Peakstone Realty Trust - PKST

An office REIT not getting credit for material industrial exposure

Peakstone (PKST 0.00%↑) is a REIT with a ~500M market cap. It has a long history as a private REIT but only came public — via a direct listing — about a year ago. Peakstone is predominantly an office REIT (~70% of rent), so you may wonder why they would choose to come public in the current, challenged environment. I believe the decision was partly driven by a hope that public trading would improve access to debt markets, but also because many owners wanted liquidity to exit a distressed sector. I think we may be seeing the impact of that selling in the price today.

Before diving into the details and valuation of PKST (I believe it is worth in the mid-$20s vs a current price of around ~$13) let me sketch out some thoughts on the office sector generally. At the moment, there is too large a supply of office buildings due to the rise of remote work. While I am a believer in the value of in-office work for many of the oft-cited reasons (impromptu conversations, better focus, greater and easier collaboration, better for junior team members etc.), and while I therefore believe there will always be a place for in-office work, I readily acknowledge that a significant amount of office capacity in the developed world is no longer needed.

A sudden shift lower in demand for office combined with a relatively fixed stock of supply has had the expected effect. Vacancy has steadily climbed, rents have dropped and leasing concessions are up. The medium-term nature of lease terms has meant that this is a slow-moving disaster for office owners rather than a rapid collapse/stabilization.

At the moment, vacancy is still ticking up, but I believe we will turn the corner sharply in the next few years. Why? Because there is now abundant evidence that new office supply is no longer being created and that existing supply is being destroyed. Here is new office construction starts:

At current valuations and in the current office rental climate, new office construction doesn’t make sense economically.

While there are many data series tracking office construction starts, a simple chart illustrating supply destruction at a headline level is difficult to find, so here we must rely on the extensive anecdotal evidence. Office-to-resi conversions are perhaps the most talked about form of supply destruction. SL Green is, of course, biased, but they estimate 20-35% of NYC class B/C office is viable for conversion to residential, and they have begun some of their own conversion projects:

Away from city-centres, it is often easier to just bulldoze low-rise office and build more economical structures on top. Low-quality suburban office has started trading on price/acre rather than price/sf in many cases. There are many examples I can point to of suburban office actually being converted to industrial (e.g. here, here and here). And here is Brandywine, a predominantly Philadelphia-based office REIT, talking about some of their conversion projects:

So we have almost no new office supply coming on-line and significant amounts of the existing office stock being converted to other uses. On the demand side, we have population growth and still some back-to-office mandates trickling through as companies realize the challenges of remote work. Eventually supply and demand will meet and vacancy/rents will normalize, though timing on this is difficult to forecast with any precision. My personal suspicion is that we will have turned the corner in a big way by the end of 2026.

Before turning back to the valuation of PKST specifically (in my view the best vehicle for playing this turn), lets talk about some of the factors an office-REIT investor would consider when evaluating REIT portfolios in the current climate.

1. WALT (weighted average lease term) - In my view this is absolutely the most important factor in office valuation. A dumpy office building that is vacant or has a <2yr lease will be valued for its land/conversion potential (can be as little as $10/sf but often more like ~$40-50/sf). That same building, should it have a 20yr lease to an IG-rated tenant, essentially has no distress at all and will be valued at a 7-8% cap rate. Even a 10yr lease allows a building to skip over the current office crisis. Perhaps even a 5yr lease is sufficient. Clearly a longer average WALT and, in particular, a low concentration of leases <2-3yrs is very important.

2. Asset quality - This is an important factor, no doubt, but I believe one that has become over-emphasized in the market. Yes, ultimately in a rationale market it will be the worst 20% of office buildings that get converted/razed and the best 20% of buildings should be full, but rent pressure is still strong on the top bucket as lower quality buildings will first drop their rents before resigning themselves to demolition. This puts cascading pressure on higher quality buckets to cut rents to remain competitive. Nevertheless, it is clear that assets in the best quintile should see a lower percentage decline in rent than the bottom half.

3. Location - There are several cross-currents here that go into a good location. First is population growth of office workers. There is a trend of migration out of high-cost California/Northeast/Mid-West cities into sunbelt cities. A market that sees population growth of 2% a year will see supply/demand for office normalize quicker than one shrinking 2% a year. The second factor is the types of industries which dominate the area. As one example, the banking/finance industry has trended towards less remote-only work than the tech industry, meaning tech-focused cities like SF/Austin have lagged what you would expect based solely on population-trends. Finally, within a given metro area, suburban vs urban location is important. Generally, urban high-rise is better than suburban low-rise as the former tends to attract companies with knowledge workers that typically reap a larger benefit from in-office work. Think front-office vs middle/back office. All these factors go into the best/worst markets for office. Currently the areas of office showing the most green-shoots are sunbelt markets and NYC city-centre.

4. “Office+” - Some buildings that fall under the “office” umbrella have unique aspects that make them less vulnerable to remote work. For instance, life-science combo office/lab space such as that owned by $ARE. You can’t do lab work from home. Other types of hybrid space include office/r&d facilities, office/data centers and office/call centers. Like office/lab, office/r&d is hard to virtualize and hence is seeing very different supply/demand dynamics vs generic office. Same thing with office/data center (although this is a bit vulnerable to the secular rise of cloud). In my view office/call center may be even worse than generic office given the work can be done from home and the industry is likely to lose employees to AI.

Now, lets turn back to the valuation of PKST. I’m going to make the case that PKST is significantly cheap to the rest of the sector at current valuations (i.e. no need for the entire sector to be cheap). The headline here is that PKST seems to be getting the same valuation as the lowest quality office REITs despite possessing superior characteristics in their office portfolio as well as an industrial portfolio contributing over 30% of EBITDA.

PKST organizes itself into four divisions: industrial, office, “other” and JV. Tackling each of these:

JV: The JV is easy to value at $0. The debt in that segment seems higher than the value of the buildings involved, yet PKST is not required to make any further capital contributions so we can safely pencil in a zero.

Other Segment: This category includes assets encumbered by the pooled “AIG” and “AIGII” mortgages loans as well as a few unencumbered assets that have problematic features like short-WALTs or high vacancy. PKST’s intention is to liquidate and/or hand-back-the-keys on these assets, so I value this segment as a liquidation and adjust EV accordingly. I value the assets backing the AIG/AIGII loans at the value of the mortgages (although almost certainly there will be some as the properties cashflow positively for a while before default is required). The remaining properties in the “other” segment I value at ~$36M. Here is a summary of these properties:

I use ~$40/sf for the two vacant/near-vacant properties (estimate of conversion value) and $100/sf for the first property, which is higher quality and commands a $20 rent per square foot (2.7yr WALT). I think these valuations are conservative, particularly on the first line item.

Office Segment: This segment includes office properties cherry picked by PKST for superior attributes (less attractive assets were either dumped into the JV or the “other” segment). The properties in this segment sport a 7.6yr WALT, which crucially includes only 5% of rent expiring through the end of 2026 (this is by far the best near-term expiry composition among the public office REITs). Every property in this segment either has a WALT > 4yrs, is in an attractive sunbelt market, or falls into the office+ category. Here is a comp sheet for office:

There is a lot going on that is unique to each REIT so we are just looking for a general sense here. I am focusing on EV/EBITDA whereas I suspect the market focuses more on P/FFO. I think EV/EBITDA is a better metric as these RETIs have significant amounts of below market debt that distort FFO temporarily higher. Obviously having below-market debt is valuable but I think its easier to start with EV/EBITDA and add back this value then work the other way around. A few general themes are that the market is willing to assign a higher price to city center REITs (PKST is not one of these). NYC city center is particularly highly valued (and the market is more willing to ignore heavy near-term lease expiry there). Sunbelt is valued relatively well within the smaller, more suburban REITs. Smaller REITs get lower multiples than larger ones. Given PKST’s standing as a small diversified REIT, though one with over 50% sunbelt exposure in the office segment, little west coast exposure and only 5% of ABR expiring through 2026, I think an 11x EV/EBITDA multiple is conservative for the office segment.

Industrial Segment: Industrial is the polar opposite of office: its currently enjoying popularity among investors thanks to the strength of secular trends like ecommerce and on-shoring. Industrial properties require less capex for improvements than other sectors and always have a chance to be sold at very attractive cap rates should a higher/better use for the land come along as cities sprawl outward. The giant in the industrial space is Prologis which I will use as the primary comp for PKST’s industrial portfolio. Prologis currently trades at an EV/EBITDA of 21x. I will use 20x for PKST. It’s difficult to use a multiple lower than this given the multiples on the more expensive end of the office segment and given how divergent the fundamentals are across the two asset classes. Here is a slide from PKST’s investor deck highlighting some of the latent value in industrial rent:

Now we put everything together to arrive at a target price for PKST: