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Why 2022 Could Be a Tough Year for Office REITs

By Bram Berkowitz – Jan 5, 2022 at 10:55AM

Key Points

  • The FDIC recently said that "the office sector may face the most significant challenges."
  • Since the pandemic began, U.S. office space vacancies rose in nearly two-thirds of U.S. markets where there is office space and in the 10 largest markets in the country.
  • Many leases are still yet to expire.

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Many people still work remotely, and the demand for office space may never return to what it was.

When the coronavirus pandemic first struck, office spaces were one of the hardest-hit areas of the real estate market, sending many people who could do their jobs remotely home. Now, just a few months shy of the pandemic's second anniversary, many of those workers who went home to work are still home.

While life has gotten more normal and progress has been made toward ending the pandemic, new coronavirus variants have made office returns tricky, and many companies have realized their employees can be just as effective working from home as they are in the office. All of this could lead to another tough year for real estate investment trusts (REITs) that focus heavily on office space.

Numerous chairs and desks sit lined up in an empty office space

Image source: Getty Images.

A new normal for office REITs

Every quarter, the Federal Deposit Insurance Corp. (FDIC) releases its quarterly banking profile, which includes an analysis of different commercial real estate sectors. In the FDIC's third-quarter report released in December, the FDIC specifically says that "the office sector may face the most significant challenges" and that demand for office space may have declined, "possibly for the long run."

Early on in the pandemic, in the second quarter of 2020, the net office absorption rate went negative for the first time in a decade. This means that new office construction space and office vacancies outpaced leased and absorbed office space by tenants. Overall, U.S. office space vacancies rose in nearly two-thirds of U.S. markets where there is office space and in the 10 largest markets in the country since the start of the pandemic.

I do think many more companies will return to the office as the pandemic continues to ease. One reason relates to studies showing worker isolation is leading to mental health issues. Another is that many CEOs of large companies have expressed a desire to get back to the office. However, going back to the way office life was prior to the pandemic (which was already changing) is unlikely. 

The FDIC's report cites a survey from PwC that asked executives about office trends. In the survey, more than two-thirds of respondents said they plan to adopt a hybrid model, where employees work from home part of the time and go into the office a few days a week as well.

This plan gives more flexibility to employees and is also strategic for companies in a tight labor market that may want or need to extend their hiring searches to a national pool of talent. But a hybrid work setup will likely lead to companies requiring less office space because they can set up shared spaces and will probably have fewer employees in the office.

Some of this has likely been priced into office REIT stock prices, considering that some of the largest office REITs in the country trade for much lower than they did prior to the pandemic, as shown on the chart below.

BXP Chart

BXP data by YCharts

But there are still a lot of unknowns. Jonathan Litt of Land & Buildings Investment Management told The Wall Street Journal last month he could see office real estate values dropping by 40% from pre-pandemic values. Part of the reason he sees this drop coming is that he thinks there could be as much as 15% fewer people in offices after the pandemic officially ends.

Many leases from before the pandemic have yet to expire. When they do, there will likely be more vacancies or rents being offered at much cheaper prices.

A very uncertain future

It's a bit early to say that office spaces are done for, but given emerging trends, it seems fairly unlikely that the world will work in offices in the same way they did prior to the beginning of the pandemic. Perhaps these buildings and spaces can be repurposed, but less demand and higher vacancies do not bode well for office REIT profits. Also, the rising interest rate environment expected this year may make the normally very attractive dividends on REITs less appealing when risk-free assets offer higher yields.

Ultimately, there is a tremendous amount of uncertainty in the office building sector, and investors generally do not like uncertainty.

Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool recommends Alexandria Real Estate Equities. The Motley Fool has a disclosure policy.

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