The Good, the Bad and the Ugly

Even with a magnifying glass, it is not easy to find value in office properties

December 15, 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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Office REITs are trading at a dear valuation. Over 90% of the office companies that compose the NAREIT index are trading at higher multiples than book value. And to purchase a position in an office REIT, at the current average multiple of 15 times the funds from operations, would leave thin room for error and should serve as a reminder: in the past twenty years, the only time office REITs traded at a multiple higher than 15 times was in 2006-2007. The exorbitant market price is not due to a stellar performance. In total, office REITs’ average return on equity was 10% in the past two years.

Risk is looming. First, oversupply is apparent in major metropolitan markets. In Washington, DC, there is twice the development activity and available office space than demand, reports JLL, a real estate brokerage firm. Second, future monetary pressures (read: inflation) may increase the interest rate environment, squeezing profits. Third, competition from shared-office companies, such as WeWork and Mindspace, continues to challenge the traditional business model.

Yet the investing public seemingly ignores any future warnings. “The biggest trend for commercial real estate in 2017 – and beyond – is the ongoing technological disruption of the industry. E-commerce is taking roughly 50% of the growth in overall retail sales, which is eroding the underlying value of retail real estate,” notes David Shulman, an economist. “On the office side, square footage per employee continues to come down, creating latent vacancies in its wake, and hoteliers have to deal with the fact that Airbnb is here to stay.”

The exorbitant prices are apparent in large, small and mid-size office REITs. Boston Properties, with $16 billion in real estate assets and $918 million in funds from operations, traded 3 times the book value and had a multiple of 21 times the funds from operations. Smaller REITs, such as First Potomac Realty, with $58 million in real estate assets and $55 million in funds from operations, traded at 2.5 times the book value, with a multiple of 18 times the funds from operations. Midsize companies, such as Equity Commonwealth, with $3 billion in assets and $390 million in funds from operations, traded at 2.7 times the book value and 18 times the funds from operations.

What can be done? For the passive investor to purchase an index fund, one such as the iShares U.S. Real Estate ETF would be sensible. The office asset class represented 10% of the index composition, so, perhaps, opportunities would unfold in other asset classes such as medical office buildings or data centers. For the active investor, catalyzed by a low interest rate environment and a 7-year increase in market value, continued development of office properties could be the right course of action. But your correspondent has chosen to focus the attention on a single office company.

Hudson Pacific Properties (NYSE:HPP) should grab your attention, too. Over the past 5 years, real estate per share increased to $67 from $36, while liabilities per share increased to $29 from $15. And its income statement entails a similar tale. Revenue per share increased to $5.90 from $3.77, while operating expenses per share remained at $2.65. And the boss of Hudson, Victor Coleman, knows a thing or two about selling at the right time. In 2006, he sold his former company, Arden Realty, to GE Real Estate at a hefty valuation of $5 billion. Given the alternatives, a share in Hudson may be a reasonable location to park cash.