Investing in Office REITs: A Beginner’s Guide

Office REITs can be a great way to generate steady income and add growth potential to your portfolio without too much downside

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There are real estate investment trusts, or REITs, that invest in just about every type of commercial property and real estate-related asset you can think of. Office buildings have excellent potential for steady income as well as capital appreciation, with relatively low risk compared with other types of commercial real estate.

Although they are a relatively low-risk form of REIT investment, there is still plenty you should know before buying your first office REIT. Here’s an overview of what office REITs are, risks you should know about, and some examples of major office REITs to get you started.

What is an office REIT?

Real estate investment trusts, or REITs, are a special classification of corporation. REITs’ businesses primarily consist of owning, operating, developing, and/or managing real estate assets. According to industry group NAREIT, though, in order to qualify as a REIT, a company needs to meet some pretty specific criteria, including:

  • A REIT must pay out at least 90% of its taxable income as dividends to shareholders. This is the most widely-known REIT qualification.
  • A REIT must invest at least 75% of its assets in real estate or related assets.
  • A REIT must derive at least 75% of its income from real estate or related activities.
  • A REIT must have a minimum of 100 shareholders.
  • No five investors can own more than 50% of the shares of a REIT. Individual REITs often deal with this by restricting the ownership of any single investor to 10%.

In exchange for meeting all of these requirements, REITs enjoy a big tax advantage. Specifically, REITs don’t pay any corporate taxes on their profits, no matter how much money they earn. Because of the requirement that they distribute most of their income, REITs are treated as pass-through businesses.

Most dividend-paying stocks effectively have profits taxed twice -- once at the corporate level, and again on the individual level after they’re paid as dividends to shareholders. Although most REIT dividends don’t get the preferential "qualified dividend" treatment by the IRS, this is still a huge tax advantage.

Most REITs specialize in a certain type of commercial property. As their name implies, office REITs own, manage, and/or develop office buildings. There are office REITs that invest in suburban office parks, REITs that invest in super-luxurious office skyscrapers in urban areas, and everything in between. These office buildings are then leased to tenants seeking office space.

Risks of investing in office REITs

Office REITs are certainly lower-risk than most other types of equity REITs, as we’ll see in this section and the next. Having said that, no stock that’s capable of market-beating returns is without risk, and these are no exception. So, here are some of the key risk factors that office REIT investors should be aware of:

Interest rate risk

No discussion of REIT investing would be complete without mentioning interest rates, which can have a huge influence over REIT stock prices. While there’s a lot more to the story than I can discuss in a paragraph or two, the main principle to know is that rising interest rates are generally a negative catalyst for REITs stock prices. The 10-year Treasury tends to be a good REIT indicator, and as you can see, this risk-free yield and REIT prices move in opposite directions most of the time:

^CRUSREIT Chart

^CRUSREIT data by YCharts

The simplified explanation is that investors are taking on more risk by choosing REITs for their portfolio as opposed to risk-free assets like the 10-year Treasury I just mentioned, so they expect a premium in exchange for the risk. So, if Treasury yields rise, REIT yields generally rise accordingly. Since price and yield have an inverse relationship, this means that in times of rising interest rates, REIT prices generally drop.

Oversupply risk

There’s always some degree of oversupply risk in commercial real estate, especially during times when the economy is strong and borrowing costs are low. For example, if there’s demand for 1 million square feet of office space in a given market, and there is exactly 1 million square feet of inventory, properties should be pretty full, and landlords should have excellent pricing power.

On the other hand, if there is 1 million square feet of demand and, because of new development, supply swells to 1.5 million, there are going to be widespread vacancies. Having said that, oversupply is generally less of an issue in office REITs, as construction costs are relatively high and these properties take quite a long time to build.

Economic risk

Office REITs tend to not be very cyclical investments. Tenants generally sign leases of 5-10 years (and even longer in urban offices), so income is generally predictable for years into the future. And, for many companies, maintaining office space is a necessary expense, so in tough times, there are several expenses that are generally cut before office rent.

Having said that, there is some degree of cyclicality here. Demand for office space, and therefore landlords’ pricing power, is dependent on employment growth and the overall health of the economy. It’s also worth mentioning that the economic sensitivity of any office real estate company depends on the nature of its tenant base. Now, most office REITs have somewhat diverse tenant bases, but an office REIT with tenants that generally operate in cyclical industries tend to be more recession-prone than office REITs whose major tenants operate in recession-resistant businesses.

3 of the largest office REITs

Here’s a quick look at some of the largest publicly traded office REITs in the market to give you a better idea of what these companies really look like.

Company (Stock Symbol) Property Sub-Category Market Capitalization Dividend Yield
Boston Properties (NYSE: BXP) Offices (Class A) $21.3 billion 2.8%
Alexandria Real Estate Equities (NYSE: ARE) Offices (Life science) $16.1 billion 2.7%
SL Green Realty (NYSE: SLG) Offices - New York City $7.4 billion 3.9%

Data source: CNBC, Nareit.

Boston Properties owns a portfolio of 164 Class A (high-end) office properties, as well as a few retail and residential properties, with a concentration in the Boston, Los Angeles, New York, San Francisco, and Washington, DC markets. It is the largest office REIT by market capitalization.

Alexandria Real Estate Equities owns over 230 properties with 22 million square feet of rentable space. The properties are located all over the U.S., but there are large concentrations in the Boston, San Francisco, and San Diego metropolitan areas. The biggest differentiating factor of Alexandria is that it specializes in renting space to life science and technology companies -- Pfizer, Alphabet (Google), and Eli Lilly are among the top tenants.

SL Green Realty owns a portfolio of 103 office properties, with nearly all (96) of them located in Manhattan. In fact, SL Green is the largest single owner of New York City office real estate. SL Green is also a major developer of real estate, with a pipeline that includes the massive One Vanderbilt property that’s currently under construction.

The bottom line on office REITs

Office REITs can be a great way to add income and growth potential to your portfolio without taking on excessive risk. Like any other high-potential investment, there are some risks to be aware of, but office REITs are one of the lower-risk types of real estate investment trusts.

Matthew Frankel, CFP has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
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