Vornado: Landmark Transaction May Re-Rate Office REITs Higher (NYSE:VNO)

Vornado Realty Trust’s (NYSE:VNO) shares rocketed higher by over 13% on June 26th as a landmark transaction with peer SL Green’s (SLG) 245 Park Avenue property supported sector valuations and raised hopes of a thawing in the frozen office real estate market.

Simply put, Vornado’s current valuation appears too cheap to ignore, with VNO shares currently trading at just 0.65x P/B. One can easily see a doubling of VNO’s shares using conservative assumptions. I rate VNO a speculative buy.

Company Overview

Vornado Realty Trust is a leading real estate investment trust (“REIT”) focusing on high-quality office and retail properties, primarily in the Manhattan area. VNO owns all or a portion of 62 Manhattan properties consisting 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 including 350 Park Avenue and the PENN District, a campus-like development surrounding New York’s Pennsylvania Station.

Vornado also owns a 32.4% interest in Alexander’s, Inc. (ALX), a publicly traded REIT that owns 6 properties in New York; BMS, a wholly owned subsidiary that provides cleaning and security services to VNO’s buildings and third parties; the 3.7 million sq. ft. MART in Chicago, and a 70% controlling interest in 555 California Street in San Francisco. 86% of VNO’s 2022 Net Operating Income (“NOI”) is generated from New York (Figure 1).

COVID, Hybrid Work And The Fed Have Crushed Office REITs

Economic uncertainty from the COVID pandemic and the resulting push to remote work has created a very challenging operating environment for office owners. Many employees are still hesitant to return to the office, leading to office occupancy stalling at roughly 50% for New York, almost 2 years since the U.S. economy re-opened (Figure 2).

The lack of demand have caused vacancy rates to soar for New York offices, with vacancy hitting a recent high of 22.7%. Furthermore, analysts widely expect New York’s vacancy rate to remain above 20% until 2026.

On the supply side, new office development continues unabated with more than 13 million square feet of office space under construction, including VNO’s PENN District, putting huge pressures on existing office owners. To add pain upon misery, many office REITs, including Vornado, are heavily levered, as real estate has enjoyed a decade of ultra-low interest rates. However, the Fed’s interest rate increases in 2022 have thrown many office owner’s calculus out the window as the carrying costs on some office towers no longer make sense at current interest rates and occupancy levels. This has led some prominent investors like Brookfield Asset Management (BAM:CA) to default on office properties in Los Angeles and Washington DC.

The combination of weak demand, supply growth, and rising interest rates have cratered the common stocks of office REITs like Vornado, with VNO’s shares delivering total returns of -73.4% when measured from December 31, 2019, before the COVID pandemic (Figure 3).

Fundamentals Performing Well Given Circumstances

Despite the negative headwinds facing office REITs, Vornado has actually performed well given the circumstances with VNO delivering $1.15 billion in NOI in 2022 and $273 million in Q1/23 (Figure 4 and 5).

Valuation At All-Time Lows

With stable NOI but a plummeting stock price, Vornado’s shares are starting to look interesting for contrarian investors. Currently, Vornado is trading at 0.6x Price to Book value (Figure 6).

This is the lowest P/B valuation ever for Vornado, even lower than valuation levels during the 2008/2009 Great Financial Crisis (Figure 7).

Furthermore, investors should note that Vornado’s real estate is recorded at cost on its balance sheet (Figure 8).

Vornado has been in operation since the 1980s, so the book value of VNO’s real estate may not be reflective of their market value. For example, consider the fact that Vornado’s portfolio generated $1.15 billion in net operating income in 2022 (from figure 4 above).

If we apply a conservative capitalization rate (“cap rate”) of 7.0% to Vornado’s NOI, I believe Vornado’s shares are worth $34 / share, or more than a double from its current stock price (Figure 9).

Alternatively, we can use our ‘napkin math’ to back into the cap rate the market is assigning to VNO’s portfolio. To justify the current ~$16 stock price, one would have to assume a 9% cap rate (Figure 10).

A 9% cap rate appears to be punitively high, given Vornado’s high quality Class A real estate portfolio. According to BNP Paribas, prime office in New York transacted at a 5.0% cap rate in 2022 (Figure 11).

However, Vornado’s New York occupancy rate is currently 89.9%, more than 10 pts better than New York’s 77.3% (backed out from the 22.7% vacancy rate mentioned above), so arguably, Vornado should trade at a premium compared to the 5.0% cap rate quoted above (Figure 12).

Regardless, using a 5% cap rate in our back of the napkin valuation above would translate into an equity value north of $65 / share or 4x VNO’s current stock price.

Frozen Market Thawing

One of the main arguments against using a cap rate valuation is because no two properties are exactly the same, so it is hard to generalize. In addition, due to the difference between buyers and sellers’ expectations, the office real estate market have been effectively frozen for the past few years with only $11 billion in transactions in 2022.

However, recently we are seeing signs that the office market may finally be thawing, with SL Green Realty Corp reportedly selling 50% of its 245 Park Avenue property at a $2 billion valuation to Japanese developer Mori Trust.

This is a landmark transaction because the price tag is consistent with the valuation SL Green paid to acquire the building out of bankruptcy in September 2022. Furthermore, it is not far from the purchase price China’s HNA Group paid in 2017 for the building. Finally, the purchase price for 245 Park Avenue “works out to a cap rate in the high 3s”, a critical data point that may help narrow the discount to NAV on fellow New York office owners.

Vornado Is Not Without Risks

The biggest risk to investing in Vornado is its heavy debt load. With $8.1 billion in net debt and $1.2 billion in preferred shares, Vornado currently trades at a staggering 8.1x net debt plus preferred shares to NOI. This makes VNO’s equity valuation very sensitive to interest rates and cap rates. As shown in my valuation example, a small change in the cap rate assumption can have large implications for VNO’s shares.

Fortunately, VNO’s debt load appears manageable, with less than $300 million due in the next two years (Figure 13).

Another risk to Vornado is the U.S. economy. Many economists are predicting the U.S. economy will fall into an imminent recession, which may further hurt the occupancy levels of office REITs (Figure 14).

Finally, there is a risk that the move to hybrid work permanently reduces the demand for offices. However, we have seen many employers starting to require employees to ‘return to the office’, so the future of office occupancy is still in flux.

Conclusion

In conclusion, I believe Vornado’s shares are simply too cheap to ignore. At ~$16 / share, Vornado is pricing in a 9% cap rate across its portfolio, which appears far too punitive for its high quality assets. The recent transaction with SL Green’s 245 Park Avenue may allow many depressed office REITs to re-rate higher. While I am concerned about the U.S. economy falling into a recession, I believe Vornado is worth a speculative buy.