Must-know: Why all commercial real estate is local
Office REITs are driven in part by the strength of the economy
The strength of the services economy is an important driver of the office real estate investment trusts (or REIT) 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.
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Of course, vacancy rates are determined not only by demand, but also by the supply of office space. Since the real estate bubble burst, we’ve had a lack of new construction, which has limited supply of office space. This same effect has been observed in the home building space, where half a decade of dismal housing starts has decreased supply.
Pay attention to the industry focus on geography
Since the real estate bubble burst, we’ve had almost a division 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. Vornado’s occupancy rate in New York City was much higher at 97% than it was in Washington, DC at 83%.
Economic strength can be a double-edged sword
Economic strength can predict 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 REITs can’t raise rents as quickly to compensate. Office leases are typically long-term agreements. Historically, office REITs have exhibited a distinct negative correlation with interest rates. This time it 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 previous chart, we’re still at relatively high vacancy rates, so there’s some slack left to take out.