AAT Q2 2023: Office Lease Terms Extend to 9.1 Years as Flight to Quality Drives Portfolio Stability

July 26, 2023 | By EarningsIQ Research

American Assets Trust’s Q2 results highlight a shift toward longer office lease terms and resilient rent growth across asset classes, even as the sector faces ongoing skepticism. Management’s guidance raise and commentary signal confidence in embedded portfolio strength, with renewed focus on quality and tenant retention setting the stage for stable cash flows into 2024.

Summary

• Lease Duration Inflection: Office deals now average 9.1 years, signaling tenant commitment to premium assets.
• Rent Growth Outpaces Headlines: Multifamily and retail segments post double-digit rent spreads in key markets.
• Guidance Confidence Up: Management raises full-year outlook, underlining conviction in portfolio fundamentals.

Business Overview

American Assets Trust (AAT) is a diversified real estate investment trust (REIT) focused on high-quality office, retail, multifamily, and mixed-use properties in select U.S. markets. The company generates revenue primarily from leasing space to tenants across these segments, with a portfolio concentrated in West Coast innovation hubs and tourism-driven locations. AAT’s business model emphasizes irreplaceable locations, tenant quality, and operational excellence to drive long-term cash flow and shareholder value.

Performance Analysis

Q2 results reveal a portfolio outperforming negative real estate sentiment, with strength in both leasing velocity and rental rate growth. Same-store cash NOI (Net Operating Income, a measure of property-level cash profitability) grew 7.7% year over year, driven by robust performance in office (+8.7%), retail (+7.6%), and multifamily (+5.8%) segments. Office outperformance stemmed from lease abatements rolling off and new occupancy at flagship properties, notably the landmark at One Market in San Francisco.

Retail momentum continued, highlighted by a 30% rent spread on a new HomeGoods lease that brought Alamo Quarry to 99% leased. Multifamily in San Diego led with blended rent increases near 10%, and a new master lease with the University of San Diego is expected to deliver $17 million over three years. Liquidity remains strong at $485 million, and leverage is being actively managed toward a 5.5x net debt to EBITDA target.

• Office Leasing Anchors Growth: 13 leases signed in Q2, including a 93,000-square-foot renewal with Autodesk, the largest San Francisco office deal of the quarter.
• Retail Leasing Spreads Narrow: Still positive, but moderated due to timing of escalations on larger renewals.
• Multifamily Rent Upside: San Diego rents now 33% above pre-COVID, with no concessions on renewals.

Overall, the quarter demonstrates AAT’s ability to capture premium rents and maintain high occupancy in its core markets, despite macro uncertainty and sector-wide skepticism.

Executive Commentary

Strategic Positioning

1. Office Portfolio: Flight to Quality and Longer Lease Terms

Tenant demand is consolidating around top-tier assets, as evidenced by the extension of new and renewal lease terms to an average of 9.1 years. This trend, up from five years in previous quarters, reflects both tenant confidence in AAT’s properties and a broader market shift toward quality. The company’s focus on amenities and location near innovation centers is translating into higher utilization rates and longer commitments.

2. Retail: Rent Spreads and Backfill Execution

Retail performance is anchored by proactive backfilling of vacated space at higher rents, such as the HomeGoods lease at Alamo Quarry, which replaced Bed Bath & Beyond at a 30% premium. While leasing spreads moderated due to timing, pipeline activity remains healthy, and management expects to discuss additional renewals in Q3.

3. Multifamily: San Diego Outperformance and University Partnerships

San Diego multifamily remains a standout, with net effective rents up 33% from pre-pandemic levels. The new master lease with University of San Diego adds visibility and stability, while Portland remains softer but still positive on blended rent growth. The company’s approach emphasizes no concessions on renewals and strategic partnerships to maximize occupancy.

4. Capital and Liquidity Discipline

Management continues to prioritize balance sheet strength, maintaining $485 million in liquidity and targeting leverage below 5.5x net debt to EBITDA. No near-term debt maturities reduce refinancing risk, and opportunistic deployment of capital is balanced by a conservative approach to leverage in a volatile market.

5. Sustainability and Stakeholder Engagement

Publication of the 2022 Sustainability Report underscores AAT’s commitment to ESG (Environmental, Social, and Governance) initiatives, supporting long-term asset value and tenant demand in a market increasingly focused on responsible ownership.

Key Considerations

This quarter’s results reinforce AAT’s differentiated positioning within challenged commercial real estate markets, with several key factors shaping the outlook:

Key Considerations:

• Lease Term Extension: The shift to longer average lease terms in office (now 9.1 years) enhances cash flow visibility and reduces rollover risk.
• San Diego Multifamily Strength: Sustained rent growth and university partnerships provide a buffer against regional softness elsewhere.
• Retail Backfill Execution: Ability to re-lease anchor space at significant rent premiums demonstrates asset quality and local market strength.
• Conservative Guidance Approach: Management maintains reserves for office and retail risk, reflecting prudence amid ongoing market volatility.
• Liquidity Buffer: $485 million in liquidity supports flexibility for opportunistic investments, but leverage discipline limits aggressive expansion.

Risks

Sector-wide uncertainty persists, particularly in office, where tenant rightsizing and hybrid work may continue to pressure occupancy despite current rent resilience. Retail exposure to consumer cyclical risks and multifamily softness in Portland present localized headwinds. Guidance incorporates reserves for potential tenant defaults, but any uptick in macro volatility or a delayed recovery in tourism (notably Japanese visitors to Hawaii) could impact results. Management’s conservative approach to forecasting and capital deployment helps mitigate, but not eliminate, these risks.

Forward Outlook

For Q3 and Q4, American Assets Trust guided to:

• FFO per share consistent with the new raised full-year range, reflecting some anticipated reserves and seasonality.
• Continued positive leasing momentum in office and retail, with multifamily occupancy expected to rebound in San Diego by late Q3.

For full-year 2023, management raised guidance to $2.28 to $2.36 FFO per share, with the midpoint up 2% from prior guidance. Management highlighted:

• Potential to outperform the high end of guidance if reserves are not needed and booking trends improve in hospitality.
• Visibility remains limited in hospitality due to short booking windows, and office/retail reserves are maintained for prudence.

Takeaways

American Assets Trust is demonstrating resilience and adaptability, leveraging premium locations and operational discipline to weather sector headwinds.

• Flight to Quality Drives Leasing: Longer lease terms and tenant retention in office underpin future cash flow stability, even as sector sentiment remains cautious.
• Rent Growth in Core Markets: San Diego multifamily and retail backfills at higher rents offset softness in other regions, supporting blended NOI growth.
• Watch for Office Absorption and Hospitality Recovery: Net absorption in office and a potential rebound in Japanese tourism to Hawaii are key variables for upside in coming quarters.

Conclusion

AAT’s Q2 results reinforce its position as a landlord of choice for quality-focused tenants, with extended lease terms, strong rent spreads, and prudent financial management. While risks remain, the company’s operational execution and balance sheet strength provide a solid foundation for navigating ongoing market volatility.

Industry Read-Through

The extension of office lease terms to 9.1 years at AAT is a notable signal for premium asset owners, suggesting that flight to quality is not just rhetoric but translating into real, longer-term commitments. This trend could help stabilize cash flows for landlords with top-tier portfolios, even as broader office demand remains challenged. Retail backfill success at higher rents highlights the bifurcation between strong and weak centers, while multifamily resilience in innovation markets like San Diego underscores the value of demographic and institutional demand levers. For peers, the quarter suggests that operational excellence and location advantage remain critical differentiators in a market still sorting through post-pandemic disruptions.

AAT Real Estate REIT Office Multifamily Retail Leasing Flight to Quality