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Rent Pressure And Development Delays Heighten Risks For U.S. Office REITs


COVID-19 Impact: Key Takeaways From Our Articles


SLIDES Published: Italian Corporates In The COVID-19 Era: First Steps On A Steep Recovery Path


COVID-19- And Oil Price-Related Public Rating Actions On Corporations, Sovereigns, International Public Finance, And Project Finance To Date


Elevated EBITDA Addbacks Are A Continuing Trend

Rent Pressure And Development Delays Heighten Risks For U.S. Office REITs

We believe stagnant job growth will pause expansion plans for office tenants, limiting their appetite for additional office space. We think REITs with large development pipelines could struggle to lease up their projects and lockdown measures could delay projects and hinder EBITDA contribution, pushing out deleveraging targets by a few quarters. We also think retention rates will remain strong and provide a buffer to potential occupancy declines. However, we believe rents will take a hit and could include higher concessions such as increased tenant improvements and longer free rent periods. Moreover, lease expirations are manageable, but tenants could request more flexible, shorter-term leases upon renewal as they assess long-term office needs. Our outlook bias for office REITs is negative. We rate 14 office REITs, 13 of which we rate in the investment-grade category. We revised our outlook to negative on four companies since the start of the pandemic.

In response to the COVID-19 pandemic, lockdowns led to depressed economic activity and historic unemployment in the U.S. As of the first week of June (less than three months into the shutdown), more than 47 million Americans filed for unemployment because of massive layoffs and temporary closures. Our economists forecast a 5.0% GDP contraction in 2020 followed by a modest recovery in 2021, with GDP expected to expand by 5.2%. At the same time, we expect unemployment will remain high at 9.3% by year-end 2020 and slowly decline thereafter, but project it will take several years to recover to prepandemic levels below 4%. Recovery prospects remains fragile – particularly because of uncertainty about when an effective vaccine will be readily available, fears of another wave of COVID-19, and businesses that survive being reluctant to rehire employees.

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Office Properties Are Cyclical And We Expect Operating Performance To Soften

We have a negative rating bias on office REITs given the cyclicality of office properties during economic downturns, exacerbated by the fact that this recession is more abrupt and steeper than any other recession in history. Some issuers had built cushion in their key credit metrics to weather the storm, but others had already stretched their balance sheets in an effort to grow (pre-pandemic), putting additional pressure on credit ratings. Office REITs were the only REIT subsector that failed to materially reduce leverage since the Great Recession in 2008-2009. Historically, office REITs have proven to be one of the most cyclical sectors in real estate. In the last recession, rated office REITs' net operating income (NOI) declined 2% in 2010 and occupancy rates plunged to around 90%, and it took issuers about five years to recover. This time around, we believe stagnant job growth will likely pause expansion plans for office tenants, limiting their appetite for additional office space, and REITs with large development pipelines could struggle to lease up their projects. We think occupancy will only decline modestly in the near term as a majority of tenants has strong credit quality and leases that are expiring should see higher–than-average retention rates given the uncertainty caused by the pandemic. However, we expect significant downward pressure on rents to drive to negative same-property NOI in the 2% to 5% area through 2021.

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We believe office landlords will share some of their corporate tenants' pain despite the protection from their long-term leases. Rent collection for office properties within our rated office REIT portfolio has remained relatively high (around 95% both in April and May) even though many office buildings sat virtually vacant during the past couple of months because of stay-at-home orders. This is significantly higher compared with rent collection for retail properties (55% range) as mandated retail store closures led to material rent deferrals and will likely result in a large number of abatements to keep tenants in place.

High Retention Will Buffer Occupancy Declines

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Although office real estate properties did not feel an immediate shock from stay-at-home orders, we expect the recession to have a modest near-term impact. As leases come due over the next 12 to 24 months, we believe leasing will be challenging, particularly in markets where new supply is coming online. We believe tenants across different industries will likely pause strategic changes throughout this recession, including decisions related to their real estate footprints and potential relocation expenses. Therefore, we think retention rates will remain strong and provide a buffer to potential occupancy declines. However, we believe rents will take a hit and could include higher concessions such as increased tenant improvement and longer free rent periods (although capex could decline modestly from fewer new leases). We think companies that have achieved higher rent spreads in recent quarters will be in better positions to absorb this impact.

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The sector's long-term leases (with an average of 7.3 years of remaining lease term) will help cushion the impact from the recession, in our view. Moreover, lease expirations are manageable with just an average of 13% of annualized base rent expiring through 2021. However, there is potential that tenants could request more flexible, shorter-term leases as they renew and assess long--term office needs. We also think REITs with a stronger tenant base, with outsized exposure to the life sciences, technology, and media industries, will likely maintain more stable occupancy rates. The office REITs we rate have an average exposure of about 50% in aggregate to those industries, with Alexandria Real Estate Equities (ARE), Kilroy Realty Corp. (KRC), and Hudson Pacific Properties (HPP) exhibiting the largest exposure. We also think exposure to government and government-related tenants somewhat mitigates downside occupancy risk, at least over the medium term. Corporate Office Properties Trust (COPT) and Office Properties Income Trust (OPI) hold the highest concentration of these tenants. Conversely, we think rent roll-up and revised lease agreements will likely encompass a wider array of tenants. We think this could have a greater impact on markets with pockets of oversupply where market rents are similar to or below expiring rents, such as New York City.

High Development Exposure And Leverage Pressure Ratings

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Over the medium term, we expect lockdown measures will result in some project delays. REITs have stated that these delays are largely immaterial, but as lockdowns persist, they could hinder EBITDA contribution even if projects are highly leased. Some projects under construction scheduled for delivery in 2020 are nearly complete, but stabilization targets might be pushed back a few quarters. Development has been a key growth driver for the sector over the past several years and many office REITs that levered-up to attain growth targets rely on rent commencements to smooth their balance sheets. Therefore, we expect the sector's deleveraging targets will likely be delayed. Ratings on office REITs with stretched balance sheets pre-pandemic were already under pressure. In the second quarter of 2020, we revised the outlook on four out of 14 office REITs, reflecting our view that a modest deterioration in operating performance could have a larger financial impact.

The likelihood for a medium-term operating disruption, prompted many office REITs to pull back on future investments and build up liquidity. High preleasing (near 70% on average) and high prefunding levels (approximately 45%) mitigate the risks for projects under construction, but longer-term uncertainties have put some new developments that were originally starting in 2020 on hold. We see this as appropriate in light of medium- to long-term supply and demand dynamics, as well as the need for REITs to preserve liquidity and manage leverage. We tend to be more cautious on issuers that plan to execute on their growth initiatives through the recession as we believe there is a heightened chance that those balance sheets will deteriorate over the next 12 months.

Office REITs enjoyed a decade of expansion, supported by multi-year economic growth in the U.S., and focused on improving asset quality gradually. However, in the process, REITs became more comfortable with higher leverage under the assumption that balance sheets would strengthen as EBITDA was accrued. We think the current pandemic and the fallout of the economic recession puts that assumption at risk.

Pandemic-Related Trends Do Not Have An Immediate Impact On Credit Ratings

National lockdowns have accelerated economic digitization and tested productivity and cost efficiencies when working from home or anywhere outside the office. As this test yields positive results, the need for office space at pre-pandemic's magnitude is in question for many corporations. Although we believe fundamentals driving the need for office space remain unchanged, with human interaction needed for collaboration, relationship building, and enhanced company culture, we think real estate footprints could shift over time. That said, we think it's still too early to assess the degree of change. We view this as more of a longer-term risk that could materialize over the next five to 10 years, but we think this trend will likely gain momentum and could affect future demand for office space.

Interestingly, a recent survey of 2,300 workers indicated that only 12% would want to work from home five days a week. This is a very small increase compared with about 10% pre-pandemic. In addition, most workers expect crucial changes to the workplace before they're comfortable returning (Gensler U.S. Work from Home Survey 2020).

Facebook stands out as the first large corporation to announce a more permanent shift to remote working with about half of its workforce granted some work-from-home arrangement over the next 10 years. Other big tech companies have announced indefinite work-from-home directives. Tech companies have been the main growth driver for office REITS over the past several years and account for about 35% of office REITS ABR. Technology companies have embraced remote working more rapidly than other industries and we think employment growth will remain relatively robust. In fact, the Bureau of Labor Statistics expects employment in computer and information technology operations to grow 12% from 2018 to 2028 (with only health care related jobs growing faster), supporting continued demand for office space.

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Conversely, new guidelines for social distancing could drive the reversal of office densification to the levels prior to the financial crisis (about 225 to 250 sq. ft. per employee from 150 to 175 sq. ft. per employee, based on market estimates). Companies across the country are evaluating strategies for returning to the office, with their workforces likely returning in phases to ensure the safety of employees. Corporations are reconfiguring floor plans and workspaces, with the tenants (not the landlords) investing capital to ensure they maintain social distancing guidelines. When looking at the office space per employee prior to the pandemic, about 30% more physical space is required than what is in use today. We believe this would more than offset the potential impact of remote working. However, once a vaccine is widely available and social distancing guidelines are relaxed, we would expect profits to motivate tenants to add density back to their office square footage, albeit perhaps not back to the 150-175 sq. ft. per employee level.

In our view, younger and higher-quality properties with more modern designs are in a better position to face shifts in future demand for office space. We believe these properties will likely require less retrofitting to comply with new social distancing guidelines and additional tenant requirements.

Second-Tier Markets Might Come Back Stronger With Possible Ratings Momentum

Over the longer term, as tenants seek to relocate or expand into lower-density and more spacious locations, where employees also reduce public transportation use, second-tier markets may become attractive at a cheaper price point. We think office REITs with high-quality properties in primarily non-gateway markets, such as Highwoods and Piedmont, could benefit from this trend. Even before COVID-19, Sunbelt markets benefitted from favorable demographic trends, including prospects for job and population growth following changes with the deduction for state and local taxes. However, we still expect some near-term pressure on office operating performance within these markets from the recession and the temporary loss of ancillary revenue sources, such as parking.

Coworking Will Pressure Office Space Demand

Coworking concepts may be the first to feel the pressure on occupancy rates, given the short-term nature of their leases and extremely dense office space (for example, WeWork operates at about 60-sq.-ft. per employee), which is likely to be less attractive because of social distancing guidelines. The rapid growth of flexible space providers drove much of the demand for office real estate over the past few years and accounted for a substantial portion of new supply absorption. Notably, in 2018 WeWork Cos. LLC (CCC+/Watch Neg/--) became the largest private office tenant in New York City, Washington, D.C, and central London. The company came under pressure in late 2019 following the collapse of its IPO and has since initiated a series of restructuring actions geared toward streamlining the business. Subsequent 2020 events, including disruption from COVID-19-fueled downturn, have placed further pressure on the company and its longer-term viability.

We expect companies that provide flexible space will likely curtail growth plans and cut expenses to preserve liquidity as they face the prospects of a sharp reduction in demand and an uncertain recovery. While our rated office companies only have moderate exposure to the flexible office industry, both in terms of tenants (less than 5% of rental income, including WeWork) and as direct providers (less than 3% of rental income), the lack of expected demand from coworking concepts will likely result in much slower absorption of new inventory and weaker rent prospects. We think this trend will be most apparent in key gateway markets such as New York City, which is already facing significant new supply pressure.

Liquidity And Debt Maturities

All office REITs under our coverage maintain solid liquidity positions with ample availability under large revolving credit facilities and no significant maturities at least over the next 12 months. Main uses of liquidity over the next several quarters include:

  • Development expenditures (most issuers have announced reduced spending in 2020);
  • Capital expenditures including maintenance, tenant improvements, and leasing commissions, which we think is largely nondeferrable; and
  • Dividend distributions, with no office REITs having yet announced a dividend cut.

For Alexandria, outstanding forward equity sales of $524 million enhanced liquidity. Alexandria is the only office REIT that we rate that trades at a premium to consensus analysts' net asset value (NAV) at about 2% as of June 30, 2020.

Equity issuance across the sector has been muted over the past few years because of unfavorable market valuations that have widened their discounts to consensus NAV. As of June 30, 2020 Office REITs traded at a median discount of -33.5%.

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Table 2

S&P Global Ratings’ Most Recent Outlook Statements On Office REITs
Issuer Rating/Outlook Comment

Alexandria Real Estate Equities Inc.

BBB+/Stable/A-2 The stable outlook on ARE reflects our view that the company will continue to report above-peer-average NOI growth, while improving its key credit metrics from the stabilization of projects under development and through the issuance of equity to fund recent acquisitions. We project S&P Global Ratings'-adjusted debt to EBITDA to decline to the mid-6x area, but we acknowledge that this deleveraging might be delayed into 2022 rather than 2021.

Boston Properties Inc.

A-/Negative/-- We revised the outlook on Boston Properties to negative in October 2019, reflecting our view of the heightened risks of a recession, the company’s significant development exposure and our expectation that adjusted debt to EBITDA will remain around 7x through 2020. As of the first quarter of 2020, debt to EBITDA was 7.1x.

Brandywine Realty Trust Inc.

BBB-/Stable/-- Our outlook on Brandywine is stable. We expect the company's EBITDA growth to remain steady, supported by positive re-leasing spreads and increasing occupancy at existing properties despite some deterioration in same-property NOI growth attributable to the vacancy and redevelopment at 1676 International Drive and the recession. We expect Brandywine will fund development in a predominately leverage-neutral manner, with larger projects involving joint venture partners. We believe the company will operate with adjusted debt to EBITDA in the high-6x to low-7x area over the next two years, with FCC in the low-3x area.

Brookfield Property Partners L.P.

BBB/Negative/-- In April, we revised the outlook on Brookfield Property Partners to negative to reflect our view that the company’s core retail portfolio will likely face significant operating pressure as a result of the COVID-19 pandemic, with significant rent deferrals likely in the current quarter. While we expect the core office portfolio to hold up relatively well, we think there is a good chance that the company's credit protection measures will deteriorate over the coming year, particularly as we don't anticipate asset sales to materialize as previously expected. In addition, we expect the company to successfully refinance upcoming debt maturities and maintain adequate covenant cushion under its bank facilities at its Brookfield Property REIT subsidiary.

Columbia Property Trust Inc.

BBB/Negative/-- In April, we revised our outlook on Columbia Property Trust to negative to reflect our view that leverage will remain elevated through 2020 from muted EBITDA growth as a result of asset sales, delayed EBITDA contribution from developments placed into service, and a modest increase in debt.

Corporate Office Properties Trust

BBB-/Stable/-- We revised the outlook on COPT to stable from positive in April because we believe the economic recession would limit the company’s ability to reduce leverage below 6x, our upside threshold. That said, we acknowledge the company’s superior rent collections in April and May (more than 98% of total billings collected each month), and think the exposure to the U.S. Government is favorable in this environment.

Highwoods Properties Inc.

BBB/Stable/-- The stable outlook reflects our expectation for stable yet decelerating revenue growth, supported by steady operating metrics and additional revenues generated from preleased development completions, despite pressure from the recession and our expectation for occupancy to decline modestly. We also expect the company to fund largely leverage-neutral portfolio growth, such that credit protection measures remain near current levels, with debt to adjusted EBITDA in the mid-5x area.

Hudson Pacific Properties Inc.

BBB-/Stable/-- The outlook on HPP is stable and reflects our expectation that the COVID-19 pandemic will modestly affect the company's portfolio in the short to intermediate term. We believe HPP’s high quality properties catering to tech and media companies will be more resilient through the downturn and rebound relatively quickly. The stable outlook incorporates our expectation for some operating pressure from potential occupancy declines and inability to raise rents, but somewhat offset by rent commencements of projects recently placed into service and a revised development spend through 2021. Under our base case we anticipate adjusted debt to EBITDA will rise to the mid- to high-7x in 2020 with FCC remaining in the mid-3x area.

Kilroy Realty Corp.

BBB/Stable/-- The stable outlook reflects our view that the COVID-19 pandemic will modestly disrupt KRC's operating performance in the short term and that the company will be able to withstand a challenging operating environment, given the cushion it has built. We believe the company's operating performance may be temporarily pressured, but we expect its focused strategy and cautious measures to enhance liquidity will ultimately result in stable credit metrics with adjusted debt to EBITDA around 6x and fixed-charge coverage above 2.5x over the next couple of years.

Mack-Cali Realty Corp.

B+/Negative/-- We lowered our rating on CLI in March and maintained the negative outlook, reflecting our view that Mack-Cali is highly reliant on the execution of planned asset sales to meet debt reduction targets, which we view as uncertain.

Office Properties Income Trust

BBB-/Stable/-- The outlook on OPI is stable. We expect, as part of the company's capital-recycling efforts, OPI will be able to achieve lower leverage through asset sales, with adjusted debt to EBITDA projected in the low- to mid-6x area by year-end 2019. We also expect relatively stable cash flows, given the company's largely investment-grade tenant profile.

Piedmont Office Realty Trust Inc.

BBB/Stable/-- The stable outlook on Piedmont reflects our view that the company will operate with S&P Global Ratings-adjusted debt to EBITDA in the low- to mid-5x area and with FCC above 4x over the next two years. We expect cash flow generation to remain healthy despite the recession, driven by largely sustained occupancy levels and continued rental rate increases despite some deceleration in cash same-property NOI growth from rent abatements in 2020. We also expect Piedmont to prudently finance any potential acquisitions and redevelopment in a leverage-neutral manner.

SL Green Realty Corp.

BBB-/Stable/-- The stable outlook reflects our view that operating performance will likely remain strong, driven by high occupancy and above-average rental rate growth relative to office peers. Moreover, we expect preleasing at One Vanderbilt to remain on track or ahead of schedule and for its construction to be finished in August 2020. Despite these positives, we think the company's aggressive share repurchase activity will continue, albeit more slowly, precluding it from significantly deleveraging over the next two years. We project S&P Global Ratings'-adjusted debt to EBITDA will remain in the high-9x to high-10x area over our forecast period.

Vornado Realty Trust

BBB/Negative/-- In June, we revised the outlook to negative to reflect our view that debt to EBITDA will remain above 9x through 2021. The negative outlook incorporates our expectation for operating disruption that will deteriorate credit metrics, largely because of contracting EBITDA. We estimate S&P Global Ratings' adjusted debt to EBITDA will increase to the mid-9x area in 2020, achieving some recovery in 2021 but remaining above 9x.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Fernanda Hernandez, New York (1) 212-438-1347;
Secondary Contacts:Michael H Souers, New York (1) 212-438-2508;
Samantha L Stevens, New York + 1 (212) 438 1888;
Ana Lai, CFA, New York (1) 212-438-6895;

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