Office REITs continue to face threats and opportunities

Real estate investment trusts (REITs) that are largely focused on offices have not been performing well since 2022.

Note that the average total return (including cash dividends) of the five listed REITs with significant office property exposure since the end of 2021 up until today is negative 25.7 percent: AREIT, Filinvest REIT (FILRT), DDMP REIT (DDMPR), RL Commercial REIT (RCR), MREIT. Although demand from new tenants has been picking up the past few years, office occupancy rates have been on a decline.

This, as several companies reduced their office footprint due to the work from home trend.

Moreover, numerous office buildings were completed the past few years leading to an oversupply situation.

The abundance of newer, better-quality buildings also caused some tenants with expiring lease contracts to move out of their existing locations, hurting companies with older buildings in terms of higher vacancies.According to Colliers, office vacancy rates increased to 18.8 percent in 2022 and 19.3 percent in 2023 from 15.7 percent in 2021.

Because of this, several REITs (DDMPR, FILRT) gave out lower cash dividends in 2023 compared to 2022.

Those that paid out higher dividends (RCR, MREIT) only gave slightly more.

AREIT was the only exception since it benefited from an asset injection. This enabled it to increase its cash dividends by 12.1 percent last year.

Making matters worse was the steep rise in interest rates.

Recall that interest rates began to go up sharply in 2022 as the US Fed aggressively tightened its monetary policy to control inflation. Because of factors related to the pandemic, inflation in the US shot up to as high as 9.1 percent last June 2022.

Here at home, the Bangko Sentral ng Pilipinas raised rates aggressively since inflation also increased sharply to a peak of 8.7 percent in January 2023. These factors led to a steep rise in interest rates.

Note that the Philippine 10-year bond rate jumped to as high as 7 percent last October from only 4.8 percent as of end 2021.

Because of this, yields on more traditional fixed income products such as time deposits and bonds also increased, making REITs less attractive to investors looking for passive income.

The worst is not yet over though as cash dividends of REITs could still decline given that the office leasing market continues to suffer from an oversupply situation.

According to Colliers, the oversupply situation will persist this year, with vacancy rates projected to increase further to 19.6 percent by the end of 2024. Meanwhile, KMC Savills expects the oversupply situation to last until 2025.

There is some silver lining though. Inflation and interest rates have already peaked, which is good for REITs.

In fact, REITs that are heavily exposed to offices already rallied during the start of this year and are up by an average of 9.6 percent for the year-to-date period. Moreover, because of the steep drop in REIT prices the past two years, the dividend yields of the five office-heavy REITs are now very attractive, averaging 7.6 percent (based on 2023 cash dividends). This is around 140 basis points higher than the current 10-year bond rate.

Although the worst is not yet over for the office leasing industry, investors with a long-term investment time horizon might find it attractive to start accumulating REITs with good quality assets. After all, doing so will allow them to lock in higher yields which may go down soon. They also stand to benefit from significant capital appreciation once the industry is no longer suffering from an oversupply situation. INQ