2023-05-25 02:38:50 ET
Summary
- Office REITs like VNO have been experiencing pain on multiple fronts, with the work-from-home push and interest rate hikes continuing to eat into cash flow generation.
- Since the VNO common stock has declined approximately 60% in the last year, further analysis is warranted to see if this decline is exaggerated.
- Considering declines in AFFO and the recent dividend cut, the selloff makes sense, and the common stock does not appear to provide great risk/reward at this time.
- Conservative investors may prefer the more well-covered preferred shares selling below 50% of par value.
Executive Thesis
Contrarian investors may be interested in investing in the stocks of beaten down office REITs that have been harmed by both rising interest rates and the work from home push following the pandemic. A prime example of this would be Vornado Realty Trust ( VNO ) a REIT consisting primarily of office properties in NYC, with a smaller amount of NYC retail and Chicago and San Francisco locations. Many investors have been harping on the valuable assets being sold for pennies on the dollar with the common stock trading at multidecade lows. I don't necessarily disagree with this in the long run, but I believe the near-term selloff has been warranted considering the steep decline in cash generation. Management has also played into the undervalued narrative, suggesting cutting the dividend will help them initiate a stock buyback program at great prices. I wanted to take a closer look to help investors understand what has been going on with the business, and if the recent selloff is warranted.
What Happened to the Properties Since 2019?
Of course, the most bearish of arguments is that office work and retail stores are dying, work from home will accelerate, and this combined with rising interest rates will do permanent harm to office REITs like VNO. Is this the case? Partially, but I think the truth, as usual, is a little more moderate.
First, looking at occupancy we can see there has been an initial downward trend in the NYC properties which has moderated in more recent years. The Chicago properties are still experiencing sharp declines in occupancy and San Francisco has slightly improved in 2022. Though the Chicago declines are alarming, the segment is a very small portion of total NOI at 8%, which can be visualized in the diagram below.
NOI has actually shown a positive trend back towards 2019 levels over the last few years, despite occupancy issues. The bear narrative that office work is in a permanent decline does not appear to be the case at least for VNO based on recent performance. Below, the NOI recovery towards 2022 levels can be visualized.
The positive trend is all well and good, but the more important question is if this is translating to FFO available to common stockholders. This takes us to our next section.
Valuation
Unfortunately, office REITs have been hit by a one-two punch, first with the pandemic work from home push and second with aggressive rate hikes increasing interest costs. It is also unclear if and when these trends will reverse, though at the very least the fed has hinted they're almost done with interest rate hikes. This can be demonstrated below, in company reported FFO numbers, and our estimates of AFFO over the years which includes capex estimates.
For 2019 and 2020, I was able to find detailed breakdowns of recurring and nonrecurring capex in the 10Ks, but the 2021-2023 capex numbers are estimates provided as guidance by the company. As we can see though, both declines in FFO and AFFO have been severe. Management has predicted about $2.75 FFO/share in FY 2023, and I believe this will translate to about $250 million in AFFO. This gives us a forward FFO yield of 20%, but only a 10% AFFO yield when adjusting for capex guidance. I believe this does not provide a large enough margin of safety given the current macroeconomic uncertainty and would be more comfortable with a forward AFFO yield of 15-20%.
Inverting the Thesis
Interest Rates Could Fall
REITs get sold off when interest rates rise, for obvious reasons. They are passive dividend paying investments, so when risk free yield goes up REIT value has to go down. They also are generally highly indebted and will pay higher floating rates and have to refinance at higher costs. If this trend for some reason reverses REIT values will increase, potentially more than other investments considering these factors.
Office Supply Could Decrease
As the demand for office space has decreased due to the shift to work from home, competitors with real estate in nonprime locations may have a difficult time leasing units. This could result in reduced competition in the space, or even conversion of subprime locations into residential units. As VNO has so far been able to maintain 90% occupancy at least in their NYC locations, this could indicate they operate more desirable units and demand for their products could continue regardless.
Manageable Debt Schedule
Though the company has clearly been harmed by floating rate debt over the last few years, the modest maturity schedule over the next 2 years will buy the company time and allow for more flexibility. By the time there will be large maturities in 2025, interest rates could be back on their way down, and refinancing may be less costly.
Conclusion
REITs like VNO are primarily sought after by income-oriented investors, so a strategic dividend cut could present a buying opportunity due to automatic selling pressure. Despite this, when reviewing VNO's recent FFO and attempting to adjust to AFFO using supplied capex estimates, cash flow available for the common stock has been reduced significantly over the years. Our estimates of AFFO using company data indicates a 50% decline when comparing 2022 to 2019 numbers, so a selloff in the common stock was likely warranted. This trend appears to be worsening in 2023 as well.
Our forward estimates of $250 million in AFFO in FY 2023 indicates at the current market capitalization of $2.5 billion, this REIT could have a forward yield of approximately 10%. There is plenty of uncertainty though, and further interest rate hikes or worsening of the commercial real estate market could erode cash flow available to the common. The fed could soon reverse course, but I generally do not like making investments that require speculation on interest rate movements.
Considering this, preferred shares seem to have a better risk/reward potential as at time of writing they are yielding 11-12% and are trading over 50% below par. $60 million of yearly preferred payments are relatively well covered considering the aforementioned $250 million in AFFO. I am interested to see how management will improve the balance sheet in the coming fiscal year with strategic asset sales and wonder if they will pay a stock dividend in lieu of part of the cash dividend for the common stock. Investors could be placated in this scenario, by explaining it made more sense to use that cash on stock buybacks. I would either like to see a stabilization in the business or a larger forward AFFO yield before I feel comfortable investing in the common.
For further details see:
Vornado Selloff Appears Justified For Now