San Francisco is turning into a ghost town.

According to recent news reports, nearly a third of the downtown office space is available for lease or sublease.

That’s 18.4 million square feet – nearly 320 football fields – of space that isn’t being used.

The same story is playing out in major cities across America.

And it could be getting worse. According to a recent Knight Frank survey, nearly half of the world’s largest companies plan to reduce the amount of office space they use over the next few years.

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In the aftermath of the pandemic, previously packed office towers have emptied out.

And with the rise of work from home, office properties have sold off and are incredibly cheap as in 50% below their normal value. Many office Real Estate Investment Trusts (REITs) are trading with double digit yields.

But before you reach for these attractive yields, you should be aware of the risks. Several office REITs have already cut or suspended their dividends.

Today, I’ll show the growing divide in the office sector. Some office REITs are doomed to struggle. Others will thrive as America looks for better places to work.

The Growing Divide in the Office Sector
Office occupancy has been cut in half.

According to Kastle Systems, average office occupancy is now hovering around 50%. And it’s been stuck at that level for many months.

While that’s an improvement over the 20% rate seen during the lockdowns, it’s still not healthy enough to keep many properties afloat.

As higher interest rates push us closer to a recession, office leasing rates have fallen for three consecutive quarters, returning to 2021 levels according to data from Jones Lang LaSalle.

In a recent report, Jones Lang LaSalle revealed that more than 300 million square feet of office space has gone vacant since the pandemic started.

If 18.4 million square feet represent about 320 football fields, 300 million square feet represent just under 5,218 abandon football fields worth of office space across the U.S.

That’s a big problem for landlords who are relying on rental income to pay back loans.

But there is a bright spot…

Offices built after 2015 have seen a net increase of 100 million square feet of leased office space. And the asking rental rates for these Class A office properties is near all-time highs.

Class A offices are typically newer, more energy efficient buildings built within the last decade with many amenities and located in prominent areas.

There is clearly a growing divide and a flight to quality as tenants reduce their real estate needs and seek out more modern spaces for the smaller number of workers who need to be in the office.

Though the office sector may face more challenges as the economy continues slowing down, there will be opportunities to invest in quality properties at a deep discount.

Three Office REITs Set to Thrive
The average age of buildings owned by office REITs is around 34 years.

Many of those could struggle to retain tenants as their leases expire.

But here are three names with newer, more modern portfolios that we like:

  • Boston Properties (BXP) – Owns properties located in gateway markets along the East and West coasts, concentrated in cities like Boston, Los Angeles, New York, San Francisco, Seattle, and Washington D.C. The average age of its portfolio is 15 years and its properties are 88.6% occupied. BXP yields 7.2%. And its shares are currently trading at 11.3x Adjusted Funds from Operations (AFFO). That’s 60% below its normal valuation of 28x AFFO.
  • Highwoods Properties (HIW) – Owns offices in Sunbelt states, in cities like Raleigh, Nashville, Atlanta, Tampa, Charlotte, and Dallas. The average age of its buildings is 20 years and its portfolio is 91.1% occupied. HIW yields 8.9%. And its shares are currently trading at 8.9x AFFO, 55% below its normal valuation of 19x AFFO.
  • Kilroy Realty (KRC) – Owns a portfolio of offices concentrated on the West Coast, in San Diego, Los Angeles, San Francisco, and Seattle. The average age of its offices is 11 years and they are 91.6% occupied. KRC yields 7.2%. And its shares are currently trading at 8.9x AFFO, nearly 70% below its normal valuation of 28x AFFO.

There will be winners and losers as America reevaluates how much office space it needs. If you’re interested in investing in the sector, stick to the quality names with portfolios of modern properties that will attract more tenants and command higher rents.

Happy SWAN (sleep well at night) investing,

Brad Thomas
Editor, Intelligent Income Daily

Source: Wide Moat Research