By Karen L. Nickerson

The office REIT sector contains some of the largest and most well- known companies in the publicly traded real estate industry. And when you factor in those diversified companies that also allocate at least a portion of their portfolio toward office properties, the sector is also one of the deepest and most diverse. To some degree, all of those varied companies faced challenges in recent years due to difficult market fundamentals in the office sector.

However, despite profitability and cash flow pressures resulting from stressed market fundamentals, 2004 marked the bottoming of performance for much of the office sector. Like most real estate companies, office REITs took advantage of the low interest rate environment and benefited from ample access to all aspects of the capital markets.

Office market fundamentals are expected to continue to improve, albeit slowly. Asset pricing levels are expected to continue to be frothy, which will lead office REITs to pursue more complex and riskier methods to grow their businesses.

Sound Credit Position, Few Surprises

Last year marked a record in terms of bond issuance for REITs, with office REITs contributing 36 percent, or $6.1 billion, of the $17 billion in total corporate REIT bond issuance. Office REITs also issued more than 25 percent of the total equity issuance (both preferred and common) offered by all REITs in 2004, according to NAREIT, exhibiting their efforts in defending their balance sheets. In addition, leverage remained steady and unencumbered asset pools were sustained.

With few exceptions, credit ratings for U.S. Office REITs held steady in 2004. Despite strains in market fundamentals, office REITs have managed their balance sheets prudently. Rating changes in 2004 were driven by changes in debt protection measures and capital structure.

Perhaps the two most notable rating changes were Equity Office Properties Trust (NYSE: EOP) and Reckson Associates Realty Corp. (NYSE: RA). EOP was downgraded by Moody's to Baa2 from Baa1, reflecting the erosion in EOP's operating performance in recent years. Reckson was upgraded to Baa3 from Ba1, acknowledging a number of material balance sheet enhancements executed by Reckson during 2004, particularly substantial common equity issuance.

As for 2005, expect office REITs' credit metrics to remain stable, and perhaps even strengthen modestly should there continue to be upward drift in office market fundamentals. Earnings should begin to strengthen and become more predictable as occupancies move toward stabilized levels, but cash flows will continue to be crimped by capital needs for replenishing occupancy.

'05 Market Momentum—Slow and Uneven

It is clear that office market fundamentals are improving. However, that improvement is slow and uneven, and it looks to continue at that pace in 2005. Vacancy rates peaked in the third quarter of 2003 at 16.9 percent and gradually improved to 15.9 percent at the end of third quarter 2004, according to CB Richard Ellis and Torto Wheaton Research.

Unfortunately, increased absorption has not yet translated into the ability to influence rental rates, or to predict lag times between leases or the pace of absorption. Negative rent rolls are expected to continue into 2005. Although momentum is seemingly sustainable, modest assumptions are being made regarding 2005 performance. Mark-to-market rents are expected to be slightly down to flat through 2005. Occupancy on a sequential basis for many office REITs will be choppy, driven by timing and location of 2005 lease expirations. Many property owners will see continued pressure from tenants in the short term to renew leases early, as tenants sense that market vacancies and their negotiating leverage have peaked.

Office
# of REITs	24
Market Cap. (in thousands)	$46,623,056
Industry Market Cap. (in thousands)	$283,483,164
% of industry	16.4%
Yield	5.9%
YTD Total Return	-7.7%
One-Year Return	10.0%
Three-Year Return	13.4%
Five-Year Return	15.4%
Average Monthly Trading Volume (Shares)	8,877,345
Source: NAREIT. Data as of Jan. 31, 2005

Although employment grew at a moderate pace during 2004, a recent report by Torto Wheaton Research suggests that momentum gained from this might not be as sustainable as it seems. In its “TWR Flash Office Vacancy Index” report, Torto Wheaton proposes that the recent decline in vacancy is not completely driven by actual market demand, asserting that much of the decline is due to sublet space transitioning to shadow space. In other words, tenants with near-term lease expirations are taking sublet space off of market because the space is not marketable given its short term. This effect could cause unexpected vacancy increases if it is not monitored and managed appropriately.

Growth Strategies Become Riskier

Moving into 2005, Moody's expects office REITs to become less focused on the “damage control” business strategy of recent years, and more focused on refining and implementing their growth strategies. Investment sales activity remained robust throughout 2004, but office REITs found asset pricing very competitive, and financially unattractive. Market fundamentals are inconsistent with pricing. Vacancies are still high, with little, if any, rent growth. Still, real estate investors have been willing to pay lofty prices for properties due to a robust flow of capital into the real estate sector and historically low interest rates. The capital flood stems from lack of alternative investments and the tangible nature of real estate. As a result, many office REITs are employing some new strategies to enhance investment returns in the current environment.

Office REITs—such as Equity Office, Reckson and Brandywine Realty Trust (NYSE: BDN)—are pursuing and purchasing vacancy more aggressively. This strategy could be quite risky in that these firms are largely relying on the improving market fundamentals (which we predict will be slow and choppy) to drive occupancy, and thus returns. However, Reckson's purchase of Three Giralda Farms in New Jersey and its ability to sign a full-building lease with Dai-ichi Pharmaceutical Corporation only three months later was a success.