Western real estate advisors case study: REIT roll-up

Real Estate Issues, Dec 1997 by McMahan, John

This surging demand for office space helped to drive down vacancy rates for both downtown and suburban markets. As of March 31, 1997, downtown vacancy rates stood at 13.2 percent, down from 17.6 percent at the end of 1992; and suburban rates were 10.6 percent, down from 19.4 percent in 1992.8 With less space on the market, effective rental rates were steadily increasing-up 4.9 percent in 1995 and 6.8 percent in 1996. 9

The nature of office space demand was also changing. As business firms downsized and outsourced their operations, office demand began shifting from larger companies to smaller companies, many of which worked for the larger companies. This trend has been accelerated by the application of new technologies which allowed many employees to operate from venues other than the traditional office (e.g. home, hotel, airplane, etc.). Many firms also have experimented with a variety of new ways to organize the work effort including open space design, "hoteling," and the widely reported "virtual" office format. In all cases, the emphasis is on providing the firm with flexibility in dealing with its office requirements.

These shifts in demand have made many older office buildings functionally obsolete. They may be designed for the large company "footprint" where columns and other obstacles make it difficult to reformat space for smaller tenants. More commonly, many older buildings are not designed to adapt to the requirements of modern technology and retrofitting is expensive, if not impossible. Finally, the building may not be functionally obsolete, but it is an area where people do not wish to work. The combination of these and other factors has contributed to suburban locations becoming more attractive to many office users. The suburbs offer lower land costs, facilitating new design and construction and are located where most people live. In many cities, (e.g. Dallas, Denver, San Diego, Tampa, etc.) suburban rents exceed downtown locations.10

OFFICE REITs SHARE IN THE BOOM

Consistent with their position in the real estate cycle, office REITs did not really get going until mid-1996. In the succeeding 12 months, six office REITs went public and a large number were poised in the pipeline, including Equity Office Properties Trust, a multi-billion national office REIT which went public shortly thereafter. The total equity raised by these REITs was $2.2 billion. As of June 27,1997, the average price had increased 13.7 percent over the issuing price (Exhibit 11).

In terms of operations, these new office REITs had a relatively low debt ratio (27.1 percent), although floating debt was quite high (22.8 percent). FFO is expected to increase 11.3 percent over the next 12 months. FFO multiples, however, were expected to decline in 1998 along with lower expectations for the market overall (Exhibit 12).

Interestingly, office REITs own only six percent of institutional grade office square footage in major metropolitan areas.ll Many observers expect this relatively low penetration to lead to a large amount of consolidation activity as managers attempt to add economic scale to their operations through the acquisition of private market portfolios and companies. The improvement in office property values also makes it more attractive to sell companies than it did a few years ago.