Owners of office buildings have faced challenges following reports of slow return to in-person work for some employees.SOL STOCK LTD/iStockPhoto / Getty Images
After suffering through a dismal 2022, office real estate investment trusts remain threatened by hybrid working schedules, rising vacancies and a gloomy economic outlook.
So why give the sector a second thought?
The steep selloff of the past year is yielding bargains, and the depressed market sentiment may be suggesting that changes in our working routines are permanent, whereas they may not be.
“Office sentiment is extremely weak right now. But many in the market are making the assumption that these challenges will exist in perpetuity,” Paul Morassutti, chairman of CBRE Canada, the commercial real estate services company, said in an interview.
“I don’t really buy into that view,” he added.
Allied Properties REIT AP-UN-T offers a good starting point for a closer look – and also provides an example of how bleak things are.
The REIT’s unit price has tumbled 59 per cent from its prepandemic high three years ago, touching an 11-year low this week. The decline sent the distribution yield up to 7.5 per cent this week, its highest level since 2009.
High yields can reflect the market’s concerns about whether distributions will be maintained.
These concerns are real. In mid-March, True North Commercial REIT TNT-UN-T slashed its monthly distribution by 50 per cent in an effort to preserve capital after reporting that its funds from operations – a measure of income, excluding lease termination fees – fell 20 per cent year-over-year.
True North’s unit price sank 39 per cent on March 15, when the cut was announced.
The challenges facing the owners of office buildings follows reports of a slow return to work for many employees who have become comfortable working from home for at least part of the week. In Toronto’s financial hub, the average current occupancy is just 43 per cent of prepandemic levels, feeding anxiety over what happens when long-term leases come up for renewal.
Add a massive wave of layoffs by Canada’s technology sector, additional supply of office space from new buildings and a looming recession, and it is little surprise that office REITs are struggling – and even posing a threat to the banking sector.
Rising office vacancies and struggling REITs “raises the risk that lenders will have to increase the loan loss provisions on their commercial real estate portfolios,” Stephen Brown, deputy chief North America economist at Capital Economics, said in a note.
There is a compelling – if risky – case for a recovery in office REITs though, starting with cyclical factors: Tech hiring will return and recession fears will ebb.
More importantly, the bullish case rests on companies limiting remote work, pushing down vacancies as new office space is absorbed. This may be happening now, if in a limited way.
According to Robert Half Canada, the number of new job postings advertised as remote is declining – to 18.6 per cent in February from 22.9 per cent in January. And Royal Bank of Canada offered an important signal recently when its chief executive offer said that remote work is hurting productivity.
CBRE’s Mr. Morassutti believes that the issue of new office supply coming on board, particularly in Toronto, at the wrong time is a bigger factor than anything else in the current weakness in the sector. Once that is absorbed, he said new supply in Toronto will be at a 20-year low.
“We think the office market is going through an evolution, rather than a revolution. But what’s getting priced in is the revolution,” Mr. Morassutti said.
He expects the office market will be recovering in 12 to 24 months, and resembling prepandemic times soon after.
A bet on the sector now, during what could be peak pessimism, could be well timed.
A number of analysts expect that Allied Properties is the safest bet, given its relatively strong balance sheet and mix of office workspaces that are located in desirable urban markets and designed for hybrid working models. The REIT appears to be holding up during these difficult times, too.
In its fourth-quarter results, released at the start of February, the REIT reported that its funds from operations rose 3 per cent, year-over-year. The amount of leased space also nudged higher during the quarter, to 90.8 per cent from 90.4 per cent at the end of 2021.
The REIT will release its first-quarter financial results on April 26. If the depressed unit price is any indication, no one is expecting good news.
Editor’s note: This story previously made the incorrect claim that dividend yield for Allied Properties had reached a record high. In fact, it has reached its highest level since 2009.