Where do contrarian and value investors look for investment opportunities with North American benchmarks at or near record highs? Though there are many sectors that are flat or slightly down, few are significantly off their peaks. One exception is office real estate and the REITs that own office space.
Over the past six months or so, a number of subscribers have reached out asking if there are office real estate investment trusts on Contra the Heard’s watch list, and what we think of the space. The answer to the watch list question is easy: Yes, there are many U.S. and Canadian office REITs on our watch list. The answer to what we think of the space is much more nuanced.
The office REIT industry is undoubtedly cheap and contrary, which makes it a potentially lucrative place to look for opportunity. No one is talking up the prospects of the sector these days, and office REITs rarely make it into a list of top picks. Here in Canada, Slate Office recently defaulted on its debt, Inovalis is basically a penny stock and large REITs such as Dream Office and Allied Properties have lost more than 75 per cent of their value from their historic highs.
The story is similar in the United States. Columbia REIT defaulted last year, former billion-dollar-plus REITs such as Office Properties Income Trust have fallen below US$100-million in market cap, and even heavyweights including BXP (formerly Boston Properties) are badly bruised and battered.
Regardless of the side of the border they are on, these operations are suffering from the same issues, which fall into three categories.
First, the work-from-home trend forced upon society during the pandemic has stuck around for a large portion of the work force. This means many office REITs have endured years of high vacancy rates and low rents. These issues have driven down the top line and, in some cases, resulted in massive net losses.
Second, REITs tend to carry a lot of debt, and the office space sector is no exception. This debt has become more expensive since 2022 when interest rates started rising in earnest to tackle inflation. The combination of lower rents and higher vacancies on the one hand, and high debts with rising interest rates on the other hand, is a terrible combination for any business.
Finally, to cover interest payments and make mortgage payments, many organizations have had to issue equity, sell assets or do both. Issuing equity when a name is beaten down can be nearly as devastating for owners as default. Alternatively, selling assets into a distressed market can result in vending properties for less than you paid for them or selling them for less than the book value or mortgage on the property, which results in little more than kicking the default day down the road. The industry is in a tough spot.
Some office providers have tried to avoid selling assets at depressed valuations and instead have converted their buildings into residential, retail or mixed-use sites. While this is happening to some locations, and conversions in Calgary were recently featured in the The Globe, the process has been slow, and uptake has been low. This is because conversion is expensive, takes a long time and can easily get swept up in regulatory and land use uncertainty at the municipal level.
Despite the warts, the industry is interesting, and here at Contra the Heard we are investigating, researching and watching. Those interested in the space may want to consider either buying a best-in-class operator such as Allied Properties or BXP with a strong-enough balance sheet to weather continued pain, or wait to see organizations lower their vacancy rates, increase rental rates per square foot and stabilize their income statements.
Additionally, REITs in this space need to strengthen their balance sheets by improving liquidity, cutting debt and extending maturities. Though there are some in the industry that have taken significant steps in the right direction, a lot of balance sheets remain in rough shape. Falling interest rates will help in this regard.
Other signs we are looking out for include insider buying and positive revisions among the analyst community. This is because insiders (that is, executives and board members) are knowledgeable investors in their own business. The terms smart and dumb money get thrown around a lot, but in my estimation, there is a good argument that insiders are some of the smartest money out there. Meanwhile, analysts tend to judge the direction of sales and earnings accurately even if they fail to pinpoint the exact sales and net income figures on a quarterly basis.
These are not foolproof signals the worst is behind the industry, but investors interested in office REITs may want to keep these features in mind if they dive into the world of office real estate.
Philip MacKellar is a writer for the Contra the Heard Investment Letter.