Governments around the world attempted to contain the coronavirus pandemic by asking people to socially distance themselves. Wherever possible, that meant a shift to working from home. Investors are worried that real estate investment trusts (REITs) that own office space will see their business models upended if this shift becomes permanent. Don't get too worried about that, but don't expect a swift return to normal, either. Here's how you might want to think about the office REIT space today.
Still a necessity
The simplest reason why office REITs won't implode is because it's important to get people together for work, at least some of the time (if not most of it). Video conference calls are functional, and even desirable in some situations, but they are not a replacement for face-to-face gatherings. Most businesses find it's easier to share ideas and brainstorm when employees are working together in the same room. This is why some companies, notably in the finance sector, are already asking employees to come back to the office.
We should also consider human nature. Some people are perfectly fine being left to their own devices. Others -- and likely a larger number -- need the structure and camaraderie of a group setting to thrive. It's not as simple as opting to work from home across the board. Yes, in a worst-case scenario, much can be done remotely. But in-person work often produces a better outcome for all involved, which is why businesses haven't been dumping their office space.
For example, geographically diversified industry giant Boston Properties (NYSE: BXP) ended the second quarter with occupancy at nearly 89%, with a hope that the number would top 90% by the end of 2022. West Coast–focused office landlord Kilroy Realty's (NYSE: KRC) occupancy was even better, at 93% at the end of March, though it expects that number to drop to 91.5% by the end of the year. And City Office (NYSE: CIO), a smaller office player with a focus on Western and Sun Belt states, had an occupancy level of 90.5% in the first quarter. Office REITs simply aren't falling off a cliff, and they aren't likely to anytime soon.
Getting 'back to normal' could take some time
That said, Boston Properties ended 2019 with occupancy of 93%, Kilroy's occupancy was 97% at Dec. 31 that year, and City Office had just shy of 92% of its space occupied at the end of 2019. The pandemic and working from home have definitely had an impact.
And the pain may linger. For example, Boston Properties noted that its first-quarter leasing volume was at 84% of pre-pandemic levels. That improved to around 90% in the second quarter, but it's still below historical norms.
That's not shocking, given that the pandemic hasn't gone away. But it stretches out the time it will take to refill empty space. Ample available space is also likely to put pressure on lease rates, which will flow through to the top and bottom lines for office REITs. Lower rates, meanwhile, are getting locked into leases, so their impact will stick around until those leases roll over.
This isn't great news, but neither is it shocking or devastating. It just means that office REITs are in for a drawn-out recovery, which is why it makes sense that the stocks of both Boston Properties and Kilroy are down by around 15% and 17%, respectively, from where they were at the start of 2020. Tiny City Office is only off around 5%, but it has been executing fairly well and actually upped its full-year 2021 funds from operations (FFO) guidance when it reported first-quarter earnings. The key here is to remember that, for a small company, small events can have big impacts. Thus, City Office's relatively strong stock performance isn't surprising.
All these factors highlight the need to examine office REITs on a case-by-case basis right now. For instance, Kilroy has material exposure to the technology industry. (The REIT is actually expanding into Texas as tech companies increasingly move into that state from California.)
That sector seems most likely to shift toward increased remote work. For example, Dropbox announced its plan to be a "virtual company" in late 2020. That's a trend that won't help companies with material West Coast exposure, a list that includes Boston Properties. However, it wouldn't be surprising to see increased remote work, even for companies that bring workers back to the office most of the time.
That could put additional downward pressure on demand, since it would reduce the amount of space companies need overall. That said, Sun Belt regions, an area where City Office has notable exposure, are seeing increased population growth, which is likely to translate into better office performance (again, it's worth noting Kilroy's move into Texas). Basically, there are a lot of moving parts that companies have to deal with.
No easy answers
The truth is that the office REIT space is facing a complicated landscape right now. Offices are still needed, so there's little risk that these REITs are facing insurmountable problems. However, there's a lot in flux as the world continues to learn how to deal with the coronavirus. There will be changes that come from these virus mitigation efforts, including increased remote working. The biggest impact, however, is most likely to be a prolonged recovery for office REITs, not a material alteration in the business model.