Office REIT Sector Still Improving Amidst Plodding Recovery

By Karen L. Nickerson, Vice President & Senior Credit Officer of Moody’s Investors Service: The office REIT sector continues to improve, although uncertainty surrounding U.S. fiscal policy remains a drag on the sector's fundamentals.

The office REIT sector continues to improve, although uncertainty surrounding U.S. fiscal policy remains a drag on the sector’s fundamentals. However, if the debt ceiling and federal spending cuts are adequately addressed, office space absorption will likely pick up speed in the second half of the year. The biggest risk to the sector’s balance sheets in 2013 will be large, leveraged acquisitions, although this risk is low, given the propensity of the office REITs we rate to issue equity to fund growth.

The recovery of U.S. office market fundamentals will maintain its slow but steady pace in early 2013. Economic indicators are mixed. Although U.S. GDP and employment growth are weak, corporate profits are growing modestly and company balance sheets are very strong.

In 2012, overall trends in the office market were positive. Office vacancy in the fourth quarter 2012 declined 60 basis points to 15.4 percent year over year.[1] Leasing activity cooled in New York City and Washington D.C., and heated up in markets driven by the energy and technology industries such as northern California, Seattle and select markets in Texas. Office property sales volume increased 23 percent over 2011[2] and net absorption was flat.

Net absorption will increase to approximately 35 million square feet from 26 million square feet in 2012.[3] In addition to energy and technology, housing-related industries will also drive tenant demand in 2013. The office market in New York City will begin to pick up now that implementation of Dodd-Frank is more certain, but will lag in Washington D.C. if defense or other government spending is cut. Nevertheless, low levels of office construction will aid overall positive net absorption.

The office REITs we rate are well-capitalized and their access to capital remains strong. Rated office REITs raised a total of $5.3 billion in 2012 consisting of $2.4 billion in unsecured debt, $1.3 billion in preferred equity, and $1.6 billion in common equity.[4] Liquidity is ample and measures of balance sheet strength are solid. Office REITs will continue to manage their liquidity and defend their balance sheets, even as they pursue growth strategies that entail both acquisitions and development. Development pipelines will likely grow modestly toward the latter part of 2013.

Rated office REITs continue to outperform their markets peers in terms of average occupancy. Outperformance should continue given their superior asset quality, strong market position and solid balance sheets.

[1]CBRE Econometric Advisors, FLASH Office Vacancy Index, 4th Quarter 2012

[2] Jones Lang LaSalle, United States Office Outlook Q4 2012

[3] CBRE Econometric Advisors, Overview & Outlook Office Q3 2012

[4] SNL Financial and Moody’s.

Earnings-based credit metrics,[1] which were flat year-over-year despite the improvement in market trends, will improve modestly in 2013. In addition to benefitting from the positive momentum in office market fundamentals, the rated office REITs have worked through much of the rent roll-downs they were facing at the beginning of the recession. In 2013, occupancy gains will drive EBITDA growth for most office REITs.

Our office REIT ratings incorporate a modest fundamental improvement in the office sector; however, our stable outlook for the office REITs and their current ratings have adequate cushion to absorb any negative shift in economic conditions. Our outlook assumes that the rated office REITS will continue to protect their balance sheets and manage liquidity and funding conservatively. Assuming that the debt ceiling and delayed federal spending cuts are appropriately addressed in the coming months, the biggest risk to balance sheets in 2013 will be large, leveraged acquisitions as the office REITs implement their growth strategies through acquisitions and development. However, this risk is low, given the office REITs’ propensity to issue equity to fund growth.

[1] These credit metrics include average same-store NOI, average operating margin, average fixed charge coverage and average net debt to EBITDA.