The Office Recovery Continues

By Aaron Levitt | April 15, 2011 AAA

Real estate was one of the hardest hit sectors during the financial crisis. However, as the U.S. economy continues to show signs of improvement, the overall sector has rebounded quite nicely over the last year. Some companies in the sector have seen tremendous gains as the credit markets have thawed. While low consumer spending and confidence rates are hurting the retail sector and funds like iShares FTSE NAREIT Retail Index (NYSE:RTL), the trend of a steadily improving job market has led to increased business confidence. Headcounts are beginning to rise and that's directly benefiting one real estate subsector.

TUTORIALS: Economic Indicators

Filling Those Cubicles
The office sub-sector of commercial real estate is seeing its sun shine again as the U.S. job market progresses. Signaling that the sector may be beginning its recovery, office vacancies in the U.S. dropped for the first time in more than three years as rents climbed. According to industry research firm Reis Inc, national vacancy rates fell to 17.5% in the first quarter down from 17.6% in the previous three months. In addition, its report found that average effective rents, which include benefits such as free rent and interior work, rose 0.5% to $22.20 a square foot during the first quarter. This is still below the 2008 highs, when effective rents average $25 a square foot. A report from CB Richard Ellis Group (NYSE:CBG) echoed similar results. Office buildings gained a net 4.7 million square feet of occupied space during the first quarter.

Both the critical office markets in New York and Washington D.C. are seeing stellar results. Overall, New York has recovered about 43% of the 140,000 jobs it lost in the recession. This compares with about 17% regained nationally. Financial-service companies within the city have added nearly 12,000 jobs. Vacancies in the Big Apple sit at just 10.7% and the expensive Midtown market is still seeing higher rental rates. In addition, the city is being buoyed by cash flush corporations looking to add a presence. Tech giant Google (Nasdaq:GOOG) recently purchased a building in the city for $1.9 billion in December. Washington vacancies sit at just 9.2% and the district is benefiting a wave of law firms and lobbying groups moving into the beltway.

Even with some cities like Detroit posting 26% vacancy rates, analysts are still bullish on the office sectors prospects. Many are forecasting modest rent increases for the national market throughout 2011. Markets such as Pittsburgh, Dallas and Houston, which are heavily tied to the energy and materials sector, should see pricing premiums and rent gains. The overall office sector should continue to do well throughout 2012, as the job market will be healthy enough to demand increase countrywide.

Playing the Bullish News
The commercial real estate sector and funds like the iShares Dow Jones US Real Estate (NYSE:IYR) have risen quite nicely over the last year as, by and large, the outlook has improved. With the jobs numbers and vacancies declining, the office sub-sector should continue to outperform the broad REIT indexes. The iShares FTSE NAREIT Industrial/Office Index (NYSE:FIO) tracks 31 different office based REITS. However, given the ETF's 25% weighting to industrial properties it's not a pure animal. Investors may be better off in some of the individual names in the space. Here are a few picks.

Using its size as an advantage, Boston Properties (NYSE:BXP) has continued to focus on a select few high-rent, high barrier-to-entry geographic markets including New York and Washington. Shares of BXP yield 2.10% and should be supported by the REITs position in strong markets. Similarly, investors can use SL Green (NYSE:SLG) as a play on New York.

For investors looking for higher dividend yields smaller office REITs Piedmont Office Realty Trust (NYSE:PDM) and Liberty Property Trust (NYSE:LRY) offer yields of 6.6% and 5.7%, respectively. In addition, focusing on high quality government tenants, Government Properties Income Trust (NYSE:GOV) offers a 6.3% yield.

Bottom Line
As the economy continues to improve, so does the commercial office space. The one-two punch of falling vacancies and rising rents signal that the sub-sector is in a recovery. Investors looking to the real estate sector may want to focus on the leadership in the office REITs. Firms like Hudson Pacific Properties, (NYSE:HPP) make excellent additions. (Looking for an income security that rivals small-cap stocks? It may be time to learn about real estate investment trusts. Check out What Are REITs.)

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