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Key December 2013 Institute for Supply Management Index updates

Part 4
Key December 2013 Institute for Supply Management Index updates (Part 4 of 4)

Will the ISM Services Index affect commercial REITs?

Office REITs are driven in part by the strength of the economy

The strength of the services economy in particular is an important driver of the office REITs like Boston Properties (BXP), Kilroy (KRC), Vornado Realty Trust (VNO), S.L. Green (SLG), and Highwoods (HIW) in that it increases demand (and prices for office space) and lowers vacancy rates.

Office Vacancy RatesEnlarge Graph

Of course, vacancy rates are determined not only by demand, but also by the supply of office space. Since the real estate bust, we have had a dearth of new construction, which has limited supply of office space. (This same effect has been observed in the homebuilding space, where a half a decade of dismal housing starts has decreased supply.)

Pay attention to the industry focus on geography

Since the bursting of the real estate bubble, we’ve had an almost bifurcation in the office REIT space, with technology jobs increasing and financial jobs decreasing. In San Francisco, this is particularly evident, but even in a traditional financial stronghold like New York, we’re seeing the same thing. That said, the ISM finance services survey appeared to be picking up, although IT is still strong.

Economic strength can be a double-edged sword

Economic strength can portend stronger demand for office space and lower vacancy rates, but it can also mean higher interest rates. For office REITs, higher interest rates are a negative because they increase their cost of funds, and they can’t raise rents as quickly to compensate. Office leases are typically longer-term agreements. Historically, office REITs have exhibited a distinct negative correlation with interest rates. This time will be interesting to see, as the increase in interest rates is on the longer end of the curve, and short-term rates will be low probably through 2015. As you can see from the chart, we’re still at relatively high vacancy rates, so there’s some slack left to be taken out.

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