Office REITs and Remote Work: A Good Contrarian Investment?
The COVID-19 pandemic has caused a significant shift in the way people work, leading many to question the future of the office. Remote work has become more prevalent, and office vacancies have reached historic levels. The pandemic has also led to rapidly rising interest rates, which has made office buildings more expensive to own and operate. With these factors in mind, many investors have been wary of investing in office properties. However, the market for office space may not be as dire as it seems.
In this blog post, we will examine the current state of the office market, with a focus on office real estate investment trusts (REITs). We will explore two Canadian office REITs, Allied Properties and Dream Office, and compare them to other more diversified REITs to determine which may hold the best value for investors.
Remote Work
Many investors have been quick to write off office space in the wake of the pandemic. The rise of remote work has led many to believe that offices are no longer necessary and will become a thing of the past. However, this may not be the case. While remote work has undoubtedly changed the way we work and many organizations have reduced their office footprint, it has not eliminated the need for office space entirely. Many companies still require a physical workspace to collaborate and conduct business. Furthermore, some employees may prefer to work in an office environment rather than from home. As such, the death of the office may be exaggerated, and investors may be underestimating the long-term demand for office space.
Interest Rates
Another reason why the value of office properties fell is due to rapidly rising interest rates. Leading into and during the pandemic, interest rates had been at historic lows. But, as consumer price inflation rose following the pandemic and central banks raised rates to counter that inflation, the value of office buildings fell accordingly. Rising interest rates represent a rising cost for office buildings. There have also been some high-profile cases of office landlords defaulting on the mortgages of some buildings. But, has the market over-estimated the impact of rising rates on office building values?
Vacancy Rate
Offices are currently experiencing high vacancy rates. For example, the vacancy rate in Toronto reached the highest level in nearly 30 years at over 15%. The pandemic and the rise of remote work have contributed to the decline in demand for office space. Suburban areas in Toronto are also experiencing higher vacancy rates than downtown, with some companies downsizing their office space while others are still looking for new office locations, particularly in suburban areas with lower rents. Overall, the challenges faced by the Toronto office market and the impact of changing work patterns on demand for office space has contributed to lower rents and lower values for office properties.
Are Offices a Good Investment?
Office buildings are out of favour with investors because of the rise of remote work, rising interest rates, and high vacancy rates. So, is now a good time to invest in office buildings given their low value?
Next, we will examine two Canadian office REITs and compare them to other more diversified REITs to determine which may hold the best value for investors.
Canadian Office REITs
In Canada, we mainly have two pure-play office REITs to consider: Allied Properties REIT and Dream Office REIT.
Allied Properties
Allied Properties is a real estate investment trust (REIT) that focuses on owning and managing primarily urban office environments in Canada’s major cities. The company was founded in 2003 and is headquartered in Toronto. Allied Properties’ portfolio comprises over 200 properties in major Canadian cities such as Toronto, Montreal, and Vancouver, with a total of over 13 million square feet of leasable area. The company is known for developing historically significant “brick and beam” office buildings such as in Toronto’s King West neighbourhood. Allied Properties is committed to sustainability, with a focus on green building practices and energy efficiency. The company is also a member of the Global Real Estate Sustainability Benchmark (GRESB).
Dream Office REIT
Dream Office REIT is a real estate investment trust that focuses on owning, managing and operating office properties across Canada. The company’s portfolio comprises over 140 properties in various cities nationwide. The company owns buildings outside of the downtown core and their offices tend to be in more suburban neighbourhoods. Dream Office REIT is committed to sustainability, with a focus on green building practices, energy efficiency, and reducing its carbon footprint. The company is also a member of the Global Real Estate Sustainability Benchmark (GRESB).
| Market Cap | Distribution Yield | FFO Yield | |
| Allied Properties | $2.89 B | 7.88% | 8.95% |
| Dream Office | $0.65 B | 7.30% | 10.81% |
| H&R REIT | $3.28 B | 4.86% | 9.78% |
| Choice Properties | $4.66 B | 5.28% | 6.78% |
Office REITs Analysis
As we can see from the table above, the two Canadian office REITs have higher distribution yields compared to other large diversified Canadian REITs. This means that investors will receive higher cashflow by investing in office REITs compared to other more diversified REITs. This added yield comes with increased risk. As mentioned earlier in this post, the current sentiment around office properties is bearish. Investors have a negative outlook for office REITs.
A good question for investors is whether this bearish sentiment for office REITs is overdone? Even though vacancy rates are historically high, is this the bottom of that trend? Will more employees go back to offices in the future? Or, will some offices be re-purposed for other uses such as residential? Would such trends reduce the supply of office space and put upward pressure on prices by reducing vacancy rates?
Which Office REIT is the highest quality?
Considering the valuation based on yield is similar for Allied Properties vs Dream Office, which REIT has a higher quality portfolio? Allied Properties holds their land in mostly urban cores, whereas Dream Office has more offices in suburban locations. This would make Allied Properties more sensitive to the potential for hollowing out of urban cores and should make Dream Office the higher yield play. But, if the yields of both these REITs are currently similar, then Allied Properties may offer a better risk profile.
Conclusion
When comparing two Canadian office REITs, Allied Properties and Dream Office, we can see that while both offer attractive yields, Allied Properties may be the better option for investors looking for a more stable risk profile due to its focus on urban office environments.