High capex, low cap rates, and narrow returns continue to stave off REITs from investing in the office sector, a webinar by Newport Beach, California–based Green Street Advisors revealed Thursday. The firm’s Cedrik Lachance, director of REIT Research, and Danny Ismail, office analyst, led the webinar titled “Office Sector: Headwinds and Trends to Watch.”
Lachance said capital expenditures are the highest in the office sector among all of the property sectors Green Street Advisors covered, as SoCal Real Estate reported in October.
Ismail discussed the operating fundamentals of the office sector, first giving a general national economic overview. He said GDP growth should remain fairly healthy due to a combination of tax cuts and strong job growth, but this growth will likely backtrack to historic norms, creating a healthy backdrop for the office sector.
In discussing employment gains this cycle, Ismail said employment growth and office demand have been positive, but the demand has been more subdued this cycle because of shadow vacancies from the Great Recession. The office-demand job-growth ratio is expected to be muted over the next few years, creating a meaningful headwind to office fundamentals and rent growth.
Regarding supply growth, Ismail noted a headwind in the New York and Washington, D.C., markets. He said tax reform could fuel new development, but rapidly rising construction costs could serve as counterweight. He also said supply has picked up meaningfully in gateway, but not non-gateway, markets and to expect office RevPAF growth to lag other sectors. Overall, forecasts remain unchanged for a fairly weak five-year office outlook.
Ismail acknowledged that this cycle has been long in the tooth and that office is farther along the deceleration path than other property sectors.
Next, he turned to the top markets in terms of fundamental office growth, citing the tech markets of San Francisco, L.A.’s Westside, and Seattle, which have received high concentrations of venture-capital (VC) funding. In San Francisco, tech companies’ presence has increased, while in L.A., the integration of tech and media continues to fund new growth in the region. However, new supply is muted relative to prior cycles, Ismail pointed out. D.C. and New York continue to be relatively top markets, but rent growth is hard to come by; however, D.C.’s increase in federal funding should benefit the region, he said.
Office stacks up pretty poorly compared to other sectors in terms of valuation, Ismail said. In fact, it is the least attractive asset type covered by Green Street: cap rates are low, capex is high, and the growth rate is not compensating for these two. The sector has a weak risk-adjusted return compared to other sectors.
Ismail explained that leasing costs plus maintenance reserves equal overall capex burden, and the office sector’s burden is pretty big at close to one-third of NOI across all markets as tenants continue to demand a more modern workspace. Gateway markets are enjoying a healthy spread in leasing costs vs. non-gateway markets, but he said there is a striking upward trend in gateway leasing costs as it costs more to maintain and retain top status in the market.
In looking at public vs. private market observations, Ismail said the office sector trades at a discount
in the public market, and these discounts continue to grow, providing a cheaper alternative to the private market. There is an implied cap-rate spread between gateway and non-gateway office markets whereby gateway office REIT shares have traditionally topped non-gateway shares, but the spread has decreased over the last few years due to tighter long-term growth rates. Even with a large discount, office is the least attractive sector among public REITs, he said.
Ismail next turned to the silver linings and storm clouds in the office sector. He said continued health in the tech sector is a silver lining, since there is a correlation between an increase in VC spending and the NASDAQ, and there has been a pick-up in VC investments over the last few years. With tech companies like Facebook, Netflix, and Amazon expanding their presence in some gateway markets, this could bode well for the sector. However, while Amazon’s HQ2 decision should benefit the specific markets in which the company is located, the broader market reaction in the surrounding areas of HQ2 might not be as positive, he said.
Co-working could either be a silver lining or a storm cloud, Ismail said. This segment of the office sector is increasing, but it is encouraging denser office configurations and highly amenitized space. Whether we see continued aggregation of independent workers into co-working space or more absorption of them into traditional office environments remains to be seen.