By Arlene Isaacs-Lowe, CPA, CFA

Faced with weakened market fundamentals and deteriorating operating performance, office REITs have maintained relatively stable credit profiles, benefiting from a favorable financing environment. But can they continue to be disciplined when faced with lease rollover risks, capital funding requirements and enticing acquisition opportunities?

Deteriorating office property fundamentals have been a result of contraction in demand, not oversupply. This should have positive implications for the timing and pace of a recovery for the office market. Throughout recent market turmoil, most office REITs have remained committed to maintaining sound balance sheets and relatively conservative leverage.

These factors are offsetting weakened portfolio fundamentals and declining operating results, and should enable office REITs to weather the lingering economic downturn, providing they resist the temptation to aggressively pursue opportunistic acquisitions and maintain flexibility to fund future leasing cost.

Impact of Supply and Demand Fundamentals

It's fair to say that the erosion of the office market is mostly a result of a sharp decline in demand for office space. Corporate failures and contractions in the technology sector—impacting technology related tenants and those markets with technology concentrations—initiated much of this deterioration. However, as the U.S. economy weakened, a drop in demand drivers spread to virtually all industry sectors across every office market to varying degrees, with few markets untouched. The good news is that supply has remained relatively constrained.

An imbalance prompted by either the supply or demand side of the equation has the same near-term effect. However, although an increase in space demand will lag an economic recovery, the pace of improvement for the office market should be better for this market cycle, barring any other events that could derail an already fragile economic recovery.

With increased public market scrutiny and a more attentive capital market, financing for office projects was constrained at the first signs of an imbalance in supply and demand. Even so, there are some markets that went into the recession with substantial supply pipelines; when combined with a sharp decline in demand, occupancy rates quickly plummeted. The extent of office market deterioration differs across the country, emphasizing the importance of portfolio diversification.

Median Occupancy Rates for Rated Office REITs

Source: SNL and company financials Data: Median occupancy rates for five quarters

Percent Change in Occupancy for Rated Office REITs

Source: SNL and company financials Data Occupancy % changes for five quarters

Leverage & Coverage for Rated REITs

Source: SNL and company financials Medians for office REITs

The correction in demand fundamentals also tends to occur more quickly. Job growth is expected to be anemic but positive in 2002, eventually picking up in 2003. Demand for office space should lag the job growth, and occupancy improvement will likely not be reflected until a few quarters later, with rents firming thereafter. Suburban markets, where much of the development activity was concentrated, should be slower to recover, while CBDs (central business districts), benefiting from their traditional barriers to entry, are expected to recover sooner.

Office properties' typical long-term lease structures continue to provide some stability of earnings during downturns in the real estate cycle. However, corporate failures and declines in the credit quality of some major office space users have compounded landlord's exposure to re-leasing risk and future capital funding.

Another phenomenon helpful in forecasting the market is the behavior of prospective buyers and sellers. While the uncertainty surrounding the timing and pace of an economic recovery has stalled some transactions, Moody's Investors Service believes there is pent up capital available for investing by REITs, opportunity funds, pension funds and foreign investors. As a result, it is expected that the pace of deals should increase as the visibility surrounding the economic outlook and its resultant effects on the office market improve. We have already begun to see evidence of this.

Will Office REITs
Toe the Financial Line?

Moody's rating outlook for office REITs continues to be cautious, on balance, and substantial rating changes are not anticipated. The public office sector is expected to demonstrate its resilience in this downturn, showcasing the benefits from sound portfolio management, public disclosure and a disciplined approach to financial management. Rated office REITs continue to maintain relatively strong balance sheets and adequate fixed charge coverages, given their typical “Baa” ratings.

However, acquisition opportunities will become more tempting, and this could lead to some balance sheet softening. In addition, office REITs that have portfolios concentrated in weaker markets have material exposure to weak credit tenants and have substantial capital funding needs to re-lease space or complete development pipelines, and could experience downward rating pressure.

Office Sector
# of REITs	20
Market Cap.	$30,419,186*
Industry Market Cap.	$171,262,385*
% of Industry	17.8%
Average Dividend Yield	7.0%
YTD Total Return	–0.8%
1-year Total Return	–1.3%
3-year Total Return	11.8%
5-year Total Return	7.3%
Weighted Daily Volume (shares)	22,941,577
Weighted FFO Growth (2001–2002)	0.8%
*These figures represented in thousands. Data as of September 1, 2002 Source: NAREIT

Deteriorating fundamentals across virtually all markets have dragged down recent operating results for office REITs, even resulting in negative FFO (funds from operations) growth for some companies and downward revisions for future earnings estimates for others (even when buoyed by lease termination fees, which are not only non-recurring but also expose the company to greater vacancy risk.) However, portfolios are beginning to show evidence of stabilization, with occupancy rates falling at declining rates.

Economic regional diversification has proven to be a more effective risk management tool than geographical diversification: the technology sector, and its impact on Boston and San Francisco, is a case in point.

Fortunately, many office REITs entered this cycle with relatively strong balance sheets and are benefiting from cheaper capital cost prompted by low interest rates and strong investor demand for their paper. Some companies have taken advantage of the low interest rate environment by converting amounts outstanding on bank facilities to long-term unsecured debt, redeeming more expensive preferred stock, and even unencumbering assets. With few acquisition transactions to date, leverage has remained relatively stable. Fixed charge coverages have also remained relatively stable, with the deterioration in earnings partially offset by lower financing costs.

What Could Go Wrong?

As the bid/ask spread for institutional-quality office assets begins to narrow, and more investment sales transactions become viable, office REITs will be tempted to acquire assets. An aggressive acquisition strategy that sacrifices the quality of the balance sheet, even on a short-term basis, while still attempting to manage a weakened existing portfolio, could prove overwhelming, both from the perspective of increased leverage as well as stretched resources.

The current downturn in the real estate cycle is an opportunity for the public office REIT market to demonstrate its maturity. Office REITs will be challenged to maintain sufficient financial flexibility to release their portfolios even as they remain competitive. Those firms that can balance these objectives will maintain stable credit ratings and will be poised to take advantage of a market recovery.