Small growth in office supply likely to soften the blow

Joe Gose is a Kansas City-based writer.

Fears of an economic slowdown amid stagnating office occupancy nationwide have given office REITs major headaches in 2007. Year-to-date as of Oct. 24, office REITs posted total returns of negative 9.9% compared with negative 5.07% for all equity REITs, according to the FTSE NAREIT U.S. Real Estate Index.

But limited new construction over the last few years in most markets should help office landlords and investors sidestep the pain they suffered earlier this decade, when new office building completions following the dot-com bust and the terrorist attacks on 9-11 eventually drove up vacancies nationwide to 17% in 2003.

“We see the office vacancy rate climbing toward the end of the year, which is something we've been anticipating as job creation slows,” says Sam Chandan, chief economist for Reis, a New York-based commercial real estate research firm. “Fortunately, big increases in labor and material costs cut out opportunistic and speculative developers over the last couple of years.”

Still, Reis projects that some 58 million sq. ft. of new office space will be built this year, a roughly 1% increase over 2006 and the most office construction since 2002. As the economy slows, however, so does the value of development pipelines within REITs, says Paul Curbo, a portfolio manager for the $1.7 billion AIM Real Estate Fund.

Investors and analysts sharpened their skills at valuing potential development as REITs consolidated and went private over the last couple of years. But the subprime mortgage meltdown, slowing job growth and uncertainty surrounding layoffs have created a dramatically more bearish outlook today compared with a year ago.

“Fully valuing office REIT pipelines is a little bit risky,” Curbo says. “In a slower economic environment, the ability of a company to lease up speculative development becomes less attractive.”

That puts more of a premium on REITs operating in markets with high barriers to entry — typically found in coastal markets — that have tenants paying below-market rents on leases made during the last recession. Those REITs will enjoy big rent increases as tenants renew leases or execute new agreements.

Ultimately, fears of a slowing economy could help keep office markets stable. While such a climate likely will impede rent growth, speculative developers will have less incentive to build, suggests Keith Pauley, a managing director with Chicago-based LaSalle Investment Management.

“New supply already looks like it's at reasonable levels,” Pauley says. “So it's going to be harder for spec projects to move forward.”
— Joe Gose