Stabilizing Market Fundamentals Bolster Office REIT Ratings

By Karen Nickerson, Moody's Investors Service

The sentiment regarding the economic recovery has turned decidedly positive in 2011, a welcome divergence from the caution and uncertainty that prevailed in 2010. There is even optimism surrounding the outlook for job growth in 2011, good news for the office sector, which needs job creation to drive office demand.

The sentiment regarding the economic recovery has turned decidedly positive in 2011, a welcome divergence from the caution and uncertainty that prevailed in 2010. There is even optimism surrounding the outlook for job growth in 2011, good news for the office sector, which needs job creation to drive office demand. The improving market should help Moody’s rated office REITs to manage some expected earnings pressure even more easily than they are already poised to do.

The fourth quarter 2010 was the second consecutive quarter to post a decline in the national office vacancy rate in three years (to 16.4 percent at year-end 2010), an important signal that the office market is stabilizing. With the exception of a few markets, namely New York City and Washington, D.C., we expect the recovery in office market fundamentals to be slow and muted. Job growth will fuel the recovery and the job market has a deep well out of which to climb. Moody’s does not expect office landlords to regain any meaningful pricing power until 2012.

Rated office REITs continue to benefit from tenants’ flight to quality and preference to conduct business with well-capitalized landlords. This dynamic has supported office REITs’ higher-than-market occupancies and to some extent mitigated Earnings before Depreciation, Interest, Taxes and Amortization declines.

Even still, fixed charge coverage ticked downward from 2009 reflecting rent roll downs and exhausted expense controls exercised in 2008 and 2009. Stress also remains on net debt to EBITDA, which ticked up from year-end 2009, largely driven by declines in EBITDA as the lagging effect from the recent recession is now being realized in office REIT earnings.

For now, any gains in EBITDA will be due to occupancy increases rather than rental rate increases. The good news: Balance sheets are largely intact and cash on hand and bank line availability can easily cover debt maturities through 2012 for all U.S. rated office REITs. Strength in the balance sheet and strong liquidity afford rated office REITs the runway to manage through expected earnings pressure and position REITs to take advantage of investment opportunities in 2011.

We expect U.S. office REITs to grow their portfolios through asset acquisitions, and in rare cases through development. We also foresee M&A in 2011 for expanding into new markets or deepening existing market positions.

Currently, office REITs have a cost of capital advantage over their private market competitors that surely presents opportunities for growth. It is too early to tell how REITs might fund growth and how that growth might impact near-term credit metrics.

Our ratings and stable outlook assume balance sheets and funding strategies remain conservative. As the office markets move into recovery, we expect average net debt to EBITDA and average fixed charge coverage changes to remain negative to flat. And while strong balance sheets and demonstrated access to multiple forms of capital position rated office REITs well for growth, Moody’s views leveraged acquisitions as the biggest risk to the balance sheet absent another shock to the U.S. and global economies.