2023-11-15 22:43:35 ET
Summary
- Boston Properties owns one of the best office portfolios in the country.
- BXP has recently announced a major disposal.
- I discuss the implications and present my price expectations based on interest rate expectations.
Dear readers,
Boston Properties (BXP) is an office REIT that holds A-Class workspace on both coasts with an especially heavy exposure to Boston, New York, and San Francisco. Notably, the REIT owns one of the youngest property portfolios with an average age of 15 years.
I've covered the company before and called BXP one of the best-positioned office REITs out there. In terms of cash flow, my expectation was for any rent increase to be roughly offset by an equal increase in interest expense. Therefore, I expected the entirety of the upside to come from a 7% dividend + multiple expansion when sentiment turns. Sentiment hasn't changed much, as yields remained high and office out of favor. Therefore, the investment has underperformed by about 15% relative to the S&P 500.
Last two weeks have been a good indication of what we can expect when interest rates finally decline. Yields declined by about 20-30 bps following the FOMC meeting and October CPI release and sparked a nice rally in which REITs outperformed.
The goal of this article is go over leasing recorder in Q3 , comment on the recent disposal of a minority interest in one of BXP's prime developments, and to provide investors with a clear understanding of how yields will likely drive BXP's valuation going forward.
Quality matters
BXP owns one of the highest-quality office portfolios. One of the main characteristics of this is a high proportion of A-Class space, which BXP likes to call premier. In particular, 90% of the REIT buildings are considered premier with another 5% currently being redeveloped to meet the high standard.
This is important because quality space has proven that it can retain tenants at a significantly higher rate. The rhetoric has been that the amount of space needed overall will likely decline as tenants downsize. But this decline was never expected to be broad-based. Rather, I expected that tenants would consolidate their office space in high-quality buildings and it would primarily be the B-Class and C-Class which would struggle with occupancy.
Recent data provided by a CBRE study confirms this view as A-Class space in BXP's market enjoys a significantly lower vacancy than lower-quality space.
The same is true of net absorption. Since the start of the pandemic, net absorption for premier space has been positive 8 Million sft, while non-premier space has seen negative net absorption of 30 Million sft. That's a big difference and puts BXP's portfolio in a fairly good position to attract and retain tenants.
The REIT records turnstile activity for approximately half of their portfolio and notably things seem to be improving on this front as well. New York City has bounced back to pre-Covid levels and while Boston and San Francisco still lag at 74% and 45% of pre-Covid turnstile activity, they're seeing improvements.
Capital recycling matters
Management has stated on the earnings call that they intend to play offense in this market, just as they did following the global financial crisis. In order to prepare, the REIT has raised $4.1 Billion in gross funding over the past year and now holds $2.7 Billion in liquidity. They say that they're in active discussions with lenders that are foreclosing and with property owners looking to decrease their office exposure, but I'd like to see them actually start putting capital to work. Cap rates have already expanded quite a bit and BXP might miss out if they wait longer.
While BXP hasn't done much in terms of acquisitions lately, only acquiring one property for $17 Million in Q3, they recently announced a massive disposal deal .
BXP has agreed to sell a 45% stake in two of their largest life science developments in Cambridge, MA to Norges Bank Investment Management. These are two properties - 290 Binney and 300 Binney.
The first is a 16-story, 570 ths. sft life sciences property currently under construction and 100% pre-leased to AstraZeneca. The second is a 6-story, 240 ths. sft redevelopment which is 100% pre-leased to the Broad Institute. Both of these properties will have long 15-year leases and represent the creme-de-la-creme of BXP's portfolio.
The deal is fairly simple. BXP will receive $213 Million at closing and the two JV partners will share future costs based on their respective ownership shares. BXP will continue to provide development, property management, and leasing services.
To date, BXP has invested about $250 Million into the development of these properties, excluding land. The initial payment will therefore almost entirely refund this amount to the REIT, but after considering land cost, won't result in substantial profit.
I see the deal as somewhat positive for BXP because it will free up cash flow which can be used to pay off some of their debt and/or used for highly accretive acquisitions. On the other hand, the REIT disposed of arguably the best part of their portfolio which will reduce future profits, and didn't really make much profit on the sale. From a broader market perspective, the deal is equally important, because it shows that investors are still willing to buy office space and that life science is the place to be.
Leasing matters
Leasing has been strong. Over the third quarter, the REIT has executed leases for 1.1 Million sft of space with an average lease term of 8.2 years. This was the highest level since Q4 2022. Moreover, rent spreads finally reached positive territory in Q3 at 4% QoQ, fuelled by strong 14% increases in Boston. As a result of strong leasing, occupancy has increased from 88.3% to 88.8% during the quarter.
For the remainder of the year, about 1 Million sft of space will expire, of which 750 ths. sft have already been leased. That only leaves 250 ths. sft of space to re-lease during the last quarter of the year, which should be very achievable considering that BXP claims to currently have almost 1.2 Million sft of space under negotiations. For 2024, management expects flat occupancy from today's levels.
Valuation matters
BXP pays a 6.9% dividend which has been flat for a while and is expected to remain at today's level going forward. The payout ratio is very comfortable here at 53% and if occupancy remains stable I see no reason why the dividend should be threatened.
If you've been following my articles, you may have noticed that I have recently changed the way I look at valuations of REITs. I believe that looking at the spread to 10-year yields is more meaningful than the traditional P/FFO ratio, especially when interest rate expectations change faster than seasons of the year. I don't know where interest rates will be in the future, which is why I include a sensitivity table so that you understand how the investment is likely to perform under a number of scenarios.
My expectation for BXP hasn't changed much. I expect any rent increase to be offset by a roughly equal increase in interest expense and I believe that management will deliver on their flat occupancy target. As a result, we have a relatively stable business from a cash flow perspective. In the meantime, the stock trades at an implied cap rate of 8.2%, which is 370 bps above the 10-year treasury yields. That's a very comfortable spread.
My conservative base case forecast calls for a 4% 10-year yield by the end of 2025 and a slight contraction of the spread from 3.7% to 3.5%. This set of assumptions yields upside of 24% over two years and a price target of about $70 per share. With the addition of a 6.9% dividend yield, investors could earn 15-20% per year if interest rates cooperate at least a bit.
My bear case is higher for longer in which case the 10-year yield would likely remain at today's levels and the spread may not contract at all. With zero upside from price appreciation, the 6.9% dividend would still provide some comfort to income investors. The only way BXP could have a significant downside from here, which would result in a loss of capital over the next two years, is if interest rates and yields climb well above 5%. I don't see that happening, which is why I'm comfortable with my BUY rating here.
For further details see:
Boston Properties Announces A Major Disposal, Upside Remains