As job growth in the professional services sector has increased substantially over the past several years, office real estate investment trusts (REITs) have benefited from strong leasing fundamentals. However, more office construction and oversupply concentrated in major metro areas such as New York City, Houston, and Washington, D.C., continue to concern those in the market. According to the D.C.-based National Association of Real Estate Investment Trusts, the 24 office REITs posted –0.43 percent in total returns in April, but are up 1.17 percent for 2017 year-to-date. Several of these office REITs hold assets concentrated in a single market, such as Manhattan or D.C. This may have contributed to –4.34 percent in first-quarter earnings for office REITs.
Investment adviser Hoya Capital Real Estate reports that the office REIT sector has been following the same trend as apartments over the past five years. The firm’s latest roundup stated that “West Coast and Sunbelt markets continue to outperform on strong demand, while NYC struggles with new supply. Despite higher taxes, the young and educated labor pool has generally kept businesses in NYC, but the same can’t be said for other high-tax states in the Northeast like Connecticut, which has yet to fully recover from the recession.”
Oversupply within the U.S. office sector appears to be a market-by-market issue, and thus the composition of office REITs’ portfolios will be vital to performance. According to CNBC, the U.S. overall “has posted seven years of continuous positive net absorption [of office space],” and the burgeoning tech industry is expected to continue to drive demand. However, this demand for office space will likely shift to secondary U.S. cities as a result of elevated office rents in the gateway markets. Singapore-listed Manulife US REIT is just one example of an office REIT shifting its primary focus for potential acquisitions toward secondary markets such as Irvine, California. The REIT claims that “favorable conditions” in these markets have led to a 5 percent to 7 percent increase in rents over the last 12 months.
Some investor uncertainty has been raised because of higher interest rates and uncertainties regarding proposed U.S. legislation. However, the impact of the latter appears to be pro-business, and many are expecting lower corporate taxes, deregulation, and increased defense spending to boost white-collar job growth. In turn, this should boost office REITs, particularly in the eyes of foreign wealth funds looking for “safe” positive-yielding assets. Still, investors should take a closer look at geographical focus when evaluating office REITs, since construction completion is expected to peak at 90 million square feet (8.4 million sq m) between 2017 and mid-2018.
* TREPP-i Survey Loan Spreads levels are based on a survey of balance sheet lenders. For more information, visit Trepp.com.