What are Office REITs?
Office REITs are REITs that build, manage, and maintain office buildings, and they lease the offices to companies that need space to accommodate their employees. While there are companies that own the buildings where they operate from, most companies turn to office REITs that specialize in leasing office space in central business districts and suburban areas.
The office buildings can range from skyscrapers to office parks, and the REITs focus on leasing to specific classes of tenants such as multinational corporations, NGOs, technology firms, banks, law firms, fintech companies, biotech firms, government agencies, etc. Office REITs trade their shares on the public exchange markets, and investors can buy REIT shares.
- Office REITs are real estate companies that own and manage office buildings, which they lease to companies and individuals.
- They focus on leasing office space to specific types of clients, such as law firms, banks, government agencies, etc.
- Office REITs specialize in leasing office space in central business districts and suburban areas, where demand for office space is high.
Understanding Office REITs
A real estate investment trust (REIT) is a company that owns and manages income-producing properties, and they generate a steady income stream for investors. Most REITs trade on the public exchange markets, allowing investors to buy shares and become shareholders in the company.
Office REITs focus on acquiring and building office buildings that they rent out to tenants, and the tenants pay monthly, quarterly, or annual rent. The rent payable is calculated per square feet of office space. The rental income is used to cover the expense of running the business, and the net revenue is distributed as dividends to shareholders.
Investors interested in investing in office REITs contribute funds to the REIT, and the management team chooses the portfolios to invest in, based on the investors’ and company’s objectives. New companies must consist of at least 100 shareholders in order to qualify as REITs and qualify for tax benefits that are offered to REITs.
Also, the ownership should not be concentrated in the hands of a few investors. The law requires that no five individual shareholders can hold more than 50% of the shares in a REIT. When choosing the areas to invest in, REITs consider a portfolio of real estate properties that are consistent with their objectives, either by building their own or by acquiring income-generating office buildings.
Benefits from Investing in Office REITs
1. Tax benefits
Although REITs are required to pass through many legal requirements, they enjoy certain tax benefits that other corporates do not enjoy. First, REITs are not required to pay corporate taxes, as long as they meet certain requirements. such as paying most of the net revenues as dividends to their shareholders.
Non-REIT companies are required to pay corporate taxes and other taxes first before they can distribute revenues as dividends to the shareholders. The REIT income is only taxed at the shareholder level after the distribution of the dividends. Shareholders are required to declare and pay any taxes due to the tax authority.
2. Guaranteed dividends
The REIT tax exemption means that more money is left for distribution to shareholders, compared to if the revenues were taxed first before paying dividends. REITs are required to distribute 90% of their revenues to shareholders. It guarantees shareholders that, as long as the company keeps making money, they will keep on receiving dividend payouts.
Office buildings tend to demonstrate a relatively low turnover since most companies rent office space that they expect to use in the long term. It assures continued business for REITs focused on office buildings.
When evaluating office REITs to invest in, investors should consider the following metrics:
1. Occupancy rate
The occupancy rate of an office building is an important metric that investors use to get an indication of the expected cash flows from office buildings. The occupancy rate is the percentage of the square foot available in the portfolio of office buildings owned by the office REIT.
Office buildings with low occupancy rates often generate low returns since the company needs to meet the maintenance costs, as well as pay property taxes. Buildings with a low occupancy are valued less compared to buildings with a high occupancy. Investors are more interested in office REITs with higher occupancy rates since it translates to higher incomes for them.
2. Funds from operations
When assessing the profitability of most companies, analysts focus on the net income and earnings per share released by the company. However, the metrics may not be appropriate for office REITs because they do not show accurate revenues generated by the investment trusts.
For example, net income includes the depreciation cost, which is not a cash charge, and therefore, not a substantial cost. A better metric for evaluating real estate companies is Funds From Operations (FFO). FFO starts with the net income, then adds back the depreciation and impairment charges, and then makes an adjustment to remove one-time impacts such as the gain/loss on the sale of properties and other adjustments. The net value of the FFO shows the incomes from a REIT’s ongoing operations.
3. Dividend yield
REIT investors use the past dividend yields of an office REIT to determine its potential to generate income. Investors can compare the dividend yields of several office REITs to determine their income-generating potential and make a decision on the REIT to invest in. The dividend yield is obtained by taking the annual dividend disbursements and dividing them by the price of the company’s shares.
CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: