Why an increase in employment is a double-edged sword for REITs

Market Realist

Must-know: Institute for Supply Management surveys—June 2014 (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 Real Estate Investment Trusts (or REITs) like Boston Properties (BXP), Kilroy (KRC), Vornado Realty Trust (VNO), SL Green (SLG), and Highwoods (HIW). 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. The 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’s 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, Vornado reported in its earnings call that the vacancy rate in New York City is quite low, around 3%, while the vacancy rate in Washington, DC, is in the mid or high teens. This is surprising, given that the financial sector had been hit extremely hard since 2009, while government spending has averaged 24% of gross domestic product (or 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—slowly

We’re seeing signs of strength in the employment market. Friday’s payroll reading was a mixed bag — payrolls were strong, but the labor force participation rate remained mired at its lows. This increase in employment will be positive for the office REIT sector, but if the Fed starts increasing rates, their cost of funds will go up.

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