to maturity of five years and a weighted average interest rate of 3.81%.
Boston Properties has had an average AFFO growth rate of 3.46% and a compound dividend growth rate of 4.62% since 2010. Analysts expect AFFO to increase by 6% in 2023 and then by 3% and 5% in the years 2024 and 2025, respectively.
BXP currently pays a 5.98% dividend yield that is well covered with an AFFO payout ratio of 83.67% and trades at a P/AFFO of 13.51x which is well below their normal AFFO multiple of 29.66x. The stock is also trading approximately 30% below its estimated net asset value with a P/NAV ratio of 0.68x.
We rate Boston Properties a Strong Buy.
Note: Since I purchased shares in BXP in 2023 shares are +30%.
More Dividend Cuts Coming To An Office REIT Near You
Piedmont Office ( PDM ) was on our dividend watch list and the company recently announced a 40% dividend cut.
Other REITs on our list, Gladstone Commercial ( GOOD ) and SL Green ( SLG ) have also cut their dividend.
Other office REITs on our watch list include Easterly Government ( DEA ) and SL Green.
Fortunately, our research has allowed us to navigate dividend cuts, but that doesn’t mean we’re immune to pain.
We continue to believe that sunbelt and life science focused office REITs are worthy of ownership, although we recommend maintaining responsible diversification across property sectors.
For further details see:
The Office REIT Conundrum