Office REITs on the Mend

By Ranjini Venkatesan, Assistant Vice President & Analyst for CRE Finance, Moody's Investors Service: What’s behind rating changes in the U.S. office REIT sector?

R Venkatesan Photo

With four consecutive years of declining office vacancy rates and absolute vacancy at 13.9 percent, the lowest level since 2008-09, the office market has almost fully recovered from the credit crisis. The improving macroeconomic environment, especially rising employment, combined with limited new supply bodes well for occupancy rates and rent growth in the office sector. On the flip side, however, densification of office space, with floor plans that allocate less space per worker, could dampen demand for office space. Leverage levels at US office REITs are higher than the historical average; some of these REITs have issued debt to fund new projects or acquisitions and the earnings potential has not yet been fully realized.

In 2015, issuer-specific events will likely drive ratings changes in the U.S. office REITs sector. Moody’s will closely monitor issuers with material exposure to markets under pressure and REITs with large development pipelines and new and value-add acquisitions.

Macroeconomic trends and modest pipeline of new completions will favor rated office REITs

Moody’s forecasts that U.S. GDP growth will reach 3.2 percent for 2015 and unemployment 5.2 percent by year-end. Given that US office market fundamentals tend to mirror the economic climate (Exhibit 1), we expect U.S. office sector trends will improve in 2015.

Exhibit 1

Executive Excel charts

Sources: CBRE/EA for Vacancy Data; Moody’s for employment data

According to CBRE/EA research, vacancy rates at year-end 2014 were at the lowest point since 2008 in 48 of the 63 metropolitan markets.  The CBRE/EA rent index is still about 4 percent lower than its 2008 value, but the gap between the index then and now is likely to be bridged over the next 12-18 months; the CBRE/EA net absorption  as new completions forecast for 2015 is a modest 0.8 percent of outstanding stock.

Vacancy rates in the suburban markets have been about 30 percent higher than central business district (CBD) vacancies, and the difference has been largely steady through the 2008-14 period (Exhibit 2). There is also no significant difference in CBRE/EA rent index movement between CBD and suburban markets. We expect that rent increases will drive revenue growth in supply-constrained major metropolitan markets, while certain second-tier markets where local economic trends are favorable will benefit from occupancy gains.

Exhibit 2

vacancy Excel charts


Source: CBRE/EA

Office REITs perform well in their markets but are still exposed to the vagaries of demand

All of Moody’s 16 rated office REITs have low investment grade ratings, and the rating outlook is stable for 14 issuers, positive for one, and negative for the other. The ratings distribution reflects our view that most of the office sector REITs are performing well in their markets, with good quality assets and better occupancy levels than corresponding market averages. For the rated office REITs, average occupancy was 90.1 percent at yearend 2014, meaningfully higher than the office sector mean. The gap between the two measures has widened from 209 bps in 2010 to 564 bps in 2014, primarily due to greater property concentration in stronger markets and active redevelopment of older properties.

Strong franchise notwithstanding, the rated office REITS are still exposed to price-sensitive tenants and potential obsolescence due to changing dynamics in work-space configuration. Some tenants are migrating to office configurations with smaller per-employee spaces, a move that could reduce demand for office real estate.

Only three of the 16 rated office REITS have meaningful exposure to new office projects, and development risk has been largely mitigated by pre-leasing and the high demand for office space at these locations.

Leverage is elevated for some REITs

The leverage profile of some REITs has weakened modestly (Exhibit 3), as some REITs have issued debt to fund development projects and value-add acquisitions. As the issuers absorb and increase the income related to their new acquisitions and projects over the next 12-18 months, the leverage metrics on these REITs will likely improve. Coverage ratios have declined because of larger debt outstanding, but are still strong for the low investment grade rating level; operating margins are stable, and the REITs have been able to access new capital and at attractive rates.

Exhibit 3


Sources : SNL Financial and company reports, calculations based on Moody’s Global Rating Methodology for REITs and Commercial Property firms