There have been a lot of headlines over the past two years suggesting that offices are dying. They surmise that with remote and hybrid work taking center stage, companies won't need as much office space in the future. This negativity has weighed on real estate investment trusts (REITs) focused on office buildings.
However, given the money institutional investors like private equity funds are pouring into the office space, it's clear that the office isn't dead. Last week, we saw another sign of life as investment firm Monarch Alternative Capital offered to buy office REIT Paramount Group (PGRE -1.49%) for $2.6 billion. Here's a look at what Monarch sees in Paramount Group and why private capital continues to pour into the office sector.
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Bidding big for an office REIT
Monarch Alternative Capital made a nonbinding proposal to acquire Paramount Group for $12 per share in cash. That valued the office REIT at $2.6 billion, a roughly 30% premium to its closing price before unveiling its offer.
Monarch is already one of Paramount's largest investors. Its clients hold about 5.5% of the REIT's outstanding shares, making it the sixth-largest investor. It made the offer based on its belief that Paramount owns a portfolio of high-quality properties that remain significantly undervalued by the public market. Even with the premium, shares of the office REIT are still about 20% below their peak value right before the pandemic hit in early 2020.
Paramount Group currently owns stakes in 13 Class A office properties in New York and San Francisco. It has seven properties with 8.6 million square feet (90.4% leased) in New York and six with 4.3 million square feet (91.6% leased) in San Francisco. The REIT manages six additional properties making up 1 million square feet across New York and Washington, D.C. The company owns an office-centric portfolio (96% of its revenue comes from office rent, giving it limited exposure to retail). It also owns some of the newest office buildings in its peer group, which command premium rental rates.
What do institutional investors see in office assets?
Institutional investors like Monarch believe that the market is too pessimistic about the office sector. That is weighing on office valuations, providing them with the opportunity to buy high-quality office buildings at what they believe are fantastic values even if they're paying a huge premium to the market price.
For example, last year, PIMCO acquired office REIT Columbia Properties Trust at a 27% premium to its closing price before the deal's announcement. PIMCO was one of nearly 90 potential bidders participating in Columbia's sales process, which started after receiving an unsolicited bid from a large shareholder. It offered a sizable premium to acquire Columbia based on its belief "that high-quality office buildings in major U.S. cities offer long-term value for our clients." It expects Columbia's portfolio of modern, well-located assets to "perform well in the years ahead."
We've also seen Brookfield Asset Management acquire large urban office portfolios over the past year. It took its real estate affiliate Brookfield Property Partners -- which owns urban offices worldwide -- private in a $6.5 billion deal. It also paid $766 million for a dozen office assets in Washington, D.C. Meanwhile, several private equity funds have acquired office assets in the past year.
Institutional investors like the office sector because these properties generate steady cash flow -- tenants sign long-term leases that produce predictable rental income. Meanwhile, these investors can secure low-cost, long-term debt against that cash flow with interest rates as low as they are these days. That enables these investors to earn a more attractive return than bonds, which appeals to income-seeking clients like pension funds.
Meanwhile, there are continued signs that office demand is picking up. Leading Manhattan office REIT SL Green Realty recently reported strong leasing volumes, hinting that the New York office market is starting to get back on its feet. Meanwhile, Boston Properties' fourth-quarter results suggest that office demand has come roaring back in large coastal gateway cities. That's enabling office landlords to replace expiring leases with new ones to keep their buildings occupied and the rental income flowing.
Offices remain alive and well
Despite all the negativity, demand for office buildings hasn't dried up. Many companies want their employees back in the office at least part of the time, leading them to continue leasing space in high-quality office buildings.
Because of that and the long-term nature of these leases, office buildings remain in high demand from institutional investors. They believe that these properties remain undervalued in the public markets, enabling them to scoop them up at great long-term values. This suggests that office REITs could be an attractive long-term investment opportunity for investors willing to look beyond the sector's current negativity.