By Karen Nickerson

Company executives, analysts and investors have anxiously waited for the recovery in the office market to take hold. Has the bottom finally arrived and the recovery begun?

Not yet. Before we can confidently claim a recovery has taken hold, there are still some lingering issues facing the sector. Continued deterioration in occupancy through the end of 2003 is expected and that will pressure already weakened same-store net operating income (NOI). Overall, leasing costs will continue to increase well into 2004. However, there are signs that the office market slump, which began in the second half of 2001, is bottoming. The number of space showings has begun to rise from the anemic levels in 2002 and early 2003, and the rate of sublet space deliveries has slowed. Torto Wheaton Research cites that sublet space was 28.3 percent of all vacancy in the second quarter of 2003 and fell to 18.2 percent of all vacancy in second quarter 2003.

Office
# of REITs	21
Market Cap.*	$32,537,981
Industry Market Cap.*	$197,172,625
% of Industry	16.5%
Yield	6.7%%
YTD Total Return	22.0%
One-Year Return	19.9%
Three-Year Return	7.7%
Five-Year Return	12.0%
Average Daily Trading Volume (shares)	33,825,924
Weighted FFO Growth (Second Quarter 2002—2003)	-5.17%
*These figures represented in thousands. Data as of Sept. 30, 2003. Source: NAREIT.

These facts indicate improving business confidence. Although confidence and employment levels have a ways to go, it is likely the office market recovery will not pick up significant steam until the second half of 2004, if not early 2005, when substantial employment growth is projected.

Lingering Challenges

Occupancy is the number one challenge facing office REITs. After an extended period of decision paralysis, more and more tenants are seizing the opportunity to lock in lower rates and higher quality space—even renewing and extending lease terms earlier than their contracted lease expiration dates. Landlords have had to stretch and be creative with lease economics to stay competitive. For example, some landlords have pre-built space to entice tenants and to compete directly with the sublet market.

Almost all of the office REITs Moody's rates have reported that tenant improvement costs and concession packages have increased substantially compared to 2002. Many office landlords are now paying full commissions on renewals, while others are considering this strategy. Landlords do not want to give brokers a reason to relocate tenants. Some landlords are also being more aggressive in taking the pulse of brokers to ensure that they are “easy to work with” and do not lose deals due to process problems. The elimination of these increased concessions will be a key signal of the office market turnaround, as it will imply the rebalancing of pricing power between landlords and tenants.

Directly related to occupancy stress is the deterioration in same-store NOI compared to one year ago that virtually all office REITs experienced in the first half of 2003. This drop is due to a combination of occupancy and rate pressures and is expected to last through the end of 2003, which will result in further weakening in same-store NOI results. In addition, market rents are lower than many in-place lease rates. When these leases roll, the declining rental rates in many locations will keep the pressure on same-store NOI.

Liquidity Is a Priority

In terms of credit concerns through the end of 2004, two main issues face the office sector—assuming that the recovery gathers at least some momentum in 2004. The first concern is short-term capital requirements. Increased needs for capital, coupled with rental rate compression, will challenge landlords' liquidity. These factors, combined with deteriorating earnings, will put further pressure on fixed-charge coverages. In addition, rising leasing activity will require higher levels of short-term capital (such as for tenant improvements) in order for landlords to compete for deals. Office landlords will need to be particularly prudent in their cash management to be able to meet this challenge.

The second concern is the potential heightened use of joint ventures to supplement REIT earnings growth through management and other fees. Joint ventures usually result in higher secured debt levels—a credit negative. Joint ventures have proven to be a vehicle for REITs to realize imputed gains and to diversify investment risk. However, office REITs need to be mindful of effective leverage levels (on and off balance sheets) as a result of joint venture activity.

New Supply Not Driving Vacancies

Unlike past downturns, weak tenant demand, rather than excessive office supply from overbuilding, is driving the escalating vacancy rates in the office sector. The national vacancy rate has increased by 200 basis points year-over-year to 16.6 percent, according to CB Richard Ellis' Office Vacancy Index, Second Quarter 2003. The development pipeline has diminished in recent years, which would suggest a speedier recovery when net absorption turns positive.

However, continued evidence of underutilized space for many tenants will keep demand at bay. This space (which has been underappreciated by the market) may be enough to slow the office recovery by one or two quarters, as it is re-absorbed. Furthermore, there still is a significant amount of sublet availability that needs to be absorbed before the office sector rounds the corner. The overall sublet market is approximately 3 percent to 4 percent of the total vacancy rate, according to Cushman & Wakefield's second quarter 2003 MarketBeat Snapshot for the office sector. The good news is the rate of sublease space delivery has diminished.

Consistent Job Growth Will Fuel Recovery

Until the job market shows consistent signs of recovery, the office property sector will remain stressed. Although there have been recent declines in jobless claims, it is not enough to constitute a reversal in the job market. Moody's does not anticipate any substantial improvement in office employment within the next year. In addition, the unemployment rate could inch higher over the next few quarters as corporate America remains credit-stressed.

The surprise in August that jobless claims continued to rise (when economists anticipated a slight decrease) validates our view. Also, as interest rates rise, corporate debt expense will increase, adding more financial stress. The point is that corporate growth will need to wrestle with growing interest expense in order for the job market to stabilize. This would be exacerbated should short-term rates rise.

Negative Sector Outlook Remains

Office REITs have weathered these challenges well on the whole. Although key financial ratios have weakened, the sector has maintained its overall average senior unsecured rating of Baa3—an investment grade rating. Few rating actions for office REITs have taken place so far in 2003. The outlooks for Reckson Associates Realty Corp. (NYSE: RA) and Equity Office Properties Trust (NYSE: EOP) were changed to negative from stable, and Highwoods Properties, Inc. (NYSE: HIW) was put on review for downgrade and subsequently downgraded in the third quarter. These actions reflected weakened operating performance and the potential for further deterioration.

The office REIT sector in the aggregate has suffered from thinning fixed charge coverages from an overall average peak of 4.1X in 2000 to an average of 2.4X for the second quarter 2003. These coverages are weaker when “fully loaded” with capitalized interest, principal amortization and ground lease payments. However, there has been some positive credit news in 2003. Mack-Cali Realty Corporation's (NYSE: CLI) debt ratings were upgraded to Baa2. This action was a result of Mack-Cali's commitment to maintaining a strong balance sheet and sustaining operating performance during these adverse market conditions. PS Business Parks (NYSE: PSB) was also upgraded.

Rating Outlook for Office REITs

As of Sept. 15, 2003. Source: Moody's Investors Service

Moody's expects no material rating changes for office REITs in the foreseeable future. Any rating changes that do occur would likely be no more than one notch. Moody's will remain focused on REITs' financial flexibility and ability to manage through these cash flow challenges.

The story remains the same: The challenging market climate persists, occupancies continue to decline, pricing power still lies with the tenants, and office REITs are experiencing growing leasing costs and rental rate compression. The good news is that most REITs have indicated that net absorption is starting to pick up in their markets, albeit at modest rates. Investors should expect only slight improvements in the office sector until the second half of 2004 at the earliest.

Leading Office REITs, Ranked By Total Assets
REIT	Ticker	Senior Debt Rating	Total Assets ($ in thou)
Equity Office Properties Trust	EOP	Baa1	24,935,336
Vornado Realty Trust	VNO	Baa2	8,971,580
Boston Properties, Inc.	BXP	Baa2	8,276,209
Duke Realty Corporation	DRE	Baa1	5,430,926
Crescent Real Estate Equities Company	CEI	Ba3	4,208,220
Mack-Cali Realty Corporation	CLI	Baa2	3,794,873
HRPT Properties Trust	HRP	Baa2	3,364,060
Highwoods Properties, Inc.	HIW	Baa2	3,362,033
Reckson Associates Realty Corporation	RA	Baa3	2,900,994
CarrAmerica Realty Corporation	CRE	Baa2	2,796,570
Arden Realty Inc.	ARI	Baa3	2,752,883
Brandywine Realty Trust	BDN	Ba1	1,886,795
PS Business Parks, Inc.	PSB	Ba1(Pfd)	1,157,830
Washington Real Estate Investment Trust	WRE	Baa1	769,858
Data as of June 30, 2003. Source: Moody's Investors Service