2023-11-12 07:00:00 ET
Summary
- Boston Properties shares have lost over 30% of their value in the past year, reflecting the poor performance of the office REIT sector.
- Higher interest rates have negatively impacted real estate valuations and reduced the appeal of dividend stocks.
- The future of work and remote work may continue to put pressure on the office sector, making Boston Properties shares unattractive.
Shares of Boston Properties ( BXP ) have been a poor performer over the past year, losing over 30% of their value, sharing in losses seen across much of the office REIT sector. Higher interest rates have weighed on real estate valuations in general while reducing the appeal of dividend stocks. At the same time, the office sector faces some secular pressures from the future of work and how much remote work eats into office demand over the long-run. I view shares as unattractive.
In the company’s third quarter , Boston Properties generated $1.86 in funds from operations (FFO), beating consensus by $0.02 as revenue rose by 4.3%. Full-year FFO is now expected to be $7.25-$7.27, down about 3.6% from last year. This represents a tightening from the previous $7.24-$7.29 guidance, pointing to a modest further deterioration in Q4.
Thanks to completed projects becoming revenue generative and fewer post-COVID concessions, revenue rose by $34 million from last year, and operating costs rose by $34 million ($17 million from depreciation). While depreciation is a non-cash expense, I would be cautious about entirely ignoring it, as buildings do suffer wear-and-tear and do need refurbishment work to remain attractive for future leases. Still, there was a $17 million increase in cash margins.
However, this has not translated to FFO growth because BXP has been hit hard by higher interest rates. Interest expense rose from $112 million last year to $148 million, more than double the cash margin increase. This year over year increase in interest expense was about a $0.23 quarterly headwind.
I would also note that interest expense is accelerating through this year. At $148 million, this was a $10 million increase from the H1 run rate. For the year, interest expense will be about a $140 million headwind. This has come from the company having to roll over maturities and issue debt at much higher yields than in the past. While the pace of interest expense increase will slow, it will continue to be a headwind next year. Indeed, according to management on the quarterly earnings call, 2024 earnings will likely decline in 2024 due to higher interest expense and lower cash balances (reducing interest income), likely a ~$60 million headwind.
The company has a $700 million maturity at 3.916% in February 2024. Boston Properties pre-funded this in October through a floating rate mortgage, which it is borrowing at SOFR (secured overnight funding rate, a rate closely correlated to the Fed funds rate) plus 2.25%. This results in an over 7% financing cost. Moreover, it has a $1.2 billion floating rate term loan, which it turned into a fixed rate obligation via swaps thru May 2024 at 4.64%. Come next May, that will reset to floating or have to be swapped again, likely north of 5%.
BXP has a fairly levered balance sheet with debt to EBITDA of 7.3x. So while higher interest rates are weighing on property valuations, they are also reducing the cash flow the business generates as BXP pays more on its debt load. Now, most of the pain has occurred already, assuming the Fed is largely complete its interest rate hiking cycle. As noted, the 2024 impact will be about 40% of the 2023 impact. In further years, this should diminish further. Still, before even looking at the business, BXP starts with a ~$0.35-0.40 hit to FFO next year from higher interest expense.
Ultimately, I think it will be difficult for the business to grow enough to offset this drag; indeed, I worry whether the business will be able to grow at all, given pressure on leasing office space. BXP is concentrated in central business districts. Unsurprisingly, given its name, its largest market is Boston at 37%, followed by 26% New York and 19% in San Francisco. Boston Properties does have a diverse set of customers, though technology is its largest exposure.
Within this customer mix, life sciences is the sector I feel most optimistic about as that is work that largely cannot be done at home. In general, financial and legal firms have also had stricter return to work efforts than elsewhere. Technology firms have in general been more flexible, though many are pushing for a hybrid, not remote, set-up. I do not view everyone working remotely as the base case, nor is that necessary to worry about office REITs.
A fundamental outstanding question is what does office demand look like for firms with a hybrid (i.e. 3 days in, 2 days out) model. They likely will require more than 60% of their current office space but less than 100%. This is likely to result in an ongoing decline in occupancy. We are seeing this with its leased rate down by 1.1% percent so far this year, with declines across all of its markets.
Now, the more optimistic take is that we are seeing BXP stabilize the situation because its executed leased have risen since the start of the year, as you can see below. However, I would note that this metric is also tied to how many leases expire during the quarter. Fewer expirations create fewer new leasing opportunities, and there were over 1 million square feet of lease expirations last quarter. Net of dispositions, vacancy declined by 30k square feet. This is still a decent result, pointing to stabilization, but not quite the acceleration seen by looking at gross figures. The company still has 5.5 million square feet vacant.
The other challenge will be that the decline in lease revenue and occupancy is more likely to be a prolonged, slow decline, than a sudden collapse. This is because office leases are long-term with BXP having an average 7.5 years of remaining life on its leases. As you see, over the next few years, it tends to have about 6% of leases come due. So even if it can only renew leases at 80-90% of current occupancies, occupancy would fall by 0.5-1% per year.
One area of concern I have is that in 4+ years, the rates it earns on its existing leases are substantially higher than current levels. As such, new leases may come in at lower rates. Even if a financial firm is staying fully in the office, if there is more vacancy and lower prevailing rates, you can be certain they will seek to negotiate lower terms in their renewal. This will pressure cash flow, even at a steady utilization rate.
Unfortunately, maintaining buildings come with significant fixed cost that are hard to reduce in tandem with lower occupancy. If we assume a ~1% per year decline in utilization and a 5% lower lease rate on renewals, that is about a $50 million headwind. Even assuming half of these can be offset by lower expenses, likely an ambitious goal, that is a further $0.18 a year headwind. Given the increasing rental price trajectory, I fear the impact will become worse past 2025. Essentially, a 1% occupancy hit becomes a 2.5-3% FFO hit.
Now, BXP has over 1.7x coverage of its $3.92 dividend, in part because it has not raised its dividend in four years. I expect FFO to fall below $7 next year, still providing ample coverage. Still, this declining FFO outlook, combined with its large debt load, are why the company is running at such high coverage. It also has 18 million square feet in its $2.5 billion development program, and with its current cost of capital, how accretive these projects will be is very uncertain.
BXP to me is a melting ice cube business. Because it has such a large dividend cushion today, the business can decline for five years without putting meaningful pressure on its payout. However, I do not see sustained dividend growth, meaning investors can collect their 7.5% yield for some time but should not expect increased income. Beyond this, I struggle with BXP trading with a $8.2 billion market cap vs an $8 billion book value. Right now, the company has a carrying value of $19.9 billion on its real estate, including $6.7 billion of accumulated depreciation.
Between higher rates and lower occupancy, I struggle to view its office property as having appreciated beyond its carrying cost. Indeed other office REITs like Kilroy ( KRC ) trade below book value, reflecting lower office valuations. The company did take an impairment on some properties this quarter, and I would not expect this to be the last one. Even with a stable dividend for several years, I think investors should seek some protection from impairments. Even a 5% decline its property values would reduce book value by about 12% or about $45/share.
Boston Properties is facing headwinds from higher rates and lower office demand. Yes, it pays a sizable dividend, but with companies in different sectors, like Hess Midstream ( HESM ) paying comparable yields and growing their payout, I view BXP as a name to be sold and rotated out of. I look for shares to migrate to $45 and believe investors can find better opportunity elsewhere.
For further details see:
Boston Properties: Higher Rates And Lower Occupancy Are Significant Headwinds