Office REIT stock prices hit rock bottom on March 6, down nearly 70% from their February 2007 highs, according to REIT consultant Green Street Advisors. Investors feared that the highly leveraged office REIT sector, faced with hefty debt maturities in an illiquid marketplace, did not have enough cash to weather the downturn.

Since the sector's early March lows, office REIT executives have been working overtime to repair their balance sheets with stock offerings and other equity-raising exercises. No fewer than 10 office REITs have announced common stock offerings since February. Among the bold moves:

• New York office landlord SL Green Realty Corp. (NYSE: SLG) gained $57.5 billion from buying back $224.9 million of its unsecured notes at a discount. The REIT also raised $387.4 million through a stock offering of 2.5 million common shares.

• Douglas Emmett (NYSE: DEI), which owns well-located office properties in West Los Angeles and Honolulu, bought back 605,600 of its common shares at an average price of $6.27 per share. By early June, the shares had jumped to $9.86. The company has roughly $2.6 billion in debt maturing in 2012, according to Green Street.

• Brandywine Realty Trust (NYSE: BDN) raised $242.5 million when it issued over 40 million shares of common stock in late May. The office REIT has more than $1 billion in debt due through 2012, according to company CEO Jerry Sweeney.

Tough times ahead

For the past few months, investors have watched with approval as more and more REITs have taken measures to reduce their debt and squirrel away cash. This new confidence is manifested in the stock prices, which jumped nearly 50% for office REITs from March through the end of May.

But the industry isn't out of the woods yet. Now that the first round of deleveraging is well under way, investors are turning their attention to declining office fundamentals, which are expected to deteriorate as job losses mount. Moody's Economy.com projects the U.S. unemployment rate to reach 10.1% near the end of this year. Commercial office vacancies and rents, however, aren't expected to bottom out until early 2011.

“On the office side, we're fairly cautious,” says Tim Pire, managing director of real estate investment management firm Heitman, based in Chicago. “Office is probably going to be, from a fundamentals perspective, the sector that bottoms last in terms of overall cash-flow declines.”

Contrary to the oft-reported storyline that office REITs are building their war chests to take advantage of distress opportunities, at the moment deleveraging is the main focus, says industry veteran Barry Vinocur, CEO of REIT Zone Publications in Novato, Calif.

In fact, experts predict a tough and long row to hoe for office REITs and their investors. In today's volatile equities market, investors have a few more considerations to take into account when sizing up an office REIT, says Ralph Block, CEO of Essential REIT Publishing Co. and author of “Investing in REITs,” a book suitable for new investors.

Is the price right?

For starters, investors need to pay more attention to the specific markets in which a REIT's properties are located. “We've never had a situation where we've had such a wide range of local economic markets,” says Block. For instance, Phoenix does not share the same robust health as Washington, D.C. In metro D.C., the office vacancy rate for all classes of space was a tight 8.5% in the first quarter, while in Phoenix, where home foreclosures are rampant, the vacancy rate topped 20.6%.

Office REIT balance sheets, once largely conservative, are now of paramount concern to investors. Due to the quick and unexpected drop in commercial real estate values, many REITs are now highly leveraged. Green Street noted in a March 20 report that the average leverage for office REITs was 63%, weighted by market cap, compared with an average leverage of 56% for all REITs over the same period.

Although a REIT's properties might be performing well, the company could have maturing debt that can't be refinanced, which would then potentially force it to let go of high-quality assets at fire-sale prices, notes Block.

While office building values in the private market could ultimately drop by 40% from peak to trough, as many analysts predict, office REIT asset values on average have already dropped by 40% from their 2007 peaks, according to Green Street Advisors. “Clearly [commercial real estate] values are down,” Vinocur says, “but what people are missing is that REITs have already essentially factored that discount into pricing.”

REITs also are a forward-looking indicator and lead the broader property market by at least six months, according to an April 21 study by New York-based REIT investment firm Cohen & Steers. The reasoning is that the liquidity of REITs provides greater transparency in pricing and a faster transfer of information than less-liquid direct markets, according to Scott Crowe, global portfolio manager with the firm and co-author of the study.

If indeed office REIT stocks are now fairly valued, then the low-hanging fruit investors plucked from early March to late May when office REIT stocks jumped 50% isn't likely to reappear anytime soon, says Michael Knott, senior REIT analyst with Green Street Advisors. Rather than expect an upside on stock prices, investors itching to get into the sector should be content with dividend yields, which average about 7%.