Brexit Helps Boost U.S. Office REIT Performance in July

This article is republished with permission from REITCafe.

The office segment has been one of the best-performing real estate investment trust (REIT) sectors this month. The 3.93 percent total return ranks fifth among 16 equity REIT sectors during July, but on a year-to-date basis, total office REIT returns of 13.26 percent fall short of the 16.41 percent FTSE NAREIT All Equity REIT total return. Do conditions point to similarly strong gains for the sector going forward, or will the office REIT sector revert to its more traditional slow but steady gains?

Office market fundamentals are solid, but alone do not account for the sector’s strong July. Overall weighted average asking rents were up 5.76 percent from year-ago levels. According to data from Cushman and Wakefield, the office vacancy rate was stable at 13.4 percent during the second quarter and was down modestly from 13.9 percent one year earlier.

Leasing activity picked up during the second quarter, although some U.S. businesses are postponing leasing decisions because of uncertainty related to the upcoming election and the volatile stock market. Oil, technology, and even banks, whose earnings have been affected by ongoing low interest rates, are reevaluating their space needs. Still, leasing activity allowed overall vacancy to stay steady or to fall slightly in most markets during the quarter even as sublease space has increased, especially in tech and oil and gas markets.

Exceptions were Houston, San Francisco, and Oklahoma City. In Houston, office vacancy climbed 130 basis points to 18.1 percent, while San Francisco office vacancy rose 160 basis points to 7.3 percent during the quarter. Vacancy in Oklahoma City climbed 440 basis points to 17.4 percent during the second quarter, according to Cushman and Wakefield.

New construction has largely stayed in check during this real estate cycle. However, Cushman and Wakefield reports that 25.3 million square feet (2.4 million sq m) of new office space was completed during the first half of this year and another 98.9 million square feet (9.2 million sq m) was under construction at midyear. Much of this new space is concentrated in top-tier markets. Year-to-date deliveries topped 1.5 million square feet (139,000 sq m) in these cities: Houston, midtown New York City, and San Francisco at 1.9 million square feet (177,000 sq m), and San Jose and Dallas/Fort Worth at 1.8 million square feet (167,000 sq m).

The June Brexit referendum is lending momentum to the office REIT sector. Brexit will keep U.S. interest rates very low for longer, making REIT yields more attractive and providing inexpensive capital for expansion. Passage of the U.K. referendum is also expected to spur an influx of foreign capital to the United States as investors seek a safe haven from volatile global markets. Values for core properties in U.S. gateway markets could rise further because of increased competition from foreign buyers. Finally, because U.S. office REITs do not own properties in the United Kingdom, the expected negative impact of Brexit on U.K. office market fundamentals will not affect U.S. REITs.

Healthy U.S. job growth is currently propelling demand, but tenants are reevaluating space needs. Demand from tenants and investors is strong in top-tier markets and urban locations, but recovery has been slow in smaller markets. Many existing tenants are also downsizing space needs, in spite of rising headcount, because they are putting more people into less space. Existing office space also frequently requires extensive retrofitting to accommodate today’s tenants. July’s strong performance has been welcome to office REIT investors, but maintaining these returns going forward will be challenging.

* TREPP-i Survey Loan Spreads levels are based on a survey of balance sheet lenders. For more information, visit Trepp.com.

** - 10 yr. Treasury Yield as of 7/15/2016.