Written by Sam Kovacs.
Stepping into Chaos
I predicted a boisterous revival for REITs in 2024.
Yet today, I proclaim that the travails of office real estate investment trusts, or REITs, are only just unfolding.
Unfolding Crisis
Office REITs face intense turmoil within the real estate sector.
A slouching shadow of distress looms over the horizon.
During the pandemic, corporate America dabbled in a mass experiment of remote work, and the results were a revelation.
Fast forward four years, and while a fully remote model hasn’t triumphed, the hybrid model, a blend of home-based and office-based work, appears here to stay.
This poses a conundrum for commercial real estate. If businesses realize they don’t need as much office space, they will opt to downsize.
Why wouldn’t they? Spend less for less space or the same for a smaller yet more exquisite space.
This shift has caused vacancies to surpass levels observed in the mid ’80s and ’90s following a spate of overbuilding.
Renewal or Retreat?
A wave of lease expirations looms on the horizon.
Major corporations are either allowing leases to lapse or subleasing unused space:
- July: Charles Schwab (SCHW) aims to reduce its real estate footprint in multiple locations.
- September: Johnson & Johnson (JNJ) is downsizing its Tampa office space by over 60%.
- October: Dropbox (DBX) is relinquishing 165,000 square feet of office space at its San Francisco HQ.
- October: Microsoft (MSFT) is vacating 50,000 square feet of office space in San Francisco.
- November: Phillips 66 (PSX) is consolidating employees to lower floors.
- November: General Electric (GE) is exiting a building in Downtown’s central business district.
A survey in June 2023 revealed that half of the world’s biggest companies planned on reducing office space by 2026, with a 10% to 20% reduction being the norm.
But why wait until 2026? Why not do it today?
Office leases traditionally span ten years, hampering landlords’ ability to respond to changes in office space needs.
Data on corporate mortgage-backed securities collateral indicates that more square feet are set to expire in 2024 and 2025 than in 2023.
In major cities, millions of square feet are set to expire in 2024.
This poses a grave predicament for office REITs, as the options boil down to renewing at lower rents or braving vacant office space.
An excess of the latter could precipitate further declines in rents.
Market Woes
This debacle is felt by all, including supposedly prestigious real estate locations.
Boston Properties, Inc. (BXP), often touted as a top office real estate firm, has seen a 5.6% decrease in net rents from re-leasing activity, according to their 10-K for second-generation leasing.
Further declines are anticipated in 2024, and as overall vacancy rates climb, tenants renewing leases gain more bargaining power, prompting rents to spiral downward.
The performance of BXP’s stock over the past eighteen months reflects this trend.
The worst may yet be lingering. One should never underestimate the depths a stock can plummet to.
Occupancy Ordeal
Kilroy Realty Corporation (KRC), another marquee office REIT, endeavors to assure investors that their buildings, being younger and of superior quality, are less vulnerable to the office crunch.
But to me, this claim is akin to stating that a boxer is better prepared than others to withstand a punch from a martial artist.
