Real estate investment trusts that specialize in office space appear likely to emerge intact (but different) from the downturn
When a newspaper mistakenly ran Mark Twain’s obituary while he was still alive, the cantankerous author supposedly responded that “reports of my death are greatly exaggerated.” These days, people who rent out office space could be feeling the same way.
Pundits are pronouncing the office kaput. They consider the office missing in action, down for the count, dead on arrival. They reason that employees who have tasted the freedom of working from home will never willingly return to the drudgery of working regular hours. And why wouldn’t employers prefer to cut their expenses by renting less office space?
But it’s not all that simple, according to executives at office-oriented real estate investment trusts, or REITs, the publicly traded companies that own, operate or finance properties on a large scale. They’re continuing to collect rent—more than 90% of the rent that’s due—and they believe that pandemic-induced selloffs have driven office REIT stock prices to artificially low levels.
Not all REITs are the same. They all own or control property, but the properties vary, notes Calvin Schnure, chief economist for National Association of Real Estate Investment Trusts, a trade association generally referred to as Nareit.
The pandemic has triggered an economic boost for REITs that own data centers and cell towers because the public has lived online during the shutdown, Schnure says. At the other end of the spectrum, the plague has temporarily shuttered hotels and halted or severely curtailed foot traffic in malls. Office REITs fall in the middle.
Offices have been idled while workers stayed home under shutdown orders, but office REIT tenants—unlike retailers—still paid the rent, Schnure maintains. That’s because office REITs tend to own fairly new prestige buildings in the central business districts of the nation’s key cities, such as New York, Chicago and Los Angeles. They rent to investment-grade Fortune 500 tenants.
What’s more, office REITs entered the pandemic-induced economic downturn in better shape than in previous hard times, according to Schnure. In the decade since the Great Recession, office REITs strengthened their balance sheets, raised about $440 billion of equity capital, reduced their leverage ratios and cut their debt to assets to about the lowest in history.
They not only lowered their reliance on debt but also lengthened the maturity of the remaining debt. In fact, the weighted average maturity before the pandemic was a year and a half longer than it was when the financial crisis of 2008 hit, Schnure continues.
“That means that they’re not going to face as many immediate cash flow problems to roll over the debt,” he says. “They were well-prepared in terms of some pretty prudent balance sheet measures ahead of the crisis, and that’s going to give them a bit of an advantage dealing with it.”
And the advantages don’t end there for office REITs. Despite the healthy pre-pandemic economy, relatively few construction projects were underway when the virus struck, Schnure says. Construction relative to existing office space was about 2% at the end of 2019, compared with 6% in the 1980s, he notes.
So even as the pandemic causes demand to weaken as leases expire, the problem won’t be compounded by a big wave of supply hitting the market. “That means that we’re probably going to be a bit more resilient in the office market over the next two years than you would have been had you had a higher level of construction,” Schnure says.
That resilience is fine, but what about the trend toward working remotely instead of commuting to the office?
Working from home
Some employees have apparently developed a fondness for working at home during lockdown, and speculation about the effect on office space has run rampant. Many fear the trend could bring irreparable harm to the office space market.
Employees might come into the office on staggered schedules, working from home a few days a week. The trend toward shared, open spaces might reverse to provide closed offices and cubicles that don’t promote the spread of infection.
But companies can’t shrink their office space overnight because commercial leases tend to run for a number of years, and redesign and construction take time. Office REIT executives insist their industry may have to change but will emerge intact.
“Working from home is not new,” says Stephanie M. Krewson-Kelly, a vice president at Corporate Office Properties Trust. “It used to be called telephonic commuting and then telecommuting. Those terms were coined in 1970s, so working from home has been around for quite a long time—almost 50 years.”
Working from home ebbs and flows, but the pandemic has demonstrated people prefer to work in an office, according to Krewson-Kelly. Offices promote collaboration and provide a backdrop for training, she says. In her view, it’s also difficult to land a promotion working remotely.
Research backs her up, Krewson-Kelly says, citing a survey of more than 2,300 office workers conducted by a third party for Gensler, a San Francisco design and architecture firm. Only 12% of workers want to work from home full-time, a summary of the survey says. Although most would prefer to return to the office, they’d appreciate more space, less desk-sharing, and more support for mobile and virtual work, the summary says.
In another study, this one of 5,000 workers, Gensler’s research partner asked employees to rank work environments. At high-performing companies, the largest group picked the office as their first choice, followed, in order, by home, coworking spaces and coffee shops. At companies defined as low-performing, workers’ preferences were, in order, home, the office, coworking spaces and coffee shops.
Meanwhile, Nareit’s head economist seems delighted to work remotely. “I’m hoping that we keep working from home,” he says. “It’s giving us a lot of flexibility. This is something that is certainly going to have a lot of momentum behind it.”
The lockdown added to that momentum by barring people from offices, but new hardware helps, too, Schnure maintains. “A lot of offices, a lot of employees, a lot of employers are finding that the technology for working from home, including the Zoom teleconference, is just head and shoulders better than it was 10 years ago,” he says.
But however the working-from-home trend shakes out, the shared workspace model—where freelancers find refuge from loneliness in surrogate offices—seems challenged.
WeWork, the best-known shared workspace company, was already troubled when the pandemic struck, notes Glenn Mueller, a business professor at the University of Denver. The company had been voraciously acquiring office space by either leasing or buying it.
WeWork was signing 15- and 20-year leases and then renting the space out by the day, Mueller says. “So they got a long-term liability with short-term income,” he continues, “and that whole concept is up for grabs as to how it works out in the future.”
For the last couple of years, WeWork was signing about 10% of all the new office leases in the nation, a trend that’s not as startling as it might appear, Mueller continues. “When you have 10-year leases, that means 10% of the marketplace is releasing each year,” he notes, “and 10% of that would be 1% of all office space. Its growth looks big but its percentage of the total is small. Growing from half a percent to 1% is a 100% increase, but out of the total it’s still just a rounding error.”
WeWork locations are mostly in big cities, says Krewson-Kelly, which is one of the reasons urban office REITs like SL Green Realty (SLG), which bills itself as New York City’s biggest commercial landlord, and Vornado Realty Trust (VNO), another Manhattan giant, are trading disproportionately worse. Their stock prices have been hit hard because of their exposure to tenants like WeWork, she says.
Yet in general, office REITs appear likely to maintain dividends and see stock prices rise, the executives say. But overall global recovery? It’s complicated.
REITs began the current crisis in good shape, but they don’t exist in a vacuum, says Schnure. “Even though the overall economy did not have a lot of imbalances prior to this crisis, it’s going to take some time for all the sectors to start working together again and heal the damage.”
It won’t be easy. “The next two years or so are going to be a period of getting through the crisis and then a macroeconomic recovery,” he says. “It takes longer than you expect. There’s a lot of economic damage, a lot of financial damage and a lack of confidence after a major shock like this, so I don’t expect a V-shaped recovery.”
Mueller agrees. “When this started, a lot of people said it’s going to be a V-shaped downturn,” he says. “Then into Month 2 and Month 3 of COVID-19, people were saying, ‘Well, it looks like it’s going to be more U-shaped, and the U may be fairly wide.’” Predictions of reaching recovery mode by the fourth quarter strike him as optimistic.
But just the same, based on conversations with REIT experts, reports of the death of the office seem exaggerated.
Reopen with Caution
Americans are blithely mingling in bars and on beaches as the economy reopens—almost as though the coronavirus has somehow been banished. But the pandemic is far from over, and companies that are asking employees to return to the office are well-advised to take precautions.
That can begin with training workers to practice infection control measures, epidemiologists say. Instruction can include the proper way to wear a mask, best practices for washing hands and tips on gauging social distancing.
Employees should form the habit of sanitizing shared objects, including copiers, coffee pots and refrigerators. They should wait to enter a common area if too many colleagues are already crowding into the space. Limiting the number of people in a conference room also makes sense.
Workers should learn to identify the symptoms of COVID-19, including fever, fatigue, shortness of breath and a dry cough. If they exhibit any of those qualities, they should not come into the office. Management should monitor employees for symptoms and send them home when appropriate.
But only 25% of the people carrying the disease exhibit symptoms, which makes social distancing vital. Companies can aid distancing by having only a portion of the workforce in the office. They can accomplish that by staggering attendance.
Some companies may redesign offices, increasing the number of offices and cubicles and relying less on shared space. In areas open to the public, companies can reduce the number of chairs to provide more space, and they can mark the floor with tape to encourage distancing.
Before reopening the doors, management should review the legal implications of bringing workers back to the office. They may be required by law to protect employees with health conditions that make them particularly susceptible to COVID-19.
Loose Lips at Twitter
Speculation about “the end of the office” doesn’t sit well with people who earn their living by renting out office space. Take it from Stephanie M. Krewson-Kelly, a vice president at Commercial Office Properties Trust. “People can talk, but where’s the proof?” she asks pointedly.
As an example of the damage that careless chatter can cause, Krewson-Kelly cites a chain of events that began May 12 when Twitter CEO Jack Dorsey announced the high-profile tech company would allow its employees to work from home “forever.”
That “choice word,” as Krewson-Kelly calls it, caused stock in real estate investment trusts to sell off strongly in anticipation that decentralization of office work would continue even after the pandemic recedes.
Investors feared that a cultural shift toward home offices could cause commercial occupancies to decline and force down rent, she observes. As the years passed and leases ran out, tenants might not renew.
But three days later, Dorsey lifted the cloud of doom when he said that Twitter didn’t plan to give back any of the corporate real estate it leases. Instead, the company would rework floorplans to provide space for social distancing.
REIT Dividends During Downturns
Even with much of the world in lockdown, dividends continued to roll in for most investors who own shares in office-oriented real estate investment trusts.
Stock prices in those trusts, often referred to as REITs, can be volatile, says Stephanie M. Krewson-Kelly, a vice president at Corporate Office Properties Trust. When the pandemic struck this year, REIT stock prices declined 24%, the mirror image of last year’s upward swing, she notes.
But stock price performance aside, REITs generally provide a 3% to 4% yield by paying a common stock dividend, Krewson-Kelly continues. Longer term, that steady dividend income accounts for about half of REIT total returns, which for the past 40 years have averaged 11% to 12%.
REITs produce bond-like income because their tenants sign long-term leases, notes Glenn Mueller, a University of Denver business professor. That makes REIT stocks valuable to investors looking for income in retirement.
REITs can raise their interest rates and have tended to pay dividends that outpace inflation, making them more advantageous than bonds, which have fixed interest rates, Mueller says. “REITs are businesses that can develop creative solutions, while bonds are set contracts,” he adds.
Krewson-Kelly agrees. “It’s important for people to realize that REITs are not in a habit of cutting their dividends,” she says. “If you take hotel REITs out of the equation, then across the board, REIT dividends have been pretty darn secure for decades. It’s important for folks not to overreact to the current crisis.”
Not Just Offices and Malls
A casual observer might think of real estate investment trusts, or REITs, as companies that own and sell shares in rental properties—like office buildings and shopping centers. That idea’s not really wrong. It’s just outdated. REITs still own properties like those, but now they also own industrial sites, hotels, apartment buildings, timberland, healthcare facilities, distribution centers, self-storage businesses, cell towers and data centers. Some REITs specialize and others diversify, says Calvin Schnure, chief economist for Nareit, a trade association. “Twenty years ago, the traditional retail, office, industrial and residential properties were over 75% or 80% of the business by market cap or by net operating income,” Schnure says. “But now they’re about half or maybe even less than half. Other sectors make up about half of the overall universe.”