By Elizabeth Campbell

Three years ago, a dramatic pullback in tenant demand sent ripples throughout the office REIT sector impacting occupancy, rental rates and tenant concessions. However, after some tough times, the sector appears to have reached a cyclical trough. Standard & Poor's expects the office market recovery to be measured, as excess supply is slowly absorbed by modest incremental demand from muted office-based employment growth, continuing the sector's history of long, deep supply and demand cycles.

Standard & Poor's currently rates 16 office REITs and real estate operating companies (REOCs), whose nearly $24 billion of rated securities comprise approximately 30 percent of Standard & Poor's rated REIT/REOC securities. Together, these 16 companies own just over 470 million square feet of CBD (central business district) and suburban office space, or nearly 16 percent of the estimated 3 billion square feet of national inventory. The average occupancy for this group was 89 percent at first quarter 2004, outperforming the national average (partially due to REIT portfolio concentrations in certain better-performing U.S. markets, such as New York City and Washington, D.C.).

The 16 companies have a total gross book value of assets of over $85 billion. The corporate credit ratings for these companies range from ‘BB-' to ‘BBB+', with the majority clustered in the ‘BBB' category, and most carry a stable outlook.

The Office Landscape

Following 13 consecutive quarters of occupancy rate declines from a third quarter 2000 peak of 92.3 percent, national office occupancy rates stabilized at 83.2 percent in the first quarter of 2004, according to Reis, Inc. However, it is likely to be another few quarters before occupancy improves enough to support positive rent growth nationally.

Unlike the prior supply-induced national office market downturn of the early 1990s, the recent cyclical downturn was driven by a material and rapid contraction in tenant demand. While levels of new supply did slow, successive blows to the U.S. corporate sector (technology, telecom, financial services, and airlines) materially reduced demand for office space. Additionally, a rise in tenant bankruptcies resulted in meaningful lease cancellations pressuring occupancy, while tenants with excess space drove sublet and "shadow" space higher, further exacerbating market fundamentals. This national supply and demand imbalance placed significant downward pressure on rents and upward pressure on tenant concessions.

The effective rents of office REITs declined roughly 5 percent last year (down a cumulative 20 percent from their peak in 2000) and are anticipated to continue to decline in 2004 (but likely more modestly) as leases signed five years ago mature. As a result, aggregate office REIT revenue may decline this year, despite the expectation for positive movement in portfolio occupancies.

Job growth is a key indicator of demand for office space, and the economy created roughly 600,000 jobs during the second quarter of 2004, according to the U.S. Bureau of Labor statistics. However, the pace of growth dropped unexpectedly in July, casting uncertainty for net positive office space absorption. Additionally, corporate outsourcing may temper long-term demand for office space from traditional users. New supply generally remains in check, but has not completely abated; therefore, deliveries are likely to restrain net absorption over the next four quarters.

Despite this lackluster picture, the sector's strong liquidity remains a relative bright spot. Very strong investor interest created a favorable seller's market for quality, well-leased assets, allowing office REITs to effectively monetize investments and cull their portfolios. Additionally, the highly competitive acquisition environment lowered cap rates, limiting REITs' acquisition appetite and competitiveness (vis-à-vis highly leveraged buyers who are willing to accept lower yields).

This recent lack of buying opportunities resulted in many REITs focusing on strengthening their operating efficiencies and margins as well as improving relationships with tenants and outside brokers in an attempt to drive leasing activity. A by-product of this focus has been successful "blend and extend" activity, with landlords retaining tenants and renegotiating leases long before they expire, which has served to cushion the impact of rent roll-downs. As a result, most rated office REITs continue to outperform their respective sub-markets in terms of occupancy.

Financially, office REIT balance sheets are generally well positioned to absorb continued moderate near-term rent roll-down. Management teams have taken advantage of the extremely liquid market for their assets, as well as available refinancing opportunities within their capital structures. Leverage has remained stable in the low 40 percent range (market value basis) on average, and the lower related financing costs from recent issuances should help cushion potential near-term erosion to free cash flow.

Credit Strengths

Generally longer-term leases result in stable and predictable revenues from year to year; just over 16 percent of portfolio square footage is rolling, on average, over the next seven quarters (through year-end 2005) for Standard & Poor's universe of rated office companies. Lease terminations have abated from unusually high levels over the prior few years, when they contributed to unexpectedly higher REIT vacancies and tenant improvement costs.

Office leases typically allow the pass-through of some increases in operating expenses, buffering the landlord from spikes in costs that are generally outside of their control, such as real estate taxes and insurance.

Investor interest in well-leased office properties remains strong (as was the case throughout the most recent cyclical downturn), enabling office REITs to sell or finance properties or enter into joint ventures to derive liquidity. Construction levels were kept in check as the economy entered the downturn and as lenders tightened their lending standards.

The office sector's relatively high credit quality tenant base, particularly for the largest tenant exposures, is also considered to be a credit strength. Lead tenants are often investment-grade or unrated, but large, nationally recognized firms. While the vast majority of smaller office tenants would be considered non-investment grade, this risk is offset by diversification across individual tenants and industries.

Credit Weaknesses

On the negative side, the office sector is subject to long, deep supply and demand cycles. In the prior cyclical downturn, vacancy peaked at over 19 percent in 1991, and positive effective rent growth was not seen for two to three years after fundamentals began to shift. In the current cycle, vacancies began to rise in late 2000; and while vacancies recently peaked, it is likely to be another few quarters before effective rent growth turns positive.

Office assets require continual significant capital expenditures to remain competitive. In addition to regular maintenance, the current competition for tenants has driven tenant allowances (on both new and renewal leases) to unusually high levels.

Medium to long-term leases are not "marked to market." While this provides some stability to the landlord's cash flow during a downturn (when in-place rents are likely to exceed market rents), during a recovery, landlord cash flow will lag the market as above-market in-place rents are re-set to market over time.

Long-term demand for traditional headquarters space is uncertain. Even as current office space users begin to grow and increase hiring, many are not fully utilizing their existing space, which will need to be absorbed before these users require additional space. Also, outsourcing tempers demand for U.S. office space over the long term.

A longer-term credit weakness is the growing office REIT exposure and concentration across legal firms, as these private entities are typically structured as limited liability companies and their credit quality is often unknown. These firms prefer to locate in CBD assets and commonly expect very high levels of tenant finish, the cost of which, in recent years, has been borne by the landlord.

Analytical Factors

Market concentration can be a double-edged sword. High concentration has boded well for those office REITs in relatively strong markets, including Vornado Realty Trust (NYSE: VNO), Reckson Associates Realty Corp. (NYSE: RA), and Arden Realty, Inc. (NYSE: ARI). But for those REITs concentrated in the weaker performing markets nationally (Dallas, Austin, Denver, Atlanta Greensville), such as Crescent Real Estate Equities Company (NYSE: CEI) and Highwoods Properties, Inc. (NYSE: HIW), the negative impact on occupancy and same-store figures has been pronounced. Additionally, Equity Office Properties Trust (NYSE: EOP) and CarrAmerica Realty Corporation (NYSE: CRE) are expected to continue to experience rent roll-downs, due primarily to above-average exposure to the still very weak greater San Francisco Bay area/San Jose market.

Interestingly, the challenging operating and reinvestment environment has probably been a motivating factor behind some recent asset swaps between public REITs. Last year's Mack-Cali Realty Corporation (NYSE: CLI) sale of an office building in Jersey City to iStar Financial, Inc. (NYSE: SFI) pared back Mack-Cali's exposure in that sub-market, while Crescent's sale of the Woodlands to The Rouse Company (NYSE: RSE) reduced its exposure to Houston and provided some liquidity and an entry into the Las Vegas office market.

Looking at near-term lease expirations, those companies with the highest 2004-2005 lease rollovers (Arden, PS Business Parks, Inc. (NYSE: PSB), Brandywine Realty Trust (NYSE: BDN), and Liberty Property Trust (NYSE: LRY)) generally face moderate market conditions. Some companies with near-term rollover in weaker markets (CarrAmerica, Equity Office) have relatively manageable leasing exposure as a percent of their total portfolio square footage.

Turning to tenant concentration, the U.S. government is among the largest tenants for nearly half of Standard & Poor's rated office REITs. Brookfield Properties Corporation (NYSE: BPO) the only company with a greater than 10 percent concentration to a single non-GSA tenant (Merrill Lynch), and this concentration concern is somewhat mitigated by the strong credit quality of that top tenant. Overall, tenant and industry diversification for the rated office REITs is good, and tenant concentrations are less of a concern today, as national corporate bankruptcy filings have peaked.

While all of the rated office REITs experienced occupancy declines during 2003, and the average same-store NOI declined 4 percent for the year, a handful of companies (Arden, Vornado, Boston Properties, Inc. (NYSE: BXP)) posted positive same-store NOI results. These three REITs benefited from their concentrations in better-performing markets, as well as the maintenance of above-average occupancy levels.

Looking forward, occupancy is expected to be stable or modestly higher in 2004, while same-store results on average are likely to be negative (but less so than was the case in 2003). Debt service and fixed charge coverage measures may decline modestly during the year, but should remain adequate in the mid-2x and low-2x range, respectively, on average. However, dividend shortfalls remain a concern.

While development activity declined during the downturn, construction did not completely subside. The aggregate 30 million square feet nationwide of development deliveries (REIT and non-REIT combined activity) is expected to continue to weigh on fundamentals and temper absorption this year. The aggregate cost of the office REITs' development projects is estimated at $2 billion (about half of which remains to be funded), and this pipeline is roughly 50 percent to 60 percent pre-leased. If leasing remains tepid, stabilization of projects would be delayed, which would likely pressure company cash flows. Those companies with the greatest absolute development exposure (Boston Properties, Vornado) tend to be large companies with development experience, and therefore are better able to absorb the risks associated with development.

Office REIT financial profiles are generally sound and liquidity is adequate, but high dividend payouts are a credit concern. Standard & Poor's has retained its stable outlook on many office REITs with dividend shortfalls (including Arden, Crescent, Equity Office, Highwoods and Reckson) if the shortfall is considered moderate and the duration brief. Capital requirements, excluding capital expenditures related to leasing, are relatively moderate. Near-term debt maturities are manageable at $7.5 billion over the next two years (roughly half of which comprises secured debt) and remaining development pipeline funding needs are manageable; leverage is expected to remain stable. Credit facility usage remains fairly low, at less than 30 percent drawn on average, resulting in adequate external liquidity. Additional liquidity remains available from investor interest in well-leased assets; however, the REITs that are net sellers may be challenged to profitably redeploy sales proceeds in the current, very competitive, low cap rate acquisition market.

The decline in interest rates combined with strong capital flows into the sector have helped to offset weak property performance, as office EBITDA debt coverage measures have been fairly stable compared to recent years. However, office REIT revenues during this period were somewhat bolstered by above-average levels of lease termination fees that have moderated in the current healthier macroeconomic climate. Overall, the office REITs did not become overly reliant upon variable rate during this period, as less than 20 percent of total debt is comprised of variable-rate debt.

Office
# of REITs	21
Market Cap. (in thousands)	$38,564,541
Industry Market Cap. (in thousands)	$251,877,522
% of industry	15.3%
Yield	6.3%
YTD Total Return	2.8%
One-Year Return	15.6%
Three-Year Return	10.5%
Five-Year Return	12.8%
Average Daily Trading Volume (Shares)	4,863,114
Weighted FFO Growth (First Quarter, 2003–2004)	-6.95%
Source: NAREIT. Data as of July 31, 2004