Meta Platforms' (META -12.22%) recent earnings grabbed a lot of headlines (many negative), and hidden in the disastrous quarter were a few details that should also sound the alarm bells for the office real estate sector, including real estate investment trusts (REITs) like SL Green (SLG -4.39%), Vornado (VNO -2.76%), and Kilroy Realty (KRC -2.58%).
The Facebook parent said it took a $413 million impairment charge in the quarter to reduce its office footprint. The company expects to take a $2 billion charge next year for the same reason, trimming its office expenses to align the company with its operating needs.
Put simply, the tech giant is paying more than $2.4 billion to break leases for offices it no longer needs. That's a significant statement about the state of the office in the current era. Meta is likely paying that much to save billions more in the long run.
Management did not elaborate on the decision, but it's worth noting that this company is still growing rapidly as a company even though its revenue just declined. Its headcount increased 28% to 87,000 over the last year, but the company is downsizing its office space because it doesn't need it anymore, and it's not a good use of its cash.
CEO Mark Zuckerberg said in 2020, "Over time, location will hopefully be less of a factor in how many people work, and we'll have the technology to feel truly present no matter where we are." Such technology is exactly what Meta is working on with its Reality Labs division, which is focused on building out its version of the metaverse.
Among the properties Meta is abandoning are two in Manhattan, including 300,000 square foot expansion in a Vornado building in Manhattan. Amazon also walked away from 360,000 square feet in a nearby Brookfield-owned property.
What all this means for the office REITs
Prior to the pandemic, big tech companies seemed to be the most eager tenants in office real estate, with Google, Facebook, and others making splashy expansions in New York and other high-profile markets.
However, the rise of remote work, the widespread adoption of videoconferencing tools like Zoom Video Communications and digital asset management platforms like Google Drive, the threat of a recession, and the cost of office space in major cities all brought about an abrupt shift in the office real estate market.
The tax structure of office REITs requires they pay at least 90% of their profits out to shareholders (usually as dividends). Thanks to the current macroeconomic environment, many of these REITs' stock prices are down sharply since before the pandemic and have continued to fall over the last year.
What's telling about the chart above is that all three of these office REITs are lower than they were in the market crash when the pandemic first started. That suggests prospects have gotten even worse for the sector.
Despite the sell-off since the pandemic, business operations mostly remained solid for these companies. For example, SL Green, which is Manhattan's biggest office landlord, saw its occupancy rate tick up slightly from 92% in the second quarter to 92.1% in the third quarter, and per-share funds from operations were down slightly from $1.78 in the quarter a year ago to $1.66.
Vornado, meanwhile, saw a slight increase in its New York office net operating income in the third quarter, while Kilroy Realty reported a 90.8% occupancy rate in its third quarter, and funds from operations jumped 20%.
Because all three stocks declined significantly but their businesses are still solidly profitable, they are all top dividend payers. SL Green and Vornado offer dividend yields in the 9% range, while Kilroy pays a 5% yield.
Why it could get worse
Office real estate is always vulnerable to a recession, and that's especially true this time around. With interest rates rising fast and the economy threatening to sink into a downturn, office landlords are even more likely to see an exodus as occupancy rates typically fall in a recession.
Rising interest rates also make real estate, including office buildings, worth less as prospective buyers have to pay higher mortgage rates.
The other challenge facing the office REITs is more structural. Technology will continue to improve, making working in the office even less necessary. Even if Meta fails in its ambitions to build out the metaverse, other companies are working on augmented reality tools and other technologies that will make working remotely even easier. Meanwhile, office landlords have little in the way of innovation to counteract this trend.
Newer buildings will outperform the older office properties, but prices in the sector are likely to come down, and occupancy rates will go up as they already have, especially as more leases come up for renewal.
As more companies like Meta rethink their office footprint, share prices for office REITs are likely to fall even further.
