Unbelievable Offer: Top-Secret Office REITs on the Market – Hurry, Limited Time Sale!

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Good morning. Yesterday we asked if anything was preventing the Fed from raising rates. On Wednesday, at the central bankers’ conference, Jay Powell he gave his answer: no, not really. “While the policy is tight, it may not be tight enough and hasn’t been tight enough for long,” the Fed chairman said. The markets shrugged. Tell us what we should write about: robert.armstrong@ft.com AND ethan.wu@ft.com.

A closer look at the Reits office

Yesterday we presented the Uncovered view of the US commercial real estate market, which is under pressure from higher interest rates and working from home. The synthesis is that the solicitations are increasing, but they are mostly confined to a small slice of the market: low quality properties. Job vacancies and delinquencies are above pre-pandemic levels, but not picking up. That said, the problems only remain confined because the economy (in the ways that matter) remains remarkably strong. In a full-blown slowdown or recession, CRE dominoes could start to fall.

Is there an investment opportunity there somewhere? One obvious place to look is office real estate mutual funds, the companies that own the worst-performing commercial real estate category. Here’s a chart of the total returns of three of the largest – Boston Properties, Vornado and SL Green – along with an office REIT index and an all REIT index:

Even including dividends, office REITs have lost half or more of their value since the start of the coronavirus pandemic. This is a lot! One could say (to simplify significantly) that the market is collectively betting that the profits of these companies will halve. Will things really get that bad? Three years into the pandemic and nearly a year into the higher tax rate regime, the damage to earnings hasn’t been that great. Here is a graph of year-over-year changes in cash flows available for distribution at the three large REIT offices:

Real estate company cash flows are volatile, and 2019 was a very strong year for all three companies, making comparisons difficult. But the basic picture here is that cash flows are flat to the downside, not tumbling off a cliff. Furthermore, the Wall Street analyst consensus predicts stability for the next three years. Of course, you can probably discount those estimates somewhat: stock prices tell you that the of investors consensus is that analyst numbers need to go down. But until now, disaster hasn’t struck and companies are trading as cheaply, relative to their cash flows, as they have since the depths of the financial crisis. Boston, Vornado and SL Green are trading at eight, seven and six times their operating funds, respectively. Through March 2022, those multiples were at 16, 13 and 11. Half off!

The basic purchase case would have two parts. While it’s clearly impossible to predict what vacancies and rents will look like when the work-from-home trend settles into a steady state, the valuation gives you a large margin of error about your best guess. And while the rate outlook is uncertain, it looks like rates are close to a peak now and any declines from here would be a boon.

The problem is that the two big risk drivers – revenue construction and interest rates – combine with each other and could interact in a variety of ways. Higher interest rates increase the financing costs of any building that is financed with variable rate debt or has to roll over its debt. Lower occupancy or lower rent reduces construction income. If both happen to the same building, that building could end up owned by its lenders, triggering a crash sale, with further repercussions for other buildings on the market and other real estate borrowers. The very low ratings of the Reits office reflect the fact that CRE is a highly leveraged and interconnected sector where, if things go wrong, completely unexpected and very bad things could happen.

The big REITs themselves have two key stories to tell to reassure investors. One is that they have structured their debt prudently, which will carry them through the current storm. Here is Steven Roth, CEO of Vornado, speaking with analysts recently:

We rely primarily on project-level non-recourse debt, old-fashioned mortgages. Only 2.5 per cent of our debt is recurred and that with well-scaled maturities. We are clear-headed and realistic about the short-term challenges of the financial market. It’s not nice when 3% of the debt goes to 6, 7 or even 8 markets. We will definitely do some workouts [ie, debt renegotiations] face in the next two years. But that’s the point of having unrecourse debt. We have no maturities this year, limited maturities at the property level next year, and no corporate maturities in 2025 with sufficient capacity on our line maturing on December 27th and therefore we don’t have to finance in the current hostile market.

“Non-recourse debt” means the debt owed to the property, not by the company itself; the point is, a workout on a building doesn’t have to jeopardize a REIT’s entire balance sheet.

The second point of reassurance is that negative issues should remain confined to the low-end of the market, as they have hitherto, and that the large public REITs specialize in high-end properties. Here’s a slide from Boston Properties from a recent presentation touting lower vacancy rates in high-end buildings (data from CBRE):

JPMorgan real estate analyst Anthony Paolone sees some truth in the idea that high-end office properties will be spared the worst this cycle. But he thinks the problems plaguing the industry didn’t start with the pandemic. Demand for office space was already in slow decline as employers cut space per employee, and this was only exacerbated by working from home. Meanwhile, both technology and financial services, which form a large part of the high-end tenant base, are facing cyclical pressures. The rate hike tops it all off. “If it was any of these problems, the industry would fix it. But they are all three at the same time. It has lower ratings than Boston, Vornado and SL Green.

For anyone who is skeptical of the home business trend and thinks interest rates can go down without a hard landing or recession, office REITs offer many benefits. For Unhedged, there are too many forms of risk interaction at once.

A good read

We wrote last week that the US liquidity boom was fading. In the Financial Times, Michael Howell does the opposite.