A Divide Is Growing In The Office Sector

Gray High Rise Buildings

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I’m sure you saw yesterday’s headlines about First Republic Bank (FRC).

Last month, the Fed quickly poured billions of dollars of liquidity into the banking system to douse the panic after the banking crisis.

But clearly, this did not solve all the problems.   

Right now, First Republic Bank is teetering on the edge trying to sell billions of underwater bonds as it tries to survive. And the next flare-up could be in commercial mortgages backed by office properties.

Here at Intelligent Income Daily, we’re focused on finding the safest income investments on the market. Office properties appear to be incredibly cheap. But before you reach for the tantalizing yields they say they could offer, you should be aware of the risks.

Today I want to show you why there’s a growing divide in the office sector and why some office real estate investment trusts (REITs) are doomed to struggle while others will thrive as America slowly returns to the office.

Go “Modern” in the Office REIT Sector

Offices have been on life support since the pandemic hit.

Plagued by high vacancy rates and increased interest expenses, it’s becoming increasingly difficult for office landlords to continue meeting their debt obligations.

A wave of defaults on office properties has already started and may worsen as the economy slows down.

That has sent the entire office sector into a deep selloff, with valuations plummeting to levels not seen since the Great Financial Crisis.

According to Kastle Systems, average office occupancy is now hovering around 50%. While that’s an improvement over the 20% rate seen during the lockdowns, it’s still not healthy enough to keep many properties afloat.

And as higher interest rates push us closer to a recession, office leasing rates have fallen for three consecutive quarters, returning to 2021 levels per data from Jones Lang LaSalle. According to a report it recently issued, more than 300 million square feet of office space has gone vacant since the pandemic started.

That’s a big problem for landlords who are relying on rental income to pay back loans.

But, there is a bright spot: Offices built after 2015 have seen a net increase of 100 million square feet of leased office space. And in fact, the asking rental rates for these Class A office properties are near all-time highs. (Class A offices are typically newer buildings built within the last decade and located in prominent areas with many amenities.)

There is clearly a growing divide and a flight for quality as tenants reduce their real estate needs and seek out more modern spaces for the smaller number of workers who need to be in the office.

Though the office sector may face more challenges as the economy continues slowing down, there may be opportunities to invest in quality properties at a deep discount.

Quality Companies Trading at a Discount

The average age of buildings that office REITs own is around 34 years. Here are three names with newer, more modern Class A portfolios that we like:

  • Boston Properties (BXP) – Owns properties located in gateway markets along the East and West coasts, concentrated in cities like Boston, Los Angeles, New York, San Francisco, Seattle, and Washington D.C. The average age of its portfolio is 15 years, and its properties are 88.6% occupied. BXP yields 7.5%.

  • Highwoods Properties (HIW) – Owns offices in Sunbelt states, in cities like Raleigh, Nashville, Atlanta, Tampa, Charlotte, and Dallas. The average age of its buildings is 20 years and its portfolio is 91.1% occupied. HIW yields 8.8%.

  • Kilroy Realty (KRC) – Owns a portfolio of offices concentrated on the West Coast, in San Diego, Los Angeles, San Francisco, and Seattle. The average age of its offices is 11 years and they are 91.6% occupied. KRC yields 7.2%.

There will be winners and losers as America reevaluates how much office space it needs.

If you’re interested in investing in the sector, stick to the quality names with portfolios of modern properties that will attract more tenants and command higher rents.

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Brad Thomas is the Editor of the Forbes Real Estate Investor.

Disclaimer: This article is intended to provide information to interested parties. ...

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