After four years of incredible growth — topped off with a 45% spike in total returns in 2006 — office REITs looked unstoppable at the beginning of the year. Remember all the excitement generated by the Blackstone Group's $39 billion purchase of Equity Office Properties? But the convergence of the subprime mortgage meltdown, widespread apprehension of a slowing economy and other market forces has transformed a bull run for the ages into a wild ride that has bruised the portfolios of office REIT investors.

The events conspired to drive down total returns for office REITs to a negative 14% for the year by the end of July, making office the worst-performing REIT property sector over that period. As of Oct. 24, total returns for office REITs were still off about 10% for the year compared with a 5.07% drop for all equity REITs.

“The public market is pessimistic about office fundamentals going forward,” says Keith Pauley, a managing director of Chicago-based LaSalle Investment Management. “We're less positive about overall fundamentals, too. But we think office REITs are trading at more attractive values than other [REIT] sectors.”

Against that backdrop, most office REITs are taking one of two approaches. Some are positioning themselves to take advantage of potential buying opportunities in the event highly leveraged office owners tumble into distress. Others are rushing to pay off debt and strengthen balance sheets in the face of flagging fundamentals in their markets.

Foremost on the mind of office investors is whether a slowing economy will eat into the rent growth needed to justify historic high prices that buyers have paid for office buildings. On average, 122,000 jobs have been created each month this year, down from 188,600 last year, reports the Bureau of Labor Statistics. Moody's Economy.com predicts an average of only 70,000 jobs will be created monthly in the fourth quarter.

“Office properties are more vulnerable to an economic slowdown, and offices have more risk of rising cap rates,” says Pauley, whose firm manages public real estate securities and private real estate assets valued at $44 billion. “The market has become more leery about whether [rent growth] will be achieved and whether it will be as robust as had been expected.”

Stalling growth

A high degree of volatility in the debt and equity markets has driven away leveraged private buyers who drove up office valuations — and office REIT share prices — over the past few years prior to the current market turbulence. Fewer buyers ultimately means that office capitalization rates will rise by 75 basis points versus a rise of 40 points across other property sectors, predict Banc of America Securities REIT analysts, who have lowered their office REIT price targets by 13%.

While office fundamentals remain relatively healthy, there are indications that growth is slowing. Effective rents grew 9.9% nationally year-over-year in the third quarter. But upon closer review, the rate of increase tapered to 2.4% in the third quarter from 3.1% in the second quarter, according to real estate research firm Reis Inc.

Office vacancy in central business districts (CBDs) declined 20 basis points to 10.9% in the third quarter while suburban office vacancy remained flat at 14%, according to Chicago-based real estate brokerage Grubb & Ellis. Development remains subdued in most markets, but it's still something of a wild card (see sidebar p. 30).

Mitchell Hersh, CEO of Edison, N.J.-based office REIT Mack-Cali Realty, suggests that doubts over continued strong fundamentals have escalated given the swift deterioration of the subprime mortgage industry.

A rise of subprime loan defaults earlier this year has all but bottled up the residential and commercial debt markets. Subprime residential mortgages more than 90 days delinquent or in the foreclosure process, for example, hit 9.27% in the second quarter, a year-over-year increase of 304 basis points, according to the latest delinquency survey by the Mortgage Bankers Association.

“We're in a rapidly changing environment,” says Hersh, whose company owns 35 million sq. ft. of office space primarily in the Northeast and Mid-Atlantic. “The cost of capital is increasing, and that [has created] uncertainty as to how high rents can go.”

Divergent strategies

The mortgage meltdown is having a decided influence on REITs. While some are gearing up for possible defaults among private office owners, other REITs are confronting the fallout directly in their markets and portfolios.

Maguire Properties, a Los Angeles-based office REIT that owns 21 million sq. ft., primarily in Southern California, has slashed its year-end occupancy expectations to 89% from 94%. The culprit: a heavy concentration of prime and subprime mortgage lenders in Orange County. The industries announced some 30,000 job cuts in California for the year through September, according to Chicago-based outplacement firm Challenger Gray & Christmas.

In particular, subprime lender New Century Financial Corp.'s Chapter 11 bankruptcy in April left Maguire in the lurch. New Century, which early this year employed 7,200 workers, vacated some 267,000 sq. ft. it leased from Maguire. The subprime lender also is walking away from 190,000 sq. ft. it agreed to lease in the REIT's new 530,000 sq. ft. office tower completed in September. New Century, which has gone out of business and is liquidating assets, faces investigations for accounting errors and other possible misconduct.

The subprime mess coincided with Maguire's $3 billion acquisition of 24 Equity Office buildings and 10 development sites in Southern California — a deal that stemmed from the Blackstone and Equity Office transaction. Maguire and other office developers also are in the process of adding nearly 2 million sq. ft. of speculative office space to Orange County.

William Flaherty, executive vice president of marketing for Maguire, acknowledges that increasing vacancies in the company's portfolio and in Orange County will slow earnings growth. But, he adds, Maguire has likely seen the worst of the subprime fallout.

“The fact is that we got a dose of reality quicker and harsher than we would have wished,” Flaherty says. “We're going to come through 2007 with some bumps and bruises, but overall in pretty good shape.”