2024-01-13 03:09:29 ET
Summary
- Vornado Realty Trust's shares have appreciated by almost 70% due to improved risk sentiment. The stock's steep discount to book value has been closed.
- However, office real estate fundamentals remain challenging, with vacancy rates at all-time highs.
- Vornado also has a heavy debt load that will be refinanced at higher rates in the coming quarters.
- I believe the risk/reward is more balanced, so I am downgrading the stock to a hold.
A few months ago, I initiated on Vornado Realty Trust (VNO) with a buy rating. At the time, markets were in panic mode as interest rates and office vacancies were both rising. Investors punished Vornado's shares to its lowest valuation levels ever, at just 0.65x Price to Book value.
Fast-forward six months and the difference appears to be night and day, as a Federal Reserve pivot has reignited investor risk appetites and Vornado's share have appreciated by almost 70% (Figure 1).
Figure 1 - VNO shares have rallied by almost 70% (Seeking Alpha)
Are VNO shares still worthy of a buy recommendation after the sharp rally in the past few months?
Brief Company Overview
Vornado, for those not familiar, is a leading real estate investment trust ("REIT") focusing on high-quality office and retail properties, with a concentration in Midtown Manhattan. In New York, VNO owns all or a portion of more than 20 million sq. ft. of office, 2.4 million sq. ft. of retail and over 1,600 residential units. VNO also owns the PENN District, a campus-like development surrounding New York's Pennsylvania Station, plus a 32.4% interest in Alexander's, Inc. ( ALX ), a publicly traded REIT that owns 6 properties in New York (Figure 2).
Figure 2 - VNO portfolio (investor.vno.com)
Vornado also owns the 3.7 million sq. ft. MART in Chicago and a 70% controlling interest in 555 California Street in San Francisco.
Extreme Valuations Normalized
The biggest driver to my speculative buy rating in June was Vornado's valuation. While I was concerned about high office vacancies and Vornado's high debt burden, the shares were simply too cheap to ignore, trading at just 0.62x P/B (Figure 3). Even during the 2008/2009 Great Financial Crisis, Vornado's shares never traded below book value.
Figure 3 - VNO valuations were too cheap to ignore in June (Seeking Alpha)
My buy call appears to have been well-timed, as Vornado's shares have rallied back to 1.16x P/B recently (Figure 4).
Figure 4 - VNO valuations have normalized to 1.16x P/B (Seeking Alpha)
However, with the extreme discount to book value eliminated, forward returns for Vornado's shares may be more challenging and will depend on the company's fundamentals.
Fundamentals Remain Severely Challenged
Unfortunately, when it comes to the fundamentals of commercial real estate, things still look horrible. According to Moody's Analytics , office vacancies reached a record high of 19.6%, surpassing peaks reached in 1991 during the Savings and Loans crisis and 1986, following a massive building boom (Figure 5).
Figure 5 - Office vacancies reach new highs (Moody's)
Despite improving macroeconomic optimism for a 'soft landing', hybrid work models continue to wreak havoc with office occupancy levels and office real estate valuations.
Almost every week, we see news of landlords defaulting or renegotiating mortgages on their office real estate. Furthermore, transactions are increasingly taking place at fractions of their last sales price, as borrowers run out of time to 'wait out the market'.
Even prominent buildings like the Bethesda Metro Center in Washington, DC, are not immune, with the building recently selling for just 22% of its last transaction price in 2019!
Vornado Outperforming National Averages
However, Vornado's occupancy continues to outperform the national average as it owns some of the most desireable real estate in the country. VNO's vacancy rate was 10.1% in Q3/23, almost half of the national average as New York office has held in relatively well (Figure 6). However, the vacancy rate is worryingly high at the MART at 25.7%.
Figure 6 - VNO vacancy rate (VNO Q3/23 press release)
The high vacancy at the MART has led to a steep 54% YoY decline in NOI in the quarter ended September 30, 2023 (Figure 7). Overall, Vornado's NOI declined 3% YoY in the quarter.
Figure 7 - VNO NOI has declined YoY (VNO Q3/23 press release)
Net Debt Remains A Concern; Expect A Rise In Interest Expenses
Another concern with respect to Vornada is its heavy debt load. As of September 30, 2023, Vornado had $8.8 billion in net debt, or 8.0x Net Debt / EBITDAre (Figure 8).
Figure 8 - VNO has $8.8 billion in net debt (VNO Q3/23 investor supplement)
Worryingly, $1.6 billion of VNO's debts are coming due in 2024 and 2025 (Figure 9).
Figure 9 - VNO debt maturity schedule (VNO Q3/23 investor supplement)
Furthermore, a fair bit of Vornado's interest rate hedges are rolling off in 2024 (Figure 10).
Figure 10 - VNO interest rate hedge schedule (VNO Q3/23 investor supplement)
So investors should be prepared for a significant rise in VNO's interest rate expense over the coming quarters.
Conclusion
Overall, my revalution thesis has played out far faster than I had hoped, with Vornado closing the discount to book value in a matter of months. Simply put, the easy money has been made.
Looking forward, office fundamentals remain challenging, as vacancies exceed historical highs. With interest expenses likely rising over the coming quarters, I expect financial performance at Vornado will continue to deteriorate.
I believe VNO's risk/reward is more balanced at the moment so I am downgrading the stock to a hold and have personally sold my position.
For further details see:
Vornado: Valuation Normalized (Downgrade To Hold)