Office REITs Stabilize Despite Downturn

Analysts at Milwaukee-based Robert W. Baird & Co., in a study that examines all categories of REITs, say they continue to like "out-of-favor suburban office names" that nonetheless hold the potential for significant earnings improvements once the capital markets stabilize.

One reason for the Baird analysts' preference for suburban markets is their view of suburban versus CBD markets. "Contrary to popular opinion concerning the supply-constrained nature of CBD office markets, it appears these markets may in fact have more supply as a percentage of inventory than suburban markets," according to their report.

The Baird report cites Corporate Office Properties Trust of Columbia, MD, which owns suburban holdings like InterQuest Business Park in suburban Denver; along with Indianapolis-based Duke Realty Corp. and Los Angeles-based Kilroy Realty among the office REITs that it expects to outperform the market. Comparing office REITs to REITs in other property sectors, the Baird analysts say that they expect healthcare, student housing and storage REITs to be the best performers among the property classes, but they expect that all other categories of REITs--including office--will offer stable returns despite the economic and real estate downturns.

The Baird analysis--authored by David AuBuchon, David Loeb, Christopher R. Lucas and Paula J. Poskon--points out that virtually all REITs are trading at prices below the net asset value of their underlying properties. Office REIT stocks are trading about 10.5% below the net asset value of the underlying properties in comparison to hotels, which is trading at 22.6% below net asset value; multifamily, 12.7%; industrial, 14.2%; net lease, 4.3%; shopping centers, 17.1%; storage REITs, 12.6%; and student housing, 8.7%.

The figures suggest that, despite all that has happened in the economy and the credit markets, the properties that the REITs own are still worth more than their stock market capitalization despite the economic woes of the past year.

Like other property owners, office REITs are facing a slowing economy, a lack of liquidity, declines in office payrolls, slowing manufacturing employment and other factors that are dragging down demand. Baird's report points out that declines in office payrolls have totaled 391,000 since the July 2007 highs although these remain well below the more than 1.1 million jobs lost during the 2001-02 recession. Manufacturing has lost about 383,000 jobs since July 2007, compared to nearly 1.8 million during the previous recession.

The Baird analysts say that they "are encouraged by the relative resiliency of the labor markets," but add that the prospect of further, more pronounced declines "remains a primary risk to real estate."

Of course, REIT performance will vary from company to company. The Baird team points out that, given that the debt markets remain in disarray and lenders continue to foresee conditions worsening, well-capitalized REITs "stand to benefit greatly" from the opportunity to buy discounted assets as a result of capital markets conditions that will force some owners to sell.

Despite some cautions regarding the economy and capital markets, the Baird analysts cite a number of factors working in favor of office REITs. "Leasing activity at this point in the cycle has actually been relatively strong," they say. And, and rent growth also has been consistent while "broad-based tenant credit issues haven't surfaced yet." A number of REITs have turned to joint ventures and other investment fund structures to preserve capital, the report notes. The publicly held REITs have also benefited from reduced private market competition as a result of more conservative underwriting by lenders.