Shares of most office real estate investment trusts (REITs) are down over the past year, with the average one producing a total return of -18.4% in 2020. Weighing on REIT valuations is the concern the rise of remote work will keep office occupancy levels down, weighing on rental rates. That suggests office property values will decline.
However, those fears seem overblown, given some of the values high-quality office properties are fetching in recent sales. Because of that, office REITs look undervalued relative to the underlying value of their real estate.
Reaching new heights
Kilroy Realty (NYSE: KRC), a leading West Coast landlord, has seen its stock slide 18% over the past year due to the pandemic's impact on the commercial real estate market. However, while shares of the REIT have slumped, the value of its properties has held up exceptionally well. That's evident in its most recent deal.
The REIT has agreed to sell The Exchange on 16th, a 750,000-square-foot office property in San Francisco's Mission Bay neighborhood, for a whopping $1.08 billion. That's the second-highest sales price ever in the city and a record value of $1,440 per square foot. This "strong price underscores the embedded value of our stabilized portfolio," stated CEO John Kilroy in a press release.
Kilroy started developing the four-building complex in late 2015 and signed a 15-year lease with cloud storage provider Dropbox (NASDAQ: DBX) for the entire office component of the property in 2017, marking the largest single Class A commercial lease ever completed in San Francisco. Kilroy spent about $585 million, or $780 per square foot, to develop the project, which reached full stabilization last year.
That implies it's netting a massive profit on this deal, "highlighting the value we have created through our development program," according to Kilroy. The company plans to use the proceeds to fund development projects, make acquisitions, and for other corporate purposes such as paying down debt, repurchasing stock, and potentially paying a special dividend.
Cashing in ahead of schedule
Kilroy isn't the only office REIT cashing in on the value of a recent development project. SL Green Realty (NYSE: SLG), Manhattan's largest office landlord, agreed to sell 410 Tenth Avenue last November. The company sold the 636,000-square-foot office redevelopment project for a total of $952.5 million, which at the time was the largest commercial property sale in the U.S. since the pandemic started last March. It achieved that value even though it's still in the middle of a comprehensive, building-wide redevelopment of the 20-story Class A office building.
SL Green doesn't expect to complete the project -- backed by long-term leases with e-commerce giant Amazon (NASDAQ: AMZN) and financial service company First Republic Bank (NYSE: FRC) -- until the third quarter of this year.
SL Green had planned to hold the property as a long-term investment. However, the sale allowed it to lock in extraordinary profits. The company achieved a 35% IRR and generated $175 million in total profits over the seven-year hold period. Further, the $1,505 price per square foot and 4.6% cap rate were even better than similar pre-pandemic deals. SL Green used the sale proceeds to repay debt and return capital to shareholders via its stock buyback program and a special dividend.
Meanwhile, SL Green subsequently agreed to sell its 25% interest in some commercial condominium units in Manhattan valued at $275 million. The company's chief investment officer David Schonbraun commented in a press release, "The transaction also serves to further demonstrate the resiliency of the Manhattan office market and the continued demand by institutional investors for well-located, Class A real estate assets in Midtown."
That sale gave it a bit more cash for share repurchases as it continues to capture the value disconnect between its stock price and the underlying value of its high-quality office portfolio.
Offices values haven't crumbled
Real estate investors dumped office REIT stocks during the pandemic on concerns property values would suffer if companies didn't return to their offices in a post-pandemic world. While remote work is here to stay in some form, most companies expect to be back in their offices as soon as it's safe, since they're better for productivity and creating culture.
This means office values have held up extraordinarily well, as evidenced by recent sales from SL Green and Kilroy Realty. These sales suggest the market has significantly undervalued shares of office REITs, which is why SL Green is buying back its stock, and Kilroy is considering a repurchase program.