2024-01-18 04:39:26 ET
Summary
- Boston Properties stock has performed poorly compared to the S&P 500, down 23% since the first article and down 7.5% including dividends.
- The recent surge in the stock was due to market speculation on a dovish Fed in 2024, but this may not be sustainable.
- The office real estate industry is still struggling with oversupply, making it uncertain if Boston Properties is out of trouble.
Introduction
Working my way through office real estate, I saw that I covered Boston Properties ( BXP ) , one of America's largest office landlords, four times in the past (this article is number five).
I started covering the stock in April of 2020.
My most recent article was written on October 8, when I went with the title "7% Yield And Mounting Risks - A Closer Look At Boston Properties".
Every single one of my articles had a Hold rating, which was essentially based on two reasons:
- I do not believe that office real estate is a great place to be, in general.
- The pandemic has done a number on an industry already struggling with oversupply.
Since my first article, BXP is down 23%. Including dividends, it's down 7.5%. During this period, the S&P 500 has returned 80%!
Since my most recent article, however, the stock has returned 35%, beating the S&P 500 by roughly 25 points.
The most recent surge was caused by the market betting on a very dovish Fed in 2024.
Looking at the overview below, we see that Federal Funds futures have priced in six rate cuts in 2024, with a terminal rate range of 5.25% to 5.50%, which happens to be the current rate.
With this in mind, two things bother me.
- While I believe that the Fed is done hiking, I hate that the market has already priced in so many cuts. It ruins the risk/reward, as it means that a lot of easing is already anticipated. It also means that if inflation continues to be sticky, the market may have to adjust this number to fewer cuts, which could be bearish.
- The office industry remains a hot mess, which I will explain in this article.
Hence, in this article, I'll explain why I do not believe that BXP is out of the woods despite the most recent surge.
Office Real Estate Remains A Mess
In its most recent (3Q23) office report , Colliers noted that the U.S. office market faced unprecedented challenges in the third quarter of 2023, marked by a combination of factors such as softening market fundamentals, a hesitant return to the office, rising interest rates, and a slowing economy.
Negative net absorption persisted, reaching over 70 million square feet for four consecutive quarters, resulting in a record-high vacancy rate of 16.7%.
As bad as this may be, there is some good news.
For example, despite the overall negative trend, some metro markets showed positive signs. Dallas-Fort Worth led in occupancy gains with nearly 500,000 square feet, followed by Detroit, Raleigh-Durham, and South Florida.
However, 12 markets experienced negative absorption exceeding 500,000 square feet, with San Francisco leading in metro market occupancy losses.
These numbers perfectly display the ongoing migration from "blue" to "red" states.
Furthermore, while the vacancy rate surged by 530 basis points since the start of the pandemic, overall asking rents showed minimal impact.
Landlords, in most cases, held firm, and the delivery of more expensive new constructions contributed to this stability. However, effective rents, considering landlord concessions, reflected the softening market conditions.
My "fear" is that if rates remain elevated, we could see a wave of defaults, pressuring market prices and rent growth even further.
What To Make Of Boston Properties?
With a market cap of $11 billion, BXP isn't just one of the biggest REITs on the market (across all segments), but it is also a company that focuses on some of the markets that residents seem to be avoiding.
As its name already gives away, it has major exposure in Boston, where it generates 37% of its net operating income ("NOI"). New York accounts for 26% of NOI. This market had 0% annual compounding rent growth over the past ten years, as we can see in the chart below.
San Francisco, where it owns properties like the Salesforce Tower, accounts for 19% of its NOI.
While none of this sounds appealing to me, there's one major reason to give BXP the benefit of the doubt: the company has some of the strongest tenants in the world.
Among its tenants, it rents to tech and financial giants, including Salesforce ( CRM ), Google/Alphabet ( GOOGL ), Bank of America ( BAC ), and Biogen ( BIIB ), which is a biotech giant.
In general, the company has a focus on newer buildings in good locations, as close to 80% of its buildings are in central business districts.
During its 3Q23 earnings call, the company noted that its core sectors remain the primary contributors to leasing activity, showing a consistent trend in demand.
However, the technology sector, particularly on the West Coast, continues to show reduced demand, with renewing technology clients often downsizing their lease premises, which is a trend that I expect to continue.
Furthermore, what's interesting is that on top of artificial intelligence ("AI") trends on the West Coast, strong demand comes from alternative asset managers, private equity, venture hedge funds, and specialized fund managers.
Expansion and leasing activities with these entities are seen in Manhattan, Boston, Northern Virginia, and San Francisco.
Hence, as of 3Q23, the company has not only met but surpassed its leasing target for 2023, with over 2.7 million square feet leased to date, which is great news in this market.
The company's in-service occupancy increased modestly to 88.8%, taking into account new additions to the portfolio and the termination of WeWork leases.
WeWork leases for 44,000 square feet were terminated in the third quarter, with expectations of additional portfolio vacancy due to WeWork defaults in the fourth quarter and into 2024. The company holds 493,000 square feet of WeWork leases as of October 1, 2023.
Moreover, with regard to new supply, the development portfolio, totaling 2.8 million square feet, is 52% leased.
As we can see below, recent leases signed for assets like 360 Park Avenue South and 651 Gateway were drivers of demand.
The company also has signed leases yet to commence, totaling approximately 750,000 square feet, with around 425,000 square feet anticipated to commence in the fourth quarter of 2023.
On top of having resilient tenants and stable occupancy rates, the company has a strong balance sheet.
Although I believe its net leverage ratio is somewhat elevated at 7.3x, the ratio has been steady in recent years.
The company also has a healthy fixed charge coverage ratio of 2.5x. And roughly 74% unsecured debt. It also has $3.3 billion in available liquidity, $1.5 billion of which consists of cash.
Its investment-grade BBB credit rating reflects its financial stability.
It also has a well-covered dividend.
BXP currently pays $0.98 in quarterly dividends per share. This translates to a yield of 5.6%.
The last time the company hiked its dividend was on December 17, 2019, when it hiked by 3.2%.
While the company is protecting its balance sheet against economic weakness by not hiking its dividend (not even by 1%), the good news is that the chance of a dividend cut is very low.
As we can see in the balance sheet screenshot above, the company has an FAD (funds available for distribution) payout ratio of 81.9%, which means even a severe reduction in its income would not necessarily result in a dividend cut.
So, what about its valuation?
Valuation
During its 3Q23 earnings call, the company noted that going into 2024, it foresees an impact on its overall earnings trajectory due to the persistent high-interest rate environment.
The refinancing of bonds at higher rates is expected to contribute to higher net interest expenses in the coming year.
While detailed earnings guidance for 2024 will be provided in the next quarter's call (January 30), the company acknowledged the challenges posed by the prevailing economic conditions.
As we look ahead into 2024, we have several developments that delivered during 2023 or will deliver in 2024, that will add incremental FFO next year. These include 2100 Pennsylvania Avenue, 651 and 751 Gateway, 140 Kendrick Street, 180 CityPoint and View Boston. However, as I described earlier, we expect our overall earnings trajectory will be negatively impacted by the persistent high interest rate environment that will result in higher net interest expense in 2024. - BXP 3Q23 Earnings Call
Analysts seem to agree with this mixed view.
Using the data in the chart below:
- BXP, which has met expectations 75% of the time over the past two years, is expected to grow adjusted funds from operations ("AFFO") by 1% in 2024, followed by a potential 5% contraction in 2025 and a 12% rebound in 2026.
- BXP currently trades at a blended P/AFFO ratio of 13.4x.
- Going back to 2007, the company has a long-term normalized valuation of 28.8x.
Technically speaking, a return to that valuation would imply a fair stock price of roughly $150, which is more than 100% above its current price.
I do not think this would be a good target, as a 28.8x normalized valuation is not appropriate in an environment of elevated rates, especially not in a real estate industry with significant long-term challenges.
The current consensus price target is $72, which is $2 above the current price. I believe that is fair, which is why I will continue to stick to a Hold rating.
With everything said in this article, I am not trying to scare anyone out of BXP. The company is not bad. It is just operating in a very tough industry.
Furthermore, it also does not help that a company like Realty Income ( O ) is currently yielding 5.2% (just 40 basis points below BXP). Meaning I do not have to take risks in a volatile industry like the office industry when I can buy a conservative income gem like Realty Income with what I consider to be a much better risk/reward.
Also, bear in mind that between 1Q07 and 1Q20 (before the pandemic hit), BXP returned just 4% per year, including its dividend!
All things considered, BXP is a good office stock, just not a good long-term play in this market.
Needless to say, please feel free to disagree with me in the comment section of this article. I look forward to hearing different opinions.
Takeaway
In my fifth article covering Boston Properties, I maintain a Hold rating due to the challenges in the office real estate sector.
Despite BXP's recent 35% surge, the broader industry faces unprecedented challenges, including record-high vacancy rates.
While some metro markets show positive signs, the overall scenario remains uncertain.
BXP, with exposure to Boston and New York, boasts strong tenants but grapples with technology sector downsizing.
However, it has resilient occupancy rates, a robust balance sheet, and a well-covered dividend, minimizing the risk of a cut.
As a result, the mixed analyst view and a fair price target of $72 led me to retain a cautious stance on BXP in the challenging office industry.
For further details see:
Office Mayhem: Why 6%-Yielding Boston Properties Remains A Hard Pass For Me