Office REITs Look At Diversification For A Life Raft

Once such champions of the asset class that they staked their profits and investors’ money on office buildings, REITs that have specialized in offices are diversifying their holdings, either through development or acquisition, making them the latest segment of commercial real estate to pull away from the troubled office market.

It’s not absolute — there are some that remain committed to office as an investment — but the growing number of companies that have pivoted to other property types signifies a coming shift in the way major investors spend their money.

“It's important not to paint all of the office REITs with the same brush, since some office REITs are still doing well, such as those that specialize in high-quality properties in the Sun Belt,” Wide Moat Research CEO Brad Thomas said. “But as a sector, it's been beaten down this year, and there's definitely going to be some changes.”

As the pressure increases on the office sector, investors have voted with their dollars, even to the point that REIT stocks in the sector are trading well below net asset values. By that metric, office REITs are the worst off among public sector owners.

Publicly listed U.S. REITs traded at a median 20.8% discount to their consensus estimates for net asset value per share as of May 1, according to an S&P Global report. The office sector traded at the largest discount to NAV, at 57.9%. Among the 10 REITs trading for the most sizable discount to NAV, eight were office REITs.

Signs of this stress are emerging, and office investors are looking for ways to cope, including leaning into new asset types.

“We’ve accelerated components of our business strategy to meet the moment of shifting demand drivers,” Brandywine Realty Trust CEO Jerry Sweeney told Bisnow. “With Philadelphia rising among the top hubs in the nation for cell and gene therapy, we augmented Schuylkill Yards, our 14-acre master-planned development in Philadelphia, with additional lab and research space for all stages of life science growth.”

Last year, Brandywine launched an incubator in partnership with the Pennsylvania Biotechnology Center, and it began work on two ground-up buildings that accommodate life sciences users: 3025 JFK Blvd., a 570K SF mixed-use tower with life sciences workspace, and 3151 Market, a 417K SF fully dedicated life sciences building. The company has completed or started other life sciences buildings in the market as well.

Kilroy Realty Corp. and Hudson Pacific Properties have also gotten more involved in specialized office types. Kilroy is incorporating life sciences uses into its Oyster Point project in South San Francisco while Hudson Pacific has gotten into Los Angeles studio space.

The diversification route isn’t without risk, however, as Hudson Pacific recently learned when it cut its dividend and scuttled its guidance for the year, citing a strike by the Writers Guild of America that is shutting down productions across Tinseltown.

Others are taking the merger and acquisition route. Rather than develop a portfolio of nonstandard office properties, Office Properties Income Trust in April agreed to acquire Diversified Healthcare Trust in an all-stock merger transaction that would create a new entity called Diversified Properties Trust.

The goal of the merger is straightforward, according to OPI President Christopher Bilotto: lowering the company's exposure to standard office.

"The merger establishes the combined company as a larger, more diversified REIT, better positioned for long-term growth," Bilotto said in a statement. “Against a challenging backdrop for traditional office assets, this merger provides OPI access to stabilized cash flows from DHC’s medical office and life science portfolio and NOI growth potential from its senior housing portfolio.”

The long-term impact of the decline of office REITs on the office market as a whole is hard to gauge, Thomas said.

REITs that successfully diversify away from pure office plays will probably do better than those who stick with office assets, Thomas said, mainly because many offices will need extensive updating to hope to be competitive, or to be converted into something else, draining resources and cutting into yield.

“The biggest takeaway for the REIT space is that adapting an office building isn't cheap, so it's going to really eat into funds from operation which, of course, means that some REITs aren't going to be able to pay as much in dividends,” Thomas said. “We're already seeing that with the REITs that have announced dividend cuts.”

Among those that have taken this approach is Vornado Realty Trust, which suspended paying dividends to owners of its common shares for the rest of 2023. That is an additional hit for investors, since Vornado's stock price is down more than 61% since this time last year.

For its part, Vornado said it is considering asset sales to help cope with the current crisis for office REITs, despite the buyers market for such assets.

“It continues to be a difficult market to sell assets in,” Vornado President and Chief Financial Officer Michael Franco said during the company's most recent earnings call early this month. “We do think they're salable and ... we may not love the price of some assets today relative to where they were a few years ago. But relative to our stock price, we do like that pricing.”

The trick in today’s market is finding a buyer willing to navigate the difficult capital markets landscape and invest in an asset with an uncertain future. There are a few candidates, though.

Private investors might take an interest, Thomas said, and often can adapt to changing market conditions more easily, especially if they have deep pockets and a clear plan for their properties. Class-A properties that can be purchased for a discount will be especially attractive as those office users who have signed new leases tend toward newer, nicer buildings with more amenities.

The often-cited flight to quality and attention to tenant experience connects with another take on the pivot away from pure office plays. Incorporating office uses into mixed-use developments is seen as a way to attract tenants and diversify income streams at the same time. 

Mixed-use will be an important part of Brandywine’s future, Sweeney said, including not only office and life sciences, but residential and retail. Brandywine is already underway developing mixed-use projects in Austin as well as Philadelphia.

“We see tremendous potential in the mixed-use development segment across markets,” he said.