Office Still a Tale of Two Markets

For maybe a year, the characterization of office markets as a bifurcation between top properties and older ones has been a given. S&P Global Market Intelligence reconfirmed the theory based on an analysis of 2024 Q1 numbers.

The sector continues to get more attention for deteriorating conditions. However, that is an average view that distorts reality, with Class-A and trophy offices on one side and Class-B and Class-C on the other. As GlobeSt.com has previously reported, the upper end of office markets tend to be in much better shape, with lower vacancies and higher rents. The lower end is where the pain exists.

According to S&P Global, the gap between the two markets has only increased over time. The most noteworthy sign is that tenants consider the state of a landlord’s balance sheet and willingness to invest capital in building improvements. The former exhibits worry that a landlord is a going concern, which is also an important consideration for lenders. The latter is a statement of wanting a “good” office property to remain so.

Concern over the gap is evident in office REITs. The report notes that they continue to “trade at vast discounts” compared to consensus net asset values. At the end of 2023, the REITs traded at a 28.1% median discount to NAV. By July 2024, the median discount had grown to 29.4%.

The median implied capitalization rate across the office REIT sector was a 20-year high of              11.6% in the last quarter of 2023. It dropped to 10.7% in the first quarter of 2024. However, it still sits higher than most of the period between 2000 and 2023.

REIT balance sheets have remained strong, as S&P Global says, which compared median net debt to the recurring last-12-months EBITDA. In the first quarter of 2024, it was 6.6 times at the end of the quarter. The median fixed-charge coverage ratio was 2.9 times. Cash and cash equivalents for the sector as a whole were $7.73 billion at the end of March 2024. That was down about 8.9% from the end of 2023 but up more than 10% from the end of 2019.

Some office REITs are sifting through their property lists to consider which ones might lend themselves to residential conversion. SL Green plans to take advantage of New York City tax exemptions for residential conversions, with first applying to 750 Third Avenue. From the office view, conversions take excess stock off the office market that “should also remove (a) portion of office supply from the market and help funnel existing tenants into other remaining buildings.”