Evaluating U.S. Office REITs in a Challenging MarketOctober 23, 2023By Brendan McCarthySenior ESG Research Analyst, Calvert Research and Management and Alysia Rodgers ESG Research Analyst, Calvert Research and ManagementWashington - It's hard to escape the headlines warning that commercial real estate is having a volatile moment in the U.S., and the US office REIT sector reflects this challenging environment. Valuations for US office REITs are currently depressed, as factors such as shifting return to office (RTO) policies, the rising cost of debt service and challenges refinancing maturing debt combine to weigh on performance and fuel investor anxiety.The S&P 1500 Office REITs Sub-Industry Index is down 55% from the end of 2021, when longer term return to office policies began being solidified and interest rates began rising in response to rising inflation.1 These depressed valuations enable Calvert to capitalize on market mispricing by identifying opportunities for long term winners in the US office REIT market.Calvert begins its assessment of office REITs with a fundamental assessment that identifies REITs with elevated risk profile. Among the metrics we consider are overall leverage, mix of floating vs. fixed rate debt, fixed charge coverage, and duration of maturities. We also conduct a market assessment that considers submarket occupancy and absorption trends, as well as portfolio vacancy and lease maturity schedule, and the RTO policies for major tenants. We overlay that information with an environmental, social and governance (ESG) assessment designed to separate office REITs poised for a rebound from those that are at higher risk of long-term shareholder value destruction. When evaluating office REITs on material ESG topics, governance issues generally play a key role.Office REITs have material governance issuesAs REITs manage large pools of real assets, Calvert elevates the importance of corporate governance when assessing their risk profiles. Corporate governance practices are strongly influenced by country of domicile and companies are evaluated in terms of rules (the legal framework within which the company must operate) and practices (observed governance practices based on a common set of beliefs and values in society). With that in mind, Calvert evaluates REITs on key governance issues like ownership structure, board independence, board effectiveness, pay, and shareholder rights. We believe how the organization is managed and how accountable management is to shareholders is essential to minimizing downside risk, an especially material element in the current environment of acute distress in the office sector. Poor governance can result in conditions that provide opportunities for management to take advantage of shareholders. For example, boards that do not meet our threshold for independence or entrenchment may illustrate an elevated risk. Obvious negative governance flags include demonstrated examples of management taking advantage of shareholders, such as related party transactions or excessive executive compensation.In addition, Calvert looks at sustainability characteristics, including sustainability building certifications, across the portfolio.Bottom line: Beyond fundamental risk assessments, Calvert believes our deep insights on governance and environmental performance enhance our ability to identify REITs that can outperform in challenging market environments and act in the best interest of investors.