Balance sheet

Descriptive analysis of Office REITs finds the higher the yield, the higher the leverage.

June 13, 2016

About the author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Between 2010 and 2020, Ganel worked for Silvergate as Vice President in Capital Markets. He provides advisory services to family offices,  private companies, and financial advisors.

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On the asset side of the balance sheet, there are office buildings and real estate loans. The industry divides among four major types of office buildings. The separating points between the building categories depend on the construction material, maintenance, location, tenant mix, and the desirability of the property. In The 3 Classes of Office Buildings: What Do They Really Mean?, Liz Wolf of HighTower, a leasing management software company, discusses the subjective nature of these  definitions.        

For Office REITs in the NAREIT Index, asset size ranges between $440 million and $20 billion, with an average of $5 billion.

On the debt side of the balance sheet, liabilities can be secured or unsecured. Secured liabilities use real estate as a collateral and allow the REIT to borrow at a low interest rate. Unsecured liabilities are shorter term in nature, with a higher interest rate. Unsecured liabilities are lines of credits, notes payable, and short-term debt obligations.

For every dollar of assets, Office REITS in the NAREIT Index carry a liability between 35 to 85 cents. For every dollar of equity, Office REITs carry between1.5 times and 6.5 times assets.  

Office REITs in NAREIT Index - Balance Sheet
Office REITs in NAREIT Index - Balance Sheet

Office REITs revenue is lease income, gains on properties, and interest rate income on loans collateralized by real estate. There are three types of leases. In a Gross Lease, the property owner pays all or most expenses. In a Net Lease, the property owner charges a lower base but the tenant a portion of the common area maintenance. In a Tripe Net Lease, the tenant pays property taxes, insurance and common area maintenance.    

To evaluate revenue quality, as part of the due diligence, factors such as tenant mix, vacancy factor and elasticity of rent are used. An office building with one tenant, for example, a local government agency, has inferior revenue quality compared to an office building with ten heterogeneous tenants. High vacancy factor deters lenders. Elasticity of rent is the ability of the owner to increase or decrease lease rental rate without affecting the building’s occupancy.

Expenses are administrative and operational in nature. To determine efficiency, the industry calculates the ratio between Operating Expenses and Effective Gross Income. For office buildings, the ratio is 60 percent for the average operator. Operating Expenses exclude Debt Service as to allow the comparison between the operating performance without the effect of leverage.

Office REITs in NAREIT Index - Earnings
‍Office REITs in NAREIT Index - Earnings

Pen&Paper researched the descriptive statistics for the 27 Office REITs included in the NAREIT index. The Office REITs asset size ranges from $440 million to $20 billion with an average of $5 billion and a median of $4 billion. 

Year 2015 yield ranged from 0.86% to 8.60% with an average of 3.95% and a median of 3.37%. Debt to assets range from 35 percent to 85 percent with an average of 60 percent and a median of 58 percent.

Unsurprisingly, a high yielding Office REIT, such as City Office REIT (NYSE:CIO), carries a significant amount of debt. And a Lower yielding Office REIT, such as Cousins Properties Incorporated (NYSE:CUZ), carries substantially less amount of debt.