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Why geography matters to REIT investors

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Updated

Office REITs are driven in part by the economy’s strength

The strength of the services economy, in particular, is an important driver of office real estate investment trusts (or REITs)—like Boston Properties Inc. (BXP), Kilroy Realty Corporation (KRC), Vornado Realty Trust (VNO), SL Green Realty Corp. (SLG), and Highwoods Properties Inc. (HIW). Strength increases demand and prices for office space. It lowers vacancy rates.

Of course, vacancy rates are determined not only by demand, but also by the supply of office space. Since the real estate bust, we’ve had a shortage of new construction. This limited the office space supply. This also holds true in the homebuilding space. Five years of dismal housing starts decreased supply.

Office Vacancy Rates

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Pay attention to the industry’s focus on geography

Since the real estate burst, we’ve had a near split in the office REIT space. Technology jobs increased, while financial jobs decreased.

Interestingly, during Vornado Realty Trust’s 2Q14 earnings call, the company reported that the vacancy rate in New York City is quite low—it’s ~3%. Meanwhile, the vacancy rate in Washington, DC is in the mid or high teens. This is surprising considering that the financial sector has been hit extremely hard since 2009. Also, government spending averaged 24% of gross domestic product (or GDP) during this period—the highest level since the Truman administration from 1945 to 1953.

It makes sense for analysts to focus on a REIT’s geographic exposure in the same way that it makes sense to pay attention to a homebuilder’s geographic exposure.

Employment growth is coming back—slowly

We’re seeing signs of strength in the employment market. The Fed probably won’t even consider hiking rates until we see wage inflation at the 4% level. Increases in employment will be positive for the office REIT sector. However, if the Fed starts increasing rates, the cost of funds will go up.

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