Office REITs: The Sector to Rent, Not to Own

The office sector, particularly in the public REIT universe, boasts some of the best-looking buildings among all property types.  Called ‘trophy properties’, they are excellent material for press coverage, property tours, and annual report covers; however, they do not always translate into superior long-term total returns.  Case and point: the completion of a new ‘tallest building in the world’ has preceded many recessions across the world, including the most recent Great Financial Crisis, which was preceded by the topping out of the Burj Khalifa in Dubai in 2008.

Therefore, it is a property type where extreme care must be taken as to the timing and location of investment.  Purchase price is also important, as the trophy nature of these buildings attracts emotional buyers that can swing prices in directions that may not correlate with underlying fundamentals.  Currently, prices are historically high on the private market, while organic cash flow growth is relatively low.  However, the public office REITs offer an alternative to investors.  The current discounts to private market values provide a much more attractive entry point for similar exposure.  As a result, the Chilton REIT Composite maintains an overweight to the office sector as of October 31.

Long Term Pain, but Some Short Term Gains

Since 1994, the NCREIF index that tracks private sector real estate shows that the office sector has had the lowest annualized total return among the major sectors of industrial, malls, apartments, and shopping centers.  Similarly, Real Capital Analytics data in Figure 1 shows that office net operating income (or NOI) per square foot (or sqft) has not kept up with inflation over the past 17 years.  However, there were some periods where office outperformed the major sector average.  Generally, office has underperformed in the recovery coming out of past recessions, then proved to be one of the best investments late in the cycle before underperforming in the crash.

Presumably office is a ‘late cycle’ investment due to its long term leases, which may restrict its cash flow growth early in the cycle as prior peak rents are rolling down to market rent.  Later in the cycle, the peak rents have all rolled off and, even if market rent growth has slowed or even halted, the power of rolling up trough rents can drive above average cash flow growth.  As such, the public REIT office sector had above average same store net operating income (SSNOI) growth in 1997-2001, 2007-2009, and 2016-2017.  We believe 2018 and 2019 will also be above average.

However, despite the above average SSNOI growth and total returns in 2016 and 2017, the NAREIT Office Index (Bloomberg: FNOFF) has underperformed in 2018 through October 26.  In fact, the NAREIT Office Index has the worst total return year to date among the major property types, including malls, shopping centers, apartments, industrial, lodging, self storage, and healthcare.  So, what is causing this ‘late cycle’ sector to underperform ten years into the cycle?

Secular Shifts

There are several reasons for the office sector underperformance in 2018, all of which are interrelated.  Supply has been increasing, which is not necessarily unusual late in the cycle.  While demand has been increasing enough to absorb the new supply, it has not been enough to generate rent growth in some of the largest gateway cities.  At a time when the country is hitting 50 year low unemployment rates, it is unusual to have stagnant rent growth.

Unfortunately, all employment is not created equal.  Office demand is driven more specifically by ‘office-using’ employment growth.  Historically, in up-cycles for the economy, office-using employment has grown faster than total employment as companies can afford to hire more workers at higher wages.  However, office-using employment has grown at only a similar rate as total employment from 2014-2017, and it grew at a much slower rate than total employment from 2010-2013. Although demand growth is positive, it seems as though something is different this cycle.

Another headwind for demand is the increased efficiency in how space is used by tenants.   In fact, the average square foot (or sqft) of office space per employee has been falling steadily since 1970, from as high as 600 sqft per person to around 180 sqft per person as of the end of 2017.  Efficient floor plates that avoid wasted space has minimized the need to pay rent on space that can’t be utilized.  Additionally, the open workplace trend fits more people in a smaller area than the traditional build-out of one-person offices.  Furthermore, mobile and cloud technology has allowed companies to go paperless and turn their offices into a flexible work environment where employees may not be in the same seat every day, thus utilizing desks more efficiently.  Finally, offsite file and data storage has also lowered the amount of space needed for onsite filing cabinets and servers as well.

Effectively No Growth

The end result is a competitive environment among landlords.  Usually this occurs at the beginning of a cycle when vacancies are high.  However, today’s market appears to have experienced a secular shift where free rent and TI’s are required to lease vacant space, which has limited net effective rent growth.

For example, a tenant who signed a 10 year lease for $50 per sqft in 2008 with 2% annual rent bumps will be paying rent of almost $61 per sqft in 2018.  If the current market rent is $61 per sqft, the landlord may have to incentivize the tenant to stay with TI’s and free rent.  In markets such as New York City and Washington, DC, TI packages can be $10 per sqft per year, along with free rent of one month per year.  The resulting new ‘net effective rent’ would only be $46 per sqft, a significant rolldown from the prior lease’s escalated rent.

Analysis by Stifel Nicolaus showed that the average change in yield for new cash rent in the first half of 2018 for 16 office REITs under its coverage was a mere +0.1%.  Excluding Vornado (NYSE: VNO), the average would have been -0.1%.  So why would a landlord sign such a lease?  The obvious reason is to cover the embedded costs of ownership such as real estate taxes and debt service, or, in other words, ‘something is better than nothing.’  In addition, a landlord that is prepping the building for sale may be willing to do a lease with initial cash flow dilution because a building is typically worth more with a tenant than without.  This is what is referred to as a ‘tenant’s market’.

Co-working is Working…For Now

The current leasing environment, combined with the growth in the ‘gig economy’, has opened the door for the proliferation of ‘co-working’.  The ‘gig economy’ is defined as ‘a labor market characterized by the prevalence of short-term contracts or freelance work as opposed to permanent jobs.’  It is important because these short term employees may not be showing up in the employment statistics appropriately, and, in particular, not in the ‘office-using’ employment statistics.  However, many of these short term workers are working in offices; just not the typical large corporate office.

Instead, many are opting for ‘co-working’, a concept where someone (or a small company) can rent space (or even just a desk) over short term periods, which allows for flexibility if the company (or idea) fizzles, or takes off necessitating a larger space.  Though it is not a new concept (Regus (LSE: IWG) has been around for almost 30 years), it has become increasingly popular with the gig economy’s growth.  In particular, these workers enjoy the vibrant culture versus a space that is closed off from other tenants.  Studies have found a collaborative culture can increase productivity, networking, and desirability for prospective employees.

Co-working tenants such as WeWork have been taking advantage of the favorable leasing conditions to gain TI packages with which to build out their highly amenitized spaces.  Recently, WeWork became the largest tenant in Manhattan with over 5 million sqft across the island, all of which was leased since 2010.  In spite of the rapid growth over the past few years, co-working tenants comprise less than 1% of all office space in the country.  The trajectory of the market share of co-working is something to watch as the same issues that forced Regus to declare bankruptcy in 2003 persist; namely, funding long term liabilities (leases with the landlord) with short term assets (payments from the customers).

As such, some landlords have eschewed co-working tenants in the portfolio, and others have limited exposure due to the higher risk.  Of the 10 largest office REIT landlords, only one company (Columbia Property Trust (NYSE: CXP)) has exposure of over 1% to WeWork, while six companies have 0%.  The transaction market also reflects an increase in risk due to a co-working tenant; according to brokers and REIT management teams, cap rates are 50-75 bps higher for properties where a co-working tenant has more than 40% of the building.  This is significant in gateway cities where cap rates are in the 4-5% range.  For example, the difference between a 4% and a 4.75% cap rate on a building with $10 million in NOI would be $40 million, or 16%!

West Coast is the Best Coast

In contrast to New York City and Washington, DC, the West Coast is currently enjoying excellent office fundamentals.  The positive environment is due to limited supply attributable to tighter regulations restricting development, while tech and life science tenants are driving demand.  Job growth in these cities is well above the national average.  Not surprisingly, San Francisco asking rents are now 6% above the dot-com bubble peak, and 74% above the previous cycle high in 2008!  Los Angeles was a bit behind San Francisco, but is now enjoying a dramatic increase in rents due to the spending by content creators and distributors such as Netflix (NASDAQ: NFLX), Hulu, and Snap Inc. (NYSE: SNAP).  Finally, Seattle is also benefiting from the tech boom on the backs of Amazon (NASDAQ: AMZN) and Microsoft (NASDAQ: MSFT).  The projections for continued rent growth have driven cap rates to cyclical low levels as well.

One risk in the California markets is the potential repeal of Proposition 13.  Called the ‘split-roll’ initiative, it would take away the favorable tax treatment for non-residential landlords in the state.  Currently, assessment increases are limited to only 2% per year until a transaction occurs, bringing the assessed value up to the transaction value.  The passage of Prop 13 in 1978 has been a boon for homeowners and landlords alike, but it is the root of budget issues that have led to high state income taxes.  The split roll expects to generate a $6-10 billion annual increase in real estate taxes, of which about 40% will be allocated to schools.

The option to repeal Prop 13 for non-residential landlords will be on the 2020 ballot and, if it passes, it will affect REITs with high exposure to California properties that have not been re-assessed in the past 5-10 years.  However, even relatively recent acquisitions or developments could be impacted as some properties have had their market value appreciate significantly due to the impact of the recent tech boom on real estate values.  While the New York office REITs are trading at larger NAV discounts (rightfully so), we believe West Coast office prices do not reflect the highly positive environment due to the potential repeal of Prop 13.  As shown in Figure 2, the most exposed in the Chilton REIT Composite include Kilroy (NYSE: KRC) and Douglas Emmett (NYSE: DEI) and, to a lesser extent, Boston Properties (NYSE: BXP) and Vornado (NYSE: VNO).

One positive of the highly regulated California markets is its effect on new supply.  Both Los Angeles and San Francisco are highly regulated markets, which limits new construction.  For example, San Francisco has ‘Prop M’, which grants only 875,000 sqft of new office construction permits per year.

Valuation Bifurcation

As mentioned above, cap rates are extremely low for office buildings in gateway cities.  Using the Real Capital Analytics data from 2001 to August 2018, cap rates are within three basis points (or bps) of the all time low registered in July 2007.  In terms of price per sqft, August 2018 office values were within $6/sqft (or 2%) of the all-time high recorded in August 2008.  While this may seem expensive, the major sector average for the Green Street Commercial Property Price Index is over 30% above the prior peak as of September 30, 2018, and office is the third lowest of 11 sectors tracked.

The relative underperformance in the private market would indicate office prices are poised to rise higher to if one were to assume a reversion to the mean.  And there are catalysts that could close that gap in short order.  According to Preqin, a research firm that tracks private real estate, public pension funds committed over $17 billion to commercial real estate in the third quarter, the highest for a quarter in more than 10 years.  The recent commitments bring the ‘dry powder’ (committed but not yet deployed) targeting real estate to a record high of $294 billion, indicating that ‘real assets’ (at least on the private side) are enjoying a comeback in diversified portfolio.

According to ISI Research, the office REIT sector was trading at a 20% discount to NAV as of October 19, 2018, only the second time that it reached that level since February 2009 (Figure 3).  Since August 1996, the average office NAV discount has been only 2%, implying office REITs are trading at historically inexpensive prices.

According Green Street Advisors, public REITs own about 5-10% of the institutional quality US office space.  With more than ten times the amount of properties in the private market than in the public market, it is safe to say that private market pricing should be indicative of fair value.  While some of the discount is warranted due to the above-mentioned headwinds of higher supply, low net effective rent growth, and a secular trend toward lower sqft per employee, the size of the discount has made the sector an overweight in the Chilton REIT Composite.  We believe the discount is too great for private buyers to ignore; why would a pension fund buy a building for $1 on the private market when it could invest in a public REIT with similar assets for $0.80?

HQ2, and Apple Too

One office market will get a shot in the arm by the end of the year in the form of Amazon’s HQ2 announcement. In addition, Apple (NASDAQ: AAPL) is quietly exploring a new 4 million sqft campus that could house 20,000 employees.  Northern Virginia and Washington, DC are rumored to be the favorite for both, which could eliminate the market’s supply and demand imbalance.  The announcement could change the fundamentals of the market overnight.  In our opinion, REITs with significant DC office exposure are currently trading at valuations that reflect the rumors, though they may also rally further upon the announcement.  Other cities on Amazon and Apple’s shortlist include: Raleigh, Boston, Denver, and Atlanta.

We don’t claim to have an inside track on the decisions of Apple or Amazon, and thus are not willing to risk an allocation to a name solely on the potential for an HQ2 announcement.  The Chilton REIT Composite allocation has a ‘barbell’ approach, focusing on names trading at the steepest NAV discounts at one end, but solid fundamentals on the other.  We believe each name in the portfolio is undervalued and will be able to prove its fair value in the public market through positive earnings reports and, in some cases, strategic alternatives.

Parker Rhea,, (713) 243-3211

Matthew R. Werner, CFA,, (713) 243-3234

Bruce G. Garrison, CFA,, (713) 243-3233

Blane T. Cheatham,, (713) 243-3266


RMS: 1839 (3.31.2018) vs 2000 (12.31.2017) vs. 346 (3.6.2009) and 1330 (2.7.2007)


Previous editions of the Chilton Capital REIT Outlook are available at

An investment cannot be made directly in an index.  The funds consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable.  Accordingly, comparing results shown to those of such indexes may be of limited use.

The information contained herein should be considered to be current only as of the date indicated, and we do not undertake any obligation to update the information contained herein in light of later circumstances or events.  This publication may contain forward looking statements and projections that are based on the current beliefs and assumptions of Chilton Capital Management and on information currently available that we believe to be reasonable, however, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements.  This communication is provided for informational purposes only and does not constitute an offer or a solicitation to buy, hold, or sell an interest in any Chilton investment or any other security.

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