Thursday, November 03, 2005

Office REITs: Fill 'er Up, Please!

Two very bullish articles about the Seattle area office and apartment market have appeared this week in my local paper. One reviews how Equity Office (and other office property owners) have benefited from local job growth since 2002, which has pounded office vacancy rates from a high of 30% all the way down to 8% in Bellevue on the Eastside of the Seattle metro. The other indicates how buyers are now chasing Seattle area apartment investments, in anticipation of rising rents as the apartment sector joins the local economic recovery. Clearly, fundamentals are strengthening, providing further support for rising asset prices.

Among the fundamental indicators in investment real estate, occupancy is perhaps simplest to track and easiest to interpret. With a "natural" 5% vacancy rate expected from normal tenant mobility, occupancy above 95% typically means that rents have room to rise. In the opposite direction, occupancy below 90% is a tell-tale sign of a very weak rental market.

A few years ago, in the middle of the dot-com doldrums which elevated nationwide office vacancy rates into the teens, I took long-term positions in a couple of office REITs (disclosure: I am long Equity Office and Trizec), expecting to see improvement over a five- to ten-year horizon as the market cycle runs its course. Below is a summary tracking annual occupancy rates of the top three REITs (by market capitalization) in the office and apartment sectors:

The table shows occupancy percentages for the years indicated. (Source: Company 10-Ks and 10-Qs)

Name (Ticker, Market Cap): 1999, 2000, 2001, 2002, 2003, 2004, 2005Q3

Office REITs:
Equity Office (EOP, $12.5 bil.): 93.7, 94.6, 91.8, 88.6, 86.3, 87.7, 89.3
Boston Properties (BXP, $7.6 bil.): 98.4, 98.9, 95.3, 93.9, 92.1, 92.1, 93.3
Trizec Properties (TRZ, $3.4 bil.): 91.4, 94.2, 94.3, 89.0, 86.6, 89.5, 88.0

Apartment REITs:
Equity Residential (EQR, $11.0 bil.): 95.1, 94.9, 94.4, 93.7, 93.0, 93.3, 94.7
Archstone (ASN, $8.1 bil.): 94.9, 96.1, 94.7, 94.6, 94.4, 94.9, 96.0
Avalon Bay (AVB, $6.3 bil.): 96.6, 97.6, 95.4, 93.6, 93.8, 95.3, 95.9

The occupancy data illustrate three of the four stages in a typical real estate cycle:

1. Overshooting: In 1999-2000, both office and apartment occupancy rates peaked in the 95% to 98% range, driven by the notable strength of the tech-driven economy in its heyday.

2. Contraction: From 2001 to 2003, office occupancy plummeted to the 86% to 92% range as many dot-com companies cancelled leases. Falling apartment occupancy is discernible but much more muted in the numbers due to the cushioning impact of short-term leases and rent concessions.

3. Recovery: During 2004, occupancy began to improve gradually. Office occupancy is now in the 89% to 93% range, and apartment occupancy has returned to a normal market range of 94% to 96%.

What ought to come next is the growth stage:

4. Growth: I expect that during 2006 and continuing for a few years, we will see further improvement in office and apartment fundamentals. Office occupancy should return to the 95% level, thereafter supporting a rise in rents. With less volatile apartment occupancy already back to around 95%, improving fundamentals should soon be reflected in higher rents.

Potential detractors from this growth scenario are rising interest rates, rising energy prices and eroding consumer confidence--all of which could lead to slower job creation, hence delayed occupancy growth. Caveats aside, though, I believe that the office sector is poised for further improvement in occupancy. In particular, following the recent selloff after 2005Q3 earnings which came in slightly below analysts' estimates, two of the large office REITs--Equity Office and Trizec--appear to have good upside potential at this point.


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