Economic strength can have positive and negative effects on REITs

Market Realist

Key takeaways for April's Institute for Supply Management release (Part 4 of 4)

(Continued from Part 3)

Office REITs are driven in part by the strength of the economy

The strength of the services economy in particular is an important driver of the office REITs like Boston Properties (BXP), Kilroy (KRC), Vornado Realty Trust (VNO), SL Green (SLG), and Highwoods (HIW) in that it increases demand (and prices for office space) and lowers vacancy rates.

Of course, vacancy rates are determined not only by demand, but also by the supply of office space. Since the real estate bust, we’ve had a dearth of new construction, which has a limited office space supply. (This same effect has been observed in the homebuilding space, where a half a decade of dismal housing starts has decreased supply.)

Pay attention to the industry focus on geography

Since the bursting of the real estate bubble, we’ve had an almost bifurcation in the office REIT space, with technology jobs increasing and financial jobs decreasing. Interestingly, Vorndado reported in its earnings call that the vacancy rate in New York City is quite low (around 3%), while the vacancy rate in Washington, D.C. is in the mid/high teens. This is surprising given that the financial sector had been hit extremely hard since 2009, while government spending has averaged 24% of GDP since then — the highest level since the Truman administration. It makes sense for analysts to focus on a REIT’s geographic exposure in the same way it makes sense to pay attention to a homebuilder’s geographic exposure.

Employment growth is coming back, albeit slowly

We are seeing signs of strength in the employment market. Friday’s payroll reading was a mixed bag — payrolls were strong, but the drop in unemployment was due to a decrease in the labor force participation rate. This increase in employment will be positive for the office REIT sector, however if the Fed starts increasing rates, their cost of funds will go up.

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