Office REITs Can Deliver Near-Term Value By Rethinking NAV

M&A deals have emerged as the best path for office REITs to deliver near-value to shareholders as NAVs are likely to remain below pre-pandemic levels for the foreseeable future – but to spark that activity, NAV expectations need to be temporarily reset, according to a new analysis from BTIG Research.

Office REIT values were already discounted even prior to the pandemic, and it now costs landlords more than ever to maintain cash flow. BTIG predicts trends in FFO-to-AFFO erosion mean discounts will continue, especially as tenants transition from a period of short term renewals to longer-term commitments with higher leasing costs.  And while the firm doesn’t “tend to see REIT M&A activity occur below consensus NAV,” it argues that a new view of NAV discounts is warranted in the current climate.

The BTIG research points to three key headwinds preventing office REITs from trading at or above NAV in M&A deals: cash flow erosion uncertainty, the cost of such deals, and better investment options elsewhere in the CRE sector.

“Office remains an active sector for investments sales, but most buyers are either private equity funds focused on sub-$1 billion transactions (primarily Core+ strategies with some value-add), or institutional investors focused on asset quality, tenant credit, and weighted average lease term (primarily Core investments),” BTIG’s Thomas Catherwood and John Nickodemus said. “Office REITs fall into the category of being too large for many private equity buyers and too high-touch (and capital intensive) for many institutional buyers.”

The pair note that while Blackstone was one of the largest buyers of office assets during the last cycle, the firm “has generally shied away from similar investments” as of late. 

And “for office REIT M&A activity to accelerate, either cash flow trends have to improve (i.e., lower tenant improvement costs, shorter free rent periods, less maintenance/defensive capex spend… all of which we view as unlikely), or projected growth rates have to slow in other real estate sectors, which could make office a more attractive investment option on a relative basis (possible, but again unlikely),” they say. “Outside of these scenarios, however, the only way for office M&A trends to reverse is for management teams to accept that their likely best-case scenario is to achieve an NAV discount in-line with pre-pandemic levels.”

And because achieving full NAV is unlikely in the near term, the pair advocate for management teams viewing take-out offers in the 15% to 20% discount range as the best way to deliver near-term value.  

“There is a lot of uncertainty about how the office is going to look, what we’re doing from the office, what we’re doing from home, and what that does for overall office space,” Calvin Schnure, a senior economist from Nareit, told GlobeSt in an earlier interview. “But the penalty investors have placed on shares of office REITs is pretty extreme given the performance of the sector. The overall real estate sector in 2020, if you looked in March last year, fell. But the S&P came back pretty quickly. REITs involved in digital communications came back right away. But the rest had a lag in recovery. The stock performance of the office REITs suggest that investors are worried about a far worse outcome than seems likely.”