Investors are pouncing on beaten-up office real estate investment trusts as though it’s 2019 again, when dividend yields were low and working from home meant you were feeling sick. But the rebound is ignoring a lingering risk: Vacancies remain high.
For sure, the recent gains are impressive and based on some encouraging news.
Allied Properties REIT (AP.UN-T) has rallied nearly 26 per cent since Oct. 25. The REIT’s announcement this week confirming its 2024 distribution plan with a monthly payout of 15 cents per unit, unchanged from 2023, may have supported the view that Allied is weathering the office real estate storm reasonably well.
But other, smaller Canadian REITs are moving higher, too. Dream Office REIT (D.UN-T) also has gained 26 per cent from its low. Among U.S. REITs, Boston Properties Inc. (BXP-N) has gained 26 per cent since Nov. 13.
These rebounds don’t come close to making up for the losses that demoralized many investors over the past two years, though. Rising interest rates raised borrowing costs and hammered property valuations. Attractive yields on bonds offered stiff competition to the distributions from REITs.
Perhaps most worrisome, office vacancy rates have soared, as many tenants gave up space amid entrenched hybrid work. In Canada, the national office vacancy rate in the third quarter increased to 18.2 per cent, a fresh three-decade high and up from 10.4 per cent in early 2020, according to CBRE. Empty spaces mean lost rents.
Allied Properties reported that its funds from operations – or FFO, a measure of cash flow – declined to 59.8 cents per unit in the third quarter, down 1.3 per cent from the same period last year. The REIT’s payout ratio, which compares cash distributions to FFO, rose to 75.1 per cent from 71.6 per cent last year.
Allied Properties is one of the more stable office REITs because of its large size, diverse geographic footprint and appealing properties. Nonetheless, its dividend yield climbed as high as 12 per cent in October after the unit price fell nearly 70 per cent since early 2022.
The high yield likely reflected unease about whether the payout was sustainable over the longer term. At the very least, an increase seemed unlikely.
The REIT’s current rally, along with similar moves by its peers, suggests that these concerns are now subsiding. On Thursday, the yield was 9.7 per cent – but still high enough to appeal to investors who missed out on the recent action.
Should they join the rally?
The good news is that central banks in Canada and the United States have paused rate hikes as inflation heads down toward their target levels. As a result, bond yields have retreated from their recent multiyear highs, returning some gloss to dividends.
In fact, the gains by Allied Properties and its peers line up very nicely with the decline in the yield on the 10-year U.S. Treasury bond. Since Oct. 25, Allied’s low point, the bond yield has fallen from nearly 5 per cent to a three-month low of 4.12 per cent.
If inflation continues to decline and central banks weigh rate cuts next year to stimulate the economy, the rally in office REITs could gain strength, even if interest rates remain considerably higher than they have been in recent years.
That’s because they’re cheap, with high dividend yields and unit prices still well off their highs. According to Mario Saric, an analyst at Bank of Nova Scotia, Allied Properties trades at just 9.1 times its adjusted funds from operations – a popular method for valuing REITs – which is nearly 50 per cent below the historical average.
The risk: While declining bond yields are making dividends look more attractive, the decline isn’t filling seats in offices.
Hybrid work is here to stay, according to a report released this summer by McKinsey & Company. The consultancy found that office attendance, globally, has stabilized at 30 per cent below prepandemic levels.
The report estimated that demand for office space will be 13 per cent lower in 2030 than it was in 2019, under a moderate scenario that considers factors such as population growth, employment trends and automation. Under a severe scenario, demand will be 38 per cent lower by 2030.
Some analysts remain cautious as well. Dean Wilkinson, an analyst at CIBC Capital Markets, reiterated his lukewarm assessment of Allied Properties in his monthly report on Canadian REITs, published this week.
“We continue to believe that Allied has potential long-term unit price appreciation, but are choosing to remain on the sidelines until we have a better vantage point on medium- to long-term office fundamentals,” Mr. Wilkinson said in his report.
Declining bond yields are boosting the appeal of office REITs. But they’re not in the clear yet.
David Berman