Righting the ship

Maguire is pushing to dispose of $2 billion in assets by the end of the year and is using the proceeds to build cash reserves and pay down its big debt load. At roughly 75% of its $6.2 billion enterprise value, the debt ratio is the heaviest among any office REIT, according to analysts.

The company had sold about $1.2 billion of properties as of late October, and it is considering spinning its 9.1 million sq. ft. downtown Los Angeles portfolio into a joint venture. Additionally, as of late October, Maguire executives were rumored to be exploring a management-led buyout of the REIT.

Analysts remain unconvinced of the company's strategy, especially since leveraged buyers have vanished as a result of the tightened credit market and as leasing activity slows. Those forces will put further downward pressure on Maguire's valuation, wrote Banc of America analysts in an October research note.

In fact, Orange County experienced negative absorption of about 1.4 million sq. ft. for the year through the end of the third quarter, and office vacancy shot up more than 300 basis points to 11.5%, according to Grubb & Ellis. While effective rents grew by 14% over 12 months ended June 30, the rate of growth slowed to less than 1% in the second quarter from 3% in the first quarter, according to the most recent report from Reis.

“Orange County is a market where there's some concern,” acknowledges Steve Shigekawa, associate portfolio manager for the $121 million Neuberger Berman Real Estate Fund. “The rent-growth levels we've seen in the past will not be possible until the market can absorb some supply.” But, Shigekawa adds, the county's long-term growth prospects remain attractive to institutional real estate investors.

Other fund managers suggest the situation might be overblown. LaSalle Investment Management owned nearly 7% of Maguire as of June 30, according to the firm's most recent filings with the Securities and Exchange Commission.

Pauley views the REIT as a value play. “We think the public market has been overly pessimistic about Orange County, and there's a lot of skepticism about [Maguire's] management to execute its plan to sell assets,” he says. “But we think the stock is at a point where all that and then some is priced in.”

Preparing for a shakeout

REITs in markets unaffected by the subprime mess — at least thus far — are strengthening their portfolios and are gearing up for potential acquisition opportunities. Highwoods Properties, based in Raleigh, N.C., has pre-leased some 66% of its $464 million office development pipeline.

The company, which now owns some 34 million sq. ft. of office, industrial and retail space predominantly in the Southeast also has sold non-core properties and land for $108 million year-to-date. Additionally, Highwoods has redeemed $40 million in preferred stock and has paid off $80 million in high-interest debt. Highwoods expects to achieve an occupancy rate of between 91% and 92.5% by the end of the year, up from about 90% at mid-year.

But the company has begun hoarding cash rather than using it to buy back more preferred stock. Why? It's preparing for buying opportunities stemming from potential distress in the office sector.

“The big question going forward is what's going to happen in reality versus the assumptions [that leveraged buyers] made to underwrite so many acquisitions,” says Highwoods Properties CEO Ed Fritsch. “If they were dead-on and conservative, then life goes on. If not, there will be some properties that need to be sold.”

Mack-Cali's Hersh has the same designs. The REIT has suffered from lackluster leasing in suburban markets. Yet it sold non-core assets for $90 million and recently extended a credit facility by $175 million to a total of $775 million. In June, Mack-Cali paid $273 million for a nearly 40% interest in 125 Broad Street in New York — its first acquisition in the market and part of a larger strategy to move into the city.

Mack-Cali's Hersh is scouting other Midtown and Downtown properties in Manhattan, although he's patiently waiting for re-pricing to become more definitive before he pulls the trigger. “I think to be well-capitalized in this kind of environment is going to prove very advantageous,” he says. “And that's frankly where I want my company to be.”

Fragile footing

Still, Fritsch and Hersh acknowledge that whether distress actually occurs remains unclear. Meanwhile, office REIT investors should remain strapped in for more potential wild swings before the ride calms.

Economic indicators likely will keep analysts and investors off balance. In September, the U.S. Department of Labor reported a net job loss of 4,000 in August, prompting howls of recession warnings. Then in October, the department announced 88,000 jobs were actually created in August in addition to 110,000 in September.

The rapid subprime collapse gives investors pause, too, making them rethink REITs operating in supposedly bulletproof strongholds such as Manhattan. That market received some good news recently. Vacancy in Manhattan fell 40 basis points to 6.2% in the third quarter and no substantial supply is due to come online until after 2010, Reis reports.

But financial services firms have announced more than 42,000 job cuts in New York through late October this year, according to Challenger Gray & Christmas. That's a 320% increase in job cuts over the same period in 2006.

Kenneth Heebner, manager of the $1.7 billion CGM Realty Fund, has cut the fund's REIT holdings to 25% from 75%. That included the disposition of its 4.5% ownership stake in New York-based SL Green Realty, the biggest office landlord in Manhattan.

Joseph Smith, a portfolio manager with ING Clarion Real Estate Securities in Radnor, Pa., remains bullish on New York and SL Green. But he's keeping his eye on weakness that could erupt from additional financial services layoffs, new supply or the rising cost of doing business in the city.

“What you worry about [in Manhattan] is a mini-version of the perfect storm,” says Smith, whose firm manages some $21 billion in real estate assets. “Significant financial distress could have negative implications for large users of office space — financial services firms and hedge funds. The harder issue to figure is how many support firms will be giving back space at the same time.”