Tradable REITs Investing – Office Buildings

In this blog, I explore investing in tradable (listed on a stock exchange) REITs of the ‘office building’ type. For my investigation, I used the largest (based on market capitalization of $11.85 billion) office building REIT company, Boston Properties Inc. (BXP). There is a great deal of very good investment information available in the annual report and 10K form (included in the annual report). URL for Annual Report and 10K form:
http://ir.bostonproperties.com/phoenix.zhtml?c=120176&p=irol-reports.

Several macro/micro economic and business factors are important in the overall return on investment (share price gain + dividend return) and the pricing of BXP’s major asset i.e. office buildings.

Macro/micro economic factors:

· Employment rate – One of the major economic risk factors for office building REITs is a high unemployment rate. Increasing unemployment will decrease the overall demand for office space which drives down the cost of office space (and decreases the profits of the REIT). This leads to decreased dividend payout by the REIT. BXP dividends decreased from $8.70 (9.48%) in 2007 to $2 (3.44%) in 2009 (the dividend payout has been $.50 per quarter in 2010).

· Deflation/Inflation – One of the best investments for inflation or hyper-inflation is ‘real assets’. Office buildings are ‘real assets’. Inflation or hyper-inflation will drive up the values of office buildings and increase the cost of office space. This will lead to increased share prices and dividend payouts. It has the opposite effect with deflation – lower value of office buildings and lower dividend payout which leads to lower stock prices.

· Economic direction – This is another major economic risk factor for office REITs (as well as other REITs). When the recession started in 2008 it had a major effect on BXP (and other REITs). When two of their ‘quality’ tenants filed for bankruptcy, it became much more difficult to fund expansion and make mortgage balloon payments, which decreased the value of their office buildings, etc. This had the effect of dropping their stock price from a high of $127.04 in April 2007 to a low of $31.73 in February 2009 (it is currently around $80).

Business factors:

· Debt servicing/capital sources – The majority of commercial (office building) mortgages require the borrower to simply make a mortgage payment small enough to pay off the mortgage in 30 years and then make a balloon payment in 7 or 10 years. The owner can either sell or refinance the property when the balloon payment is due. The 10K form shows all mortgage debt by office building and includes the balloon payment date. It also shows the mortgage balloon payments due by year. After reviewing BXP’s mortgage debt most of it is proportionally the same per year over the next 7 years except for 2011when it is double that of 2010. You would not want to see that most of its balloon payments are due in the same year. This could raise the cost of debt financing. BXP has done a very good job of either refinancing or selling property in the last 2 years in a very difficult capital market. The liquidity crisis resulting from the subprime lending crisis could be a major risk to office building REITs. Since REITs must return at least 90% of their earning to shareholders, they cannot finance expansion by retaining earnings – they must borrow money to expand.

· Lease rate and lease expiration date – The 10k form will list the lease rate of the building and lease expiration date by percent per year. For example, 9.1% of the leases will expire in 2010, 8.1% will expire in 2011, etc. When you are researching REITs you do not want to see a large percent of leases expiring in one year or near term. BXP has done a very good managing their lease expiration dates.

· Tenants rating – It’s very important that tenants are of the highest quality. Business bankruptcy has a very negative effect on the earnings of REITs. BXP had two major tenant bankruptcies that terminated their leases, Lehman Brothers and General Motors (it is sometimes hard to identify high quality tenants). This caused two major problems: they lost over one year of rent and in a declining economy they needed to drop the price of office space to be able to lease the buildings. The 10K form will list the major tenants so you can assess whether they are of the highest quality (unlikely to go bankrupt) or have not paid their lease (or need to decrease their payments to stay in business).

· Tenants business sector– It is very important that REITs have tenants that are in diverse business sectors. All tenants should not be in the same business sector, for example, financial services. In the event there is a major decline in financial services, it could have a major effect on the REIT earnings. The tenants’ business sectors are listed in the 10k form. BXP’s largest business sectors are legal services (26%), financial services (24%), and manufacturing/consumer products (10%).

· Regional diversification – BXP are located in the following areas: Boston, Washington D.C., mid Manhattan (New York City), San Francisco and Princeton, New Jersey. It is important that the office buildings are located in more than one geographical area. If all its office buildings were located in one area, it could be disproportionately affected by local economic factors. The 10k form will list every office building by location and square feet of available office space.

· Management – Key to the success of any business is the strength of its management. For REITs it is especially important that management are able to choose optimal office locations (and when to sell the assets), attract high quality tenants, and acquire new sources of funding for building new buildings and re-financing their existing buildings (balloon payments every 7 to 10 years) at low cost. It speaks to the strength of BXP’s highly experienced management team that BPX holds prime office space locations in the US, has high quality of tenants and has been able to raise capital at a reasonable rate (in a very difficult economic environment) for making balloon mortgage payments (to avoid being forced to sell the property) and funding future expansion.

· Earnings – The best measurement for reviewing office building REITs’ earnings is Funds From Operations (FFO). This has become the REIT industry standard for evaluating overall performance of REITs. It excludes the historical depreciation cost from the net income amount. It is also interesting to review the REIT dividend payout ratio as a measure of its sustainability for paying out future dividends. This information is included in the 10K form.

All REITs are particularly sensitive to changes in the economy. When the macro and micro economic factors that are favorable to BXP change, I will invest in BXP. It has offices in all the prime office location areas in the US, a strong management team and probability of a high dividend payout in the future. For now, I will keep BXP as an arrow in my quiver waiting for the right economic environment.

Please chime in with comments about Boston Properties Inc., buying tradable REITs, economic forecast for types of REITs (office building, retail, medical, etc.), REITs to buy or short, etc. Next blog I’ll write about cash management in this difficult economic environment and whether ‘high quality’ dividend paying companies are a good idea for cash investment.

© 2010 Paul Cusick

Paul