REIT Office Sector Still Struggling

The outlook for office REITs in the near term remains concerning, according to Michael Knott, managing director with Green Street Advisors.

In a video interview with REIT.com in New York at REITWeek 2012: NAREIT's Investor Forum, Knott offered his analysis of fundamentals in the sector. He noted that while the sector has seen "average" growth in net operating income (NOI), capital expenditure requirements have been above average and cap rates have been below average.

"To us, that's an unappealing mix," Knott said. Knott did point out that he's more bullish on markets with high barriers to entry, as opposed to "more plain vanilla" suburban markets.

"For long-term investors, we feel like the high-barrier markets tend to be better," he said. "We feel like the long-run rent growth on an after capex basis has been much stronger, and that has helped deliver strong returns. We feel like that will continue to be the case in the future."

One factor working in favor of the high-barrier markets in central business districts is the difficulty faced by developers in bringing new supply online. That provides greater protection for building owners and creates a longer economic life for existing buildings.

The current state of fundamental measures in the office sector is "weak," according to Knott.

"The forecast really hasn't been that robust to begin with, and recent weakness in job growth numbers raises a little bit of a cautionary flag," Knott said. He did note that demand for space has seen slight growth, and cash flows held up well during the economic downturn thanks to long-term leases. That led to better NOI growth during the downturn than other sectors, but it has started to lag.

He said the expectations for office fundamentals going forward would be a process of slow improvement. He said Green Street expects NOI growth in the office sector won't start to exceed the average for other property types until 2015.

"It will feel like a slow recovery until then," Knott said.