Businesses across the nation need space in order to get things done. Among the millions of people who work in office buildings, few likely think about who actually owns the space where they spend so much of their lives. Although some businesses own the real estate they use for office space, many more turn to companies that specialize in leasing office buildings.
Many of the companies that build, manage, and maintain office buildings are publicly traded, letting investors buy shares. For the most part, these companies are able to qualify as real estate investment trusts, or REITs, and therefore earn some tax benefits that many other types of companies lack.
Because most office building tenants pay rent every month, buying shares of office REITs can be a smart investment, as you can benefit from both regular payments of income and long-term appreciation in the value of the real estate itself. Later in this article, we'll reveal five of the top office REITs available to investors. But before we get there, below you'll find some key information about real estate investment trusts in general and why they can make smart investments.
Image source: Getty Images.
The basics of real estate investment trusts
A real estate investment trust is a special structure that businesses are allowed to use if they primarily hold real estate interests. Most office REITs own real estate directly, either by buying office buildings or by building their own office buildings on land that they've purchased. Then, the office REIT finds tenants that need office space and charges them rent. This income for the REIT covers its expenses, and anything left over is profit for investors.
In order to qualify as a real estate investment trust, a company has to meet certain restrictions. A REIT must invest at least 75% of its total assets in real estate of various types. It also must get at least 75% of its gross income either in the form of rental income from real property, or from mortgage interest or real estate sales. Therefore, you have two potential types of REITs: equity REITs, which own real estate directly and charge tenants rent, and mortgage REITs, which invest in securities backed by the mortgages that real estate buyers use to finance their purchases.
REITs are also required to have minimum numbers of investors. To qualify as a REIT, corporations must have no fewer than 100 shareholders. Moreover, a REIT can't be too concentrated in the hands of a select group of investors, as no five individual shareholders can have more than a 50% stake in the REIT. As with most businesses, REITs must be managed by a board of directors or trustees.
For shareholders, the biggest benefit of REITs is that they're required to pay out the bulk of their income to their shareholders. The minimum threshold is 90% of taxable income -- if shareholders don't get at least that much in dividends, then it could jeopardize the company's REIT status.
New REITs get capital from investors who are interested in the investment objective that the particular REIT chooses. Then, they look at gathering a portfolio of real estate properties that are consistent with that objective. Some REITs focus on acquisitions, while others build their own properties. Like any other business, REITs then make strategic moves to stay ahead of competitors, take advantage of high-demand niches, and squeeze the most income possible from their real estate portfolios.
The main reason companies want to be REITs
There are a lot of requirements to be a REIT, but there's a good reason companies are willing to jump through all those hoops: REITs don't have to pay corporate tax. By contrast, non-REITs that are formed as corporations have to pay corporate-level taxes on their net income, and only then can they pay dividends to shareholders, that then get taxed a second time in many cases.
Here's how it works: If a business qualifies as a REIT, it has to pass through all of its income and deductions to its individual shareholders. It's then the responsibility of the shareholder to pay any tax that might be due. That's still good news for investors, though, because the fact that the REIT avoided corporate-level tax means that there's more money left over for the REIT to distribute in the form of dividends.
The main reason investors like REITs
Investors like REITs primarily because the REIT structure guarantees that investors will receive almost all of the income that the business generates. With non-REITs, a shareholder won't necessarily receive any dividend -- it's all up to the company. The 90% requirement for paying out net income makes REITs cash cows for income investors, and as long as the REIT keeps making money, shareholders can count on receiving payouts.
Moreover, the corporate tax exemption that REITs have often lets them pay much higher dividend yields than what you'll find with other types of businesses. It's not unusual to see yields of 3% to 5% among real estate investment trusts, and some REITs sport even larger yields. With the broader stock market averaging about a 2% yield, REITs can whet income investors' appetites quite a bit.
Why investing in office buildings is a smart play for REITs
There are many different types of REITs that focus on various niches in the real estate market. Yet office REITs offer some advantages that other types of REITs don't always share.
First, office buildings tend to have relatively little turnover. The companies that rent space in office buildings typically expect to need the space for the long run, as it houses key operations that are essential for the overall business. That stands in stark contrast to niches like mall and retail REITs, where turnover can be fierce and conditions are especially turbulent right now. Tenant stability leads to more predictable flows of income for REITs and their shareholders.
In addition, office REITs tend to have positive correlations to the health of the economy. When economic conditions make it easier for existing businesses to grow and new businesses to form, demand for office space rises. That, in turn, helps to support the prices of the real estate these REITs own, as well as helping to justify raising the rents they collect. The combination of income and growth leads to attractive total returns for office REITs.
Every office REIT investor should understand these business metrics
REITs aren't the same as most types of businesses. In order to pick top REITs, you have to understand the metrics by which most investors judge them and how to compare different players in the industry.
For instance, rather than focusing on net income, most REITs use funds from operations as their primary measure of profitability. The reason is that real estate depreciation shows up in net income, but because depreciation isn't a cash charge, its impact on a REIT's success isn't as substantial as net income would imply. Typically, REITs further adjust funds from operations, or FFO for short, to remove the one-time impact of property sales and focus entirely on ongoing operations.
Occupancy rate is also a key metric for office REITs. Obviously, the more space an office REIT has rented, the greater its income will be. Occupancy rates are usually stated as a percentage of total available square footage in the REIT's portfolio of buildings. For office REITs that construct their own buildings, shareholders have to expect a ramp-up period. However, if the buildings don't fill up, it's an indication of bad strategic planning in the original construction decision.
REIT investors should also understand net asset value, which is the total current market value of a REIT's portfolio of real estate holdings minus the REIT's outstanding debt. Leverage is measured through the debt-to-equity ratio, with higher numbers reflecting greater reliance on borrowing to raise capital.
Last, REIT investors use dividend yield as a measure of income-producing potential. Calculated by taking the total annual distributions and dividing them by the share price, dividend yields show how REITs compare in terms of generating income.
5 top office REITs
Below are five of the most promising top office REITs for investors to consider.
Current Dividend Yield
Boston Properties (NYSE: BXP)
SL Green Realty (NYSE: SLG)
Hudson Pacific Properties (NYSE: HPP)
Highwoods Properties (NYSE: HIW)
Mack-Cali Realty (NYSE: CLI)
Data source: Yahoo! Finance.
These REITs all focus on office buildings, but they're far from identical. Investors can look at their differences to find exactly the type of office REIT they think has the most potential for growth.
Boston Properties is one of the largest owners, managers, and developers of office properties in the U.S. The company has its most significant presence in five markets -- Boston, Los Angeles, New York, San Francisco, and Washington, D.C. Founded in 1970, Boston Properties currently has more than 165 office properties in its portfolio encompassing about 50 million square feet, and it also has a handful of real estate holdings in other categories. The company prides itself on developing premium projects in central business districts, but it owns a variety of suburban office centers as well. It also can build office properties to prospective tenants' specifications.
Currently, Boston Properties sees plenty of opportunities in the industry. It actively looks at chances to develop new projects while selling off existing assets selectively in order to reuse capital. The REIT embraces leverage, but it's not reliant on it and maintains healthy balance sheet standards. Boston Properties aims to pre-lease most of its space before buildings are complete. Its pre-leasing levels have reached roughly 85% recently, which help support occupancy rates in the low 90%s.
Dividends play a vital role for Boston Properties investors. The company has boosted its dividend regularly, including a near doubling since 2011. Its most recent boost came during the summer of 2018, with an almost 20% boost taking the quarterly payout to $0.95 per share and giving the stock its current 3.4% yield. Boston Properties, offering exposure to key growing metropolitan areas, is a premier pick in the office REIT space.
SL Green Realty
SL Green Realty is also a major office REIT, but its business model is very different from those of Boston Properties and most of its other REIT peers. SL Green looks almost exclusively at properties in the New York City metropolitan area, with a primary focus on acquiring, managing, and maximizing the value of commercial properties in Manhattan. The REIT has interests in more than 100 Manhattan office buildings, with 46.4 million square feet of space. The majority of SL Green's positions are fully owned buildings. In addition, the company has interests securing debt and preferred equity investments, which let the REIT tap into the income that building owners generate from rent through the stock dividends the owners pay the REIT. SL Green also has interests in 15 suburban buildings covering 2.3 million square feet in Brooklyn, as well as in outlying areas like Westchester County and southwestern Connecticut.
SL Green's results have been impressive lately. Occupancy rates in Manhattan have approached 96%, and rental rates on leases have been steadily climbing. Those trends, which have led funds from operations to climb dramatically, look durable.
With a 4.3% dividend yield, SL Green is generous with shareholders. Current payouts amount to $0.85 per share quarterly -- that's up considerably from just $0.10 per share back in 2011. Many investors expect that SL Green will give investors another boost within the next few months, further enhancing the REIT's income proposition to shareholders.
Hudson Pacific Properties
As its name suggests, Hudson Pacific Properties focuses on real estate markets on the West Coast. The company has built out an impressive portfolio spanning not only Southern and Northern California but also key areas of the Pacific Northwest, mostly in the Seattle area. The REIT boasts more than 17 million square feet of office and studio properties, and its anchor tenants include many of the biggest technology companies in the world.
Hudson Pacific has benefited from the rise in the tech sector, but it has also made some strategic moves to sell off noncore assets in order to concentrate on its core strengths. That contributed to slight drops in revenue and funds from operations in the third quarter of 2018 compared to year-earlier levels, but tight markets have led to rising occupancy and rental growth.
Hudson Pacific's 3.5% dividend yield is solid, and its $0.25-per-share quarterly payout has doubled since 2014. As long as conditions in Silicon Valley, Los Angeles, and Seattle remain strong, Hudson Pacific is well-positioned to benefit.
Highwoods Properties is smaller than some of its peers on this list, but it has a broader scope that covers much of the Southern U.S. region. Headquartered in Raleigh, North Carolina, Highwoods looks primarily at the best business districts in key metropolitan areas like Atlanta, Tampa, Orlando, and Pittsburgh, as well as the somewhat smaller markets of Nashville, Memphis, Raleigh, and Richmond, as well as Greensboro, North Carolina.
Highwoods concentrates most of its attention on development, and its pipeline of real estate projects is impressive. The REIT sports 10 projects in its current pipeline covering 2 million square feet in five different markets, and it's already pre-leased 95% of the space it intends to build. The company has a well-diversified tenant base in areas like professional services, healthcare, and finance, and many of its tenants are among the best-known companies in their fields.
Highwoods has a higher yield than many of its peers, currently at 4.8%. Increases have been more modest over time, however, as the REIT has tended to have more use for internal capital than some of its competitors. Even so, investors got a 5% boost to the payout at the beginning of 2018, and many hope for further increases in the future.
Finally, Mack-Cali is a regional REIT that invests primarily in the Northeastern part of the U.S. market. The New Jersey-based real estate company has 15.2 million square feet of office space, with an office lease occupancy rate of 84%. The company also has some multifamily properties in its portfolio.
One key area for Mack-Cali lately has been the Waterfront district of Jersey City. The REIT said in its most recent quarter that it had made considerable progress in leasing major chunks of space in its portfolio offerings there, including two leases with major financial players in the Harborside 2 project and another with a high-profile tech company nearby.
A 4.1% yield gives dividend investors a lot of confidence in Mack-Cali as an income investment. Yet some will point to much higher quarterly payouts in the past as a sign that Mack-Cali hasn't yet rebounded fully from the pain that the New York metro area suffered during the financial crisis. Nevertheless, for now, shareholders are getting a healthy yield to compensate for any risks in Mack-Cali's key markets.
What risks do office REITs have?
Like any investment, there's always the chance that things won't work out perfectly for a real estate investment trust.
The biggest risk facing office REITs right now is that interest rates are on the rise. That makes it more expensive to finance real estate, and makes it more crucial for REITs to manage their portfolios effectively in order to make the most of their opportunities. Even when REITs are successful, their share prices can fall as investors demand higher yields for a given risk level.
Office REITs are also vulnerable to shifts in local economic conditions. That's a big concern for geographically focused REITs such as SL Green, as a slowdown in the New York City area could have a much bigger impact on its Manhattan-centric portfolio than it would for a REIT with national coverage.
Finally, favorable conditions create a threat that real estate developers will do more deals than the market can bear. In many markets, expansion is difficult due to regulatory constraints, making overdevelopment concerns less important. However, in markets where there are few restrictions on building, investors have to keep an eye on development to make sure that demand for space keeps up with construction.
Take a look at office REITs
Real estate investment trusts offer an attractive combination of growth and income, and REITs that focus on office buildings are in a good spot right now. With these five office REIT selections, you have choices among a set of healthy yet differentiated investments that you can use to match up with your particular preferences and needs.
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