When Equity Office Properties Trust (EOP) slashed its dividend last month, few people were surprised. The nation’s largest office landlord hasn’t covered its dividend by earnings since late 2002. But the 34% dividend cut from $2 to $1.32 a share was an about-face for EOP Chairman Sam Zell, who has often said the dividend is “sacred.”

A key reason for the soaring popularity of REIT shares over the past few years has been dividend yields that averaged well above the S & P 500 — a magnet for investors at a time of miniscule returns from stocks and investment-grade bonds. Over the past 15 years, for example, REIT dividend yields have exceeded S & P yields by as much as 8%, and the gap at the end of last year was roughly 3%.

So when a bellwether REIT like EOP chops its dividend, does it mean more trouble ahead? An analysis of REIT cash flows by Boston-based Property & Portfolio Research suggests that EOP won’t be the only office REIT fighting to raise rents in 2006 to maintain sufficient net operating income (NOI) to cover its dividend.

Despite measurable improvements in some office markets, particularly in major coastal cities, conditions in many markets prevent landlords from demanding large increases, leaving them under margin pressures as fuel and other costs rise.

“The office sector is the most volatile of the four major property classes,” says Hans Nordby, research strategist at Property & Portfolio Research. “When rents start to go up, they can do so very quickly. But the reverse is also true, and many office landlords are signing new tenants at lower lease rates today.”

Nordby says that rents rose just 0.5% in 2005 and predicts a 4.3% increase for 2006. Things should improve in 2007 when rents advance by 5.1% and allow REITs to outperform the stock market by 2008 or 2009, he says. That’s what REITs in general have been doing lately. The NAREIT Equity REIT index was up 11.7% on a total return basis during 2005 compared to the S & P 500’s 5.8% total return during that period.

Outperforming the market may not be likely for EOP this year, however. “Maybe they should have cut it earlier or put more of a focus on operations,” says analyst Harris. Even after the dividend cut, EOP will still be as much as $50 to $100 million short of covering its dividend with cash flow this year, says EOP.

The sellers’ market helped EOP put off the day of reckoning: In 2005, the REIT sold $2.6 billion worth of assets. But EOP also used proceeds on new acquisitions in primary office markets like Manhattan. One such deal was the $505 million Verizon Building in midtown Manhattan, which EOP bought in April 2005.

But the company has warned that it won’t have the same kind of sales this year. “We do not anticipate the same level of capital gains in 2006 that we expect in 2005,” said Richard Kincaid, president and chief executive officer at EOP, during a late December conference call to tell investors about the dividend cut.

How safe is the new EOP dividend? Lehman Brothers analyst David Harris believes that EOP’s underlying cash flow will only modestly improve in 2006 as occupancy gains are offset by downward rent roll pressure. He’s also not fully convinced that EOP has ended its aggressive disposition campaign, though staying the course also presents risks.

Harris, who is under-weighting shares of EOP with a price target of $28, adds: “They may sell some more properties this year, but they have to bear in mind that they’re selling cash flow after a certain point.”