The Nareit office REIT index produced a negative return of 37% over the past year. That could mean a buying opportunity.
The office real estate market has hit the skids over the past three years.
First the covid pandemic kept workers at home. Then even as the pandemic has waned, many employees still aren’t going back to the office full-time.
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The office occupancy rate in 10 major cities tracked by real-estate security provider Kastle Systems averaged only 50.1% in the week ended Feb. 22. To be sure, with workers trickling back to their offices, that’s the first reading above 50% since the pandemic began in March 2020. But it’s only 50.4% of the levels prevailing prior to the pandemic.
Office-building owners are starting to take serious hits. Much of their debt has floating interest rates. With the Federal Reserve raising rates by 4.5 percentage points over the past year, their debt payments are soaring.
Even landlords who are paying low fixed rates on debt they accumulated before the Fed rate hikes are affected. As their old debt matures, their new debt has much higher rates.
The delinquency rate for commercial-mortgage securities made up of office loans totaled 1.83% in January, up 25 basis points from December. That’s the biggest increase since December 2021, according to Trepp, a real estate research firm.
Vaunted asset manager Pacific Investment Management Co. recently defaulted on $1.7 billion of office-building debt. Another big-time investor, Brookfield Asset Management, has defaulted on more than $750 million in debt for two Los Angeles skyscrapers.
All these weaknesses have hammered office REITs (real estate investment trusts). The Nareit office REIT index generated a negative return of 37% over the past year. But that drop may have gone too far, creating a buying opportunity.
Here is Morningstar’s assessment of two of the biggest office REITs.
Morningstar analyst Suryansh Sharma assigns the company no moat (durable competitive advantage) but puts fair value for the stock at $107. It recently traded at $65.65.
The firm owns Class A office properties concentrated in Boston, Los Angeles, New York City, San Francisco, Seattle, and Washington, D.C.
“The company’s strategy is to develop and own premier properties … in supply-constrained markets that have the strongest economic growth and investment characteristics for office real estate,” Sharma said.
One specific strength: “the company has positioned itself to benefit from the burgeoning life sciences sector, as it owns approximately 4.6 million square feet of life sciences space,” he said.
Sharma gives the company no moat but puts fair value for the stock at $69. It recently traded at $36.70.
Kilroy owns premier office, life science, and mixed-use properties in Los Angeles, San Diego, San Francisco Bay Area, Seattle, and Austin.
Kilroy too is positioned to benefit from the growth in life sciences, as it has “material exposure [to the sector] in its current portfolio and future development pipeline,” Sharma said.
“We also welcome management’s focus on ESG [environment/social/government], as it aligns its office portfolio to meet the sustainability requirements of its clients.”
The firm “reported a decent set of numbers in the fourth quarter amid a very challenging West Coast office environment,” Sharma said.