Why Office REITs Still Face Some Risk
Chris Wimmer of Fitch Ratings on the challenges facing owners of urban office properties.
In New York City and other coastal gateway markets in the Northeast and the West Coast, office jobs have made almost a full recovery to pre-pandemic levels. Though employment has generally bounced back, many workers still have yet to return in-person to the office. In Manhattan, for instance, the building census rate was roughly 70 percent pre-pandemic. Today, that rate sits near 40 percent.
Despite ongoing discord between market participants about the lasting impact that flexible work options will have on tenant space, Fitch has adopted a more cautious, through-the-cycle view on U.S. office tenant demand.
Fitch believes U.S. office REITs focused on coastal markets should operate with more conservative credit protection metrics to sustain low investment-grade ratings. Underpinning this belief is their relatively more inhibited access to attractively-priced capital, which could lead office REITs to engage in less credit-friendly activities, such as speculative development and share repurchases, particularly should these be funded with proceeds from any combination of joint venture proceeds, secured debt or variable rate debt.
In the past, Fitch had set cash flow-based leverage rating sensitivities higher at any given rating level for REITs that own portfolios in New York City and similar large coastal cities, compared to REITs with portfolios concentrated to smaller metro and suburban markets. This was reflective of lower capitalization rates and generally superior asset liquidity.
Impacts of Office Vacancies
Marginal debt and equity capital available to office owners is expected to be relatively less available, mainly due to large amounts of vacancies within office buildings resulting in weaker fundamentals and, consequently, lower investment returns. Flexible work and outmigration have led to a dip in office demand, combined with increased institutional investor interest in sunbelt markets. Tenant sector profiles and lease rollover risk will be increasingly important, potentially gating factors affecting capital access.
Going forward, Fitch sees tight labor market conditions as the most important factor driving low office census rates as workers ask for remote work flexibility. Weaker economic growth or higher unemployment, however, could shift the balance of power back toward employers wanting their workers to be in-office. In turn, this could boost physical occupancy and, ultimately, tenant demand.
Public transportation burdens, public safety, and lingering pandemic-related health concerns also continue to play a role in the ongoing return-to-office conversation, and will be areas to watch in the coming months and years.
Long lease durations, strong asset and tenant credit quality, and below-market face rents will support office REIT cash flow across the country, including in more challenging coastal markets. Fitch expects the clear separation in performance by building class to continue—with occupancies and rent economics for modern Class A space outperforming the broader market.
Christopher Wimmer, CFA, is senior director, Fitch Ratings.