Investors Are Still Down On Office Owners, While REITs Benefiting From Digital Economy Have Soared

The stock market is still bearish on companies that own large portfolios of office buildings, with investors concerned about the uncertain future of the workplace, while many REITs that own in trendier sectors like industrial and data centers have outperformed the market this year. 

The office REIT sector is still 8.1% below its pre-pandemic level as of Nov. 30, making it the second-worst-performing real estate sector ahead of hotels, according to Nareit's 2022 Outlook report, released last week. 

The industrial, data center and telecommunications infrastructure REIT sectors have experienced stock bumps of 57%, 44% and 24%, respectively, from their pre-pandemic level, the report found. These three sectors reflect investor sentiment that the future of the economy will be more focused on digital communications, while investors worry about what the future holds for the office.  

The office sector underperformance is largely a result of forward-looking speculation around the impact of remote work, experts said. Performance-wise, office REITs saw improving cash flow last quarter that in some cases beat analyst estimates.

But that hasn't impressed the stock market. 

"Office is interesting, because rents have been paid, but this is investors pricing in the forward impact of work from home," Nareit Executive Vice President for Research and Investor Outreach John Worth said last week at the National Association of Real Estate Editors conference in Miami. 

While investors are concerned about the impact of remote work on office landlords, signs have begun to emerge that the return to the office may be accelerating. Average occupancy across the 10 largest U.S. office markets rose to 40.6% during the week of Dec. 1, its highest level since the start of the pandemic, according to Kastle Systems. And a survey conducted last week by Workhuman found that 77.2% of respondents said their companies are going to proceed with return-to-office plans in January. 

Investors who believe the impact of remote work is overblown and the office market will recover next year have a chance to capture value, given that the prices of office REIT stocks have been kept down by more negative outlooks, Worth said.

He said many office REITs are trading at less than their net asset value, a commonly used metric estimating the total private market value of their buildings. 

"This is the time when, if you're bullish on offices and think we're going to see more of a return to the traditional work structure than is the conventional wisdom, that's a trade you can execute using REITs," Worth told Bisnow in an interview. 

Nareit uses Feb. 1, 2020, as the pre-Covid baseline for comparing REIT performance, Worth said, because the stock market began to decline throughout the month of February as investors worried about pandemic-related news. 

Using that time frame shows how far some major office REITs still sit below their pre-pandemic levels. Vornado Realty Trust has fallen from over $65/share at the start of February 2020 to $41.40/share when the market closed Monday. Boston Properties has fallen from more than $142/share to $113.80/share during that time frame. SL Green has fallen from over $90/share to $73.09/share. 

Investors using their bets on office REITs as a statement on the future of the overall U.S. office market may be overestimating the pain these REITs will face.

Green Street Senior Analyst Daniel Ismail, who leads the firm's office REIT coverage, said most office REITs have portfolios with higher-quality buildings than the market at large. He said they tend to own newer Class-A office buildings, which have performed better than the older Class-B and C buildings. 

"Class-A office buildings are seeing greater demand from tenants, they are seeing generally better pricing in terms of cap rates, and if you think about longer term given the variety of concerns — whether it be tenant demand, environmental concerns and the risk of obsolescence, etc. — those Class-A properties seem better positioned than lower-quality peers to maintain their relevancy," Ismail said. "And those are the types of buildings that office REITs tend to own." 

Still, Ismail said investor concerns over the future level of office demand have merit.

"What the pandemic taught many companies is that the use of remote work is a viable component of workplace strategy," he said. "It does seem like the tea leaves are pointing to a more flexible work environment in the future, which very clearly points to lower office demand in the aggregate."

The return-to-office efforts, and the related sentiment around office REITs, could also be impacted by the omicron variant or any future variants that become the dominant strain of the coronavirus and increase the number of cases in the U.S.

"If things get bad again, you have the possibility that many of these tenants decide to kick the can down the road," Ismail said. "If omicron or the next variant pushes the return-to-office date, history says there's a negative impact to office REITs."

The disparity between office REIT stock prices and their net asset values makes them potential targets for merger and acquisition activity, given that bullish buyers could acquire them at a discount, Worth said. But he said this would require a large investment fund to make a big bet on the office market.

"You need a willing buyer, that means private capital that wants to go deeper into the office space, and a willing seller, that means a REIT that’s willing to take [the] price that’s offered," Worth said. 

The likelihood of a large private fund wanting to increase their exposure to office space is slim, Ismail said, given that most of them have been reducing the share of office in their portfolios and redeploying capital to hotter real estate sectors. 

"We haven’t seen prices reach a level where it’s induced a higher level of interest among institutional owners," Ismail said. "In many cases, large institutional owners might have had too much office exposure, and now you’re seeing them branch into other areas such as life sciences."

Investors are also branching into sectors such as industrial, data centers and telecommunications infrastructure, a trend that Worth said represents a bet on the digitization of the economy. 

The industrial market has benefited from e-commerce companies building out distribution networks. The data center sector has benefited from big tech companies storing the troves of data that their users generate. And infrastructure REITs that own cell towers have benefited from the demand for better wireless coverage across the country. 

These companies have experienced rising market values during the pandemic, and they now account for 38% of the total value of REITs on the stock market, Worth said. Before the pandemic struck, they made up 32% of the REIT market. 

Prologis, a major industrial REIT, has seen its stock rise from around $93/share at the beginning of February 2020 to $161.08/share Monday. Data center REIT Digital Realty has risen from around $123/share to $171.42/share. Infrastructure REIT American Tower Corp. has risen from around $238/share to $276.02/share. 

"This is the digital economy in real estate terms," Worth said. "These are the logistics facilities delivering the goods you order online, the data centers processing the orders and the cell towers picking up the signal. This is a very important part of the real estate world today."

The world was already moving in this direction before last year, but Worth said the pandemic accelerated these trends as more people communicated through video calls and ordered meals and goods through delivery services. 

The relative overperformance of these REITs compared to their counterparts in the office sector not only reflects their better financial metrics, but it shows that investors have a more clear picture of how they will fit into the future of the economy. While they are unsure about whether people will come into the office every day in the future, they know that people won't stop making video calls and online purchases. 

"Those sectors are going to be well-placed going forward; the digitization of the economy is not stopping," Worth said. "The changed ways that we're working, shopping and interacting with each other are going to stay."