2023-06-29 10:34:50 ET
Summary
- The article discusses the potential investment merits of preferred shares in Vornado Realty, a large REIT with a focus on high-quality office and retail properties in New York.
- The company is facing challenges due to COVID-19, increased office construction, and rising interest rates, which have led to a decrease in demand for office space and increased debt expenses.
- Despite these challenges, I remain bullish on Vornado stock due to the fundamental value of the company's high-quality real estate assets.
- I estimate Vornado's real estate assets to be worth $16.4 billion, which should more than cover its $8.1 billion in net debt and $1.2 billion in preferred shares.
- Vornado's preferred shares may offer an attractive risk/reward opportunity with potentially better protection than common shares, but with less capital appreciation upside.
I recently wrote a bullish article on Vornado Realty ( VNO ), and some readers suggested the preferred shares of Vornado may be a better investment vehicle than the common shares. This article takes a look at VNO's preferred shares in detail to consider their investment merits.
Overall, I agree with my readers that Vornado's preferred shares offer good risk/reward currently. Most of VNO's preferred shares are currently yielding between 9.3 - 9.4%, and I especially like the Series L Preferred Shares ( VNO.PL ), as it is past its call date and may be next in line to be redeemed in the next few years if the company can recover.
Company Overview
Briefly for those who have not read my prior article, Vornado is one of the largest real estate investment trusts ("REIT") in the market, with a focus on high-quality office and retail properties in New York. Vornado owns all or a portion of 19.9 million sq ft. of office, 2.6 million sq. ft. of street retail, over 1,600 residential units in 6 properties, and multiple development sites in New York.
In addition, Vornado also has a 32.4% interest in Alexander's, Inc. ( ALX ), a publicly traded REIT that owns 6 properties in New York; BMS, a wholly owned cleaning and security business servicing office buildings for Vornado and third parties, the 3.7 million sq. ft. MART in Chicago, and a 70% controlling interest in 555 California Street in San Francisco. Figure 1 shows Vornado's 2022 Net Operating Income ("NOI") breakdown.
Figure 1 - VNO NOI breakdown (VNO 2022 annual report)
Fundamentals Challenged On All Sides
There are many well documented fundamental challenges facing office owners like Vornado. First, COVID and the subsequent uneven recovery have pushed many office workers to spend less time at the office, reducing demand for office space in central business districts. This has led to soaring office vacancy rates in New York and other once bustling city centers.
At the same time, office construction continues apace, with more than 13 million sq. ft. of office space currently under construction in New York. Furthermore, recent interest rate increases have put strain on the balance sheets of REITs like VNO, with VNO's interest and debt expenses increasing 65% YoY to $86.2 million in Q1/23 compared to Q1/22 (Figure 2).
Figure 2 - VNO's interest expenses have soared (VNO investor presentation)
The combination of weak demand, increasing supply, and rising interest rates have produced a triple threat to Office REIT stock valuations, with Vornado's Price to Book Value ("P/B") declining to all time lows recently (Figure 3).
Bullish Thesis Predicated On Real Estate Value
My bullish thesis on Vornado is predicated on the fundamental value of the company's high quality real estate assets. For example, using conservative capitalization rate ("cap rate") of 7% vs. market Q4/2022 cap rate of 5% for New York offices, I estimate Vornado's real estate assets to be worth $16.4 billion, which should more than cover its $8.1 billion in net debt and $1.2 billion in preferred shares (Figure 4).
Figure 4 - Simplified cap rate valuation of VNO common equity (Author created with data from company reports)
Value In The Preferred Shares
In fact, as rightly pointed out by my astute readers, if Vornado's real estate assets offer a lot of upside for the common shares, then they should benefit the preferred shares as well.
Vornado currently has $1.2 billion in preferred shares outstanding labeled as Series L, M, N, and O, with differences in coupons and call dates.
Figure 5 - VNO preferred shares outstanding (VNO Q1/23 10Q report)
As a reminder, preferred shares are securities that share common characteristics with both bonds and common equity. Within a company's capital structure, Preferred equity ranks above common equity, but below debt (Figure 6). In the event of a bankruptcy, preferred equity has a higher claim to the company's assets than common shareholders, but lower than bondholders.
Figure 6 - Illustrative capital structure (royalbank.com)
As long as Vornado does not default on its mortgage and debt obligations, the preferred shares should be well protected and continue to pay out their generous yields.
For example, the Series L Cumulative Redeemable Preferred Shares ("VNO.PL") pays a 5.40% coupon on $25 face value. However, with VNO.PL trading down to $13.85 recently, it is now yielding 9.4% (Figure 7).
Series L, M, and N preferred shares are all yielding around 9.3 - 9.4%, while the most recently issued Series O preferred shares are yielding 8.9%.
Out of the preferred shares outstanding, I especially like the Series L preferred shares, as it has passed its call date, meaning the company can choose to redeem these shares at any time.
In 2021, Vornado issued $300 million of Series O preferred shares at 4.45% coupon to redeem its Series K preferred shares paying a 5.70% coupon. If a similar event were to occur, investors in the Series L preferred shares could be redeemed at par, which would be an 80% gain on their current price.
Assessing Vornado's Credit Metrics
Every quarter, Vornado provides a convenient presentation to help fixed income investors track its credit metrics and covenants. As of March 31, 2023, Vornado is well within its unsecured notes covenant ratios, with total debt to assets of 50% (vs. <65% threshold), secured debt / total assets of 33% (vs. <50% threshold), interest coverage of 2.24x (vs. >1.5x), and unencumbered assets / unsecured debt of 340% (vs. >150%) (Figure 8).
Figure 8 - VNO unsecured covenants (VNO investor presentation)
The company also has $3.2 billion of liquidity ($1.3 billion of cash plus balances available on revolving credit facilities) versus $307 million of debt maturities before 2025 (Figure 9 and 10).
Figure 9 - VNO has ample liquidity (VNO investor presentation)
Figure 10 - Against relatively few near-term maturities (VNO investor presentation)
Overall, while Vornado's net debt to EBITDA ratio appears high at 8.0x, there are no pressing maturities that will threaten the company's solvency.
Downside Threat From Recession
On the downside, Vornado's large debt load does make it susceptible to a weakening economy. As I alluded to in my prior article, economists are widely expecting a recession to hit the U.S. economy in the coming quarters. This could further dampen demand for offices and retail leases and hit valuations for Vornado's assets.
So what kind of cap rates are the preferred shares pricing in currently? Remember, preferred shares rank ahead of common shareholders in the capital structure.
In a bad economic cycle, Vornado's NOI will likely decline as well. In 2020 and 2021, during the COVID pandemic, Vornado's NOI declined to $1.02 and $1.03 billion respectively (Figure 11).
Figure 11 - VNO's NOI declined in 2020 and 2021 (VNO investor presentation)
If we conservatively model $1.0 billion in recessionary NOI (13% decline from LTM $1.15 billion), then for the preferred shares to be priced at 55-60 cents on the dollar, the common shareholders must be wiped out and preferred shareholders must face $500-600 million in haircuts. This would imply a 'fire-sale' cap rate of ~10% (Figure 12).
Figure 12 - Preferred shares are pricing in a 10% cap rate on recessionary NOI (Author created)
I believe a 10% cap rate on Class A office real estate in a major metropolitan city like New York is possible, but unlikely. According to an old Seeking Alpha article , Manhattan CBD Office cap rates spiked during the 2008/2009 Great Financial Crisis, but only to ~7% (Figure 13).
Figure 13 - Historical New York cap rates (Seeking Alpha)
Investors will have to go back to the 1990s to find cap rates north of 9%. However, the key difference between now and the 1990s is that long-term treasury yields were between 5 - 7% back then, whereas currently, even after the Fed's interest rate increases in the past year, 10Yr treasury yield is still sub-4% (Figure 14).
Conclusion
After reviewing Vornado's assets and credit metrics, I agree with my readers that Vornado's preferred shares offer a compelling investment opportunity at this point. For example, the Series L Preferred Shares currently pay a 5.4% coupon on $25 face value which works out to a 9.4% dividend yield.
In order to justify the preferred shares current valuation of 55-60 cents on the dollar, the cap rate on Vornado's Class A real estate portfolio will have to approach 10% on recessionary NOI and common shareholders will have to be wiped out. While this is possible, I do not believe it is likely.
Out of the four series of preferred shares outstanding, I especially like the Series L preferred shares, VNO.PL, as it may be next in line to be redeemed at par by the company in the coming years. I rate VNO.PL a buy.
For further details see:
Vornado Preferred Shares: Attractive Investment Opportunity Given Real Estate Value