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Oct 16, 2023

Vornado: Revisiting My Investment Thesis After Dividend Suspension (NYSE:VNO)

Patrick Gross/iStock via Getty Images On 4/26/23, Vornado Realty (NYSE:VNO)

Patrick Gross/iStock via Getty Images

On 4/26/23, Vornado Realty (NYSE:VNO) issued a press release that it was suspending its common stock dividends unto the end of 2023. This happened to be the next day after my article on VNO was published about why I was starting a position in VNO. It's been just over a month, and VNO has declined -11.78% compared to the S&P 500, appreciating by 1.91%. The timing of my article couldn't have been worse. Now that the market has digested the news, and VNO reported its Q1 earnings, I wanted to reexamine my investment thesis and write a follow-up article.The warning bells continue to go off regarding commercial real estate, especially office buildings. According to Mortgage Bankers Association Data almost 1/4th of mortgages on office buildings must be refinanced in 2023, and analysts have raised concerns that developers might default on a substantial part of the $3.1 trillion in U.S. commercial real estate loans that Goldman Sachs (GS) says is outstanding. Periods of chaos create opportunities for investors who can pick winners within sectors that are experiencing hardship. I could be 100% wrong on VNO, but my investment thesis hasn't changed, and I believe VNO will emerge as a winner in several years. It could get more painful, and many variables could impact VNO, but I am willing to wait out the storm.

Seeking Alpha

The premise is simple. There are fewer workers going to the office as the pandemic made companies pivot and implement existing technologies that weren't emphasized to stay connected. Before the pandemic, products such as Slack, Zoom (ZM), and Microsoft (MSFT) Teams were available but weren't heavily utilized. Everyone knows the story, these products became widely accepted during the pandemic, and more than 3 years later, companies are still utilizing them. Some organizations have returned to the office full-time, some have hybrid policies, while others have downsized their physical footprint or abandoned it altogether. There is also a cohort of business owners waiting for their leases to end so they can downsize or eliminate their footprint. Everyone has an opinion on remote work, and in a recent CNBC interview, Elon Musk called remote work morally wrong and was explicit in how he feels about working from home. Every company will need to figure out what works for them, as one person's opinion won't dictate how millions of businesses conduct their operations.

Kabir Caprihan is an analyst for JPMorgan Chase (JPM), and in a report from March 24th, had warned that 21% of office loans are destined to go bad, and lenders would lose an average of 41% of the loan principles. According to the National Office Report from Commercial Edge the U.S. national vacancy rate in April was 16.7%, up 10 basis points MoM and 100 basis points higher YoY. In addition to the national vacancy rate increase, 118.2 million sq feet of office space are under construction as of April, representing 1.8% of the total stock. Of the 118.2 million sq feet, Class A and A+ properties accounted for 109.9 million sq feet of the new office space being built. As vacancy rates increase and new supply enters the market, it could become problematic for older buildings and current operators as the price per sq foot could tighten further.

Commercial Edge

Brookfield Corporation is one of the world's largest real estate investors, with $263 billion in assets. On 4/18, Forbes reported that Brookfield defaulted on $161.4 million of office building mortgages. The defaults cover roughly 12 office assets in the Washington D.C area, which comes after Brookfield defaulted on $784 million in mortgages for 2 office towers in Los Angeles, California. The combination of vacancies and higher interest rates has impacted profits, and Green Street has indicated that property values have declined by roughly -25%.

Green Street

The commercial real estate market is going through some turmoil, and I am expecting more negative headlines to circulate before it gets better. Brookfield defaulting on almost $1 billion of mortgages doesn't paint a strong picture, and as individuals and companies leave high-tax states, the office REIT sector is uncertain at best. There are many reasons not to invest in REITs that specialize in office space, and quite honestly, just investing in an S&P 500 index fund is a lot safer and less stressful. At the same time, there are many red flags and reasons to stay away from the sector, providing an opportunity for the REITs that survive.

I am sticking to what I know and see with my own eyes. Living and working in NYC, I remember driving through the city during the day and not seeing a single person for several blocks. If you have ever been to NYC, that's almost unimaginable. I drove down 7th Ave through Time Sq and saw 3 police officers with no pedestrians. I’ll never forget how empty NYC felt in March of 2020. Since then, things have drastically changed, and NYC is far from empty. I am not seeing the doom and gloom I hear about in NYC as I am seeing a large uptick of people and activity with my own eyes. I do not know if NYC will return to its pre-pandemic days, but the city certainly feels increasingly vibrant as the months pass.

Look, those are my observations, which are ultimately my opinions, except for the part about driving through the city during the early stages of the pandemic. Here is actual data coming out of NYC. Per the New York City Comptroller's office, NYC is picking up. In February of this year, there were 69.1 million subway trips during the week which is 65% of pre-pandemic levels in February of 2019. On the weekend, there were 15.2 million subway trips which was 75% of the ridership in February 2019. I go to the office 3 days a week, which is 60% of the workweek. Many companies have hybrid work policies, and when I see 65% of the subway ridership from 2019 levels, it's not alarming to me for this investment thesis. The 2022 Long Island Railroad (LIRR) annual ridership report shows that the 2022 total ridership increased YoY by 50% to 52.5 million customers, which is still a decrease of -42.4% from 2019.

Office of the Comptroller NYC

I am looking at the data from mass transit and what I see with my own eyes. Taking into consideration that many companies have hybrid work policies, the data reported by the LIRR and NYC about ridership makes sense. If these numbers were much lower, my thesis would probably be different. If more companies adopted 100% remote work policies, the ridership numbers would be much lower. People are going places in the city, and many that I see during the day are dressed in business attire or business casual.My premise on what will occur is that less desirable buildings will lose tenants as companies look to lease space in Class A buildings. I also think that the hybrid environment has put a different value on time, and more companies will want to be closer to mass transit which would place them in Midtown near Grand Central or outside of Penn Station. The LIRR just finished its Grand Central Station, and commuters from Long Island no longer have to take a train to Penn and then either walk or catch a subway to get to the east side. There are more than 8.3 million people who live in NYC and millions more living on Long Island or in Westchester that commute to the city. I believe there will always be a need for office space in NYC, and that over the next decade, there will be companies reducing their footprints due to remote work but also companies looking to move out of lower-tier buildings and into Class A assets that are closer to Penn and Grand Central. I could be wrong, but I think the REITs who own and operate the more desirable buildings in NYC will be ok, and that's why I still like VNO.

I invested in VNO for two main reasons, I felt it was undervalued, and the dividend yield was 9.84%. I figured I could sit back and collect the dividend while I waited for the situation to unfold. I was wrong, as VNO the next day announced they were suspending the dividend. VNO postponed the common share dividends until the end of 2023 and would determine what gets paid out based on the finalization of its 2023 taxable income, which includes asset sales. Whatever VNO pays shareholders at the end of 2023 may not be 100% cash as they are reserving the right to pay the remaining 2023 dividends in either cash or a combination of cash and securities. In the same announcement, VNO announced that it would be authorizing the repurchases of up to $200 million of its common shares. The cash retained from dividends or from asset sales would be used to reduce debt and/or fund share repurchases.

On the Q1 conference call, which occurred on 5/2, Steven Roth (VNO CEO) addressed the dividend immediately. He outlined that dividends are a focal point at VNO, and VNO has paid $5.1 billion in regular dividends and $400 million in special dividends over the past decade. In 2022, VNO paid a dividend of $2.12 per share, which added up to $435 million. In Q1 2023, VNO paid a $0.375 dividend which amounted to $75 million. VNO is pausing the 2nd and 3rd quarter dividends, and in Q4 they will pay out the remaining taxable income required in either cash or a combination of cash and scrip.

The dividend at VNO isn't based on funds from operations (FFO), its size is based on taxable income. In 2021 taxable income was $2.03, and VNO paid out $2.12, and in 2022 taxable income was $2.08, and the dividend was $2.12. VNO is projecting that 2023 taxable income will be $1.05 prior to asset sales, and Mr. Roth assured shareholders that there would be some asset sales. If there are no asset sales for some odd reason, VNO should pay at least another $0.675 per share in their dividends based on prior years.

The next part was important to me. Mr. Roth said that he had resisted buybacks for years as industry peers repurchased shares, and analysts indicated they wanted to see buybacks to close the net asset value (NAV) gap. Mr. Roth addressed that since the dividend announcement, shares of VNO fell -35% from what he considered a low level to an even lower level. Mr. Roth is no longer resisting buybacks as he sees the current price as an opportunity to create shareholder value by repurchasing shares. The board authorized $200 million in buybacks, and Mr. Roth is on board.

I am not thrilled, but I am not upset either. VNO is still going to pay dividends, and for me, this is a short-term setback. I am bullish on the buybacks, especially as Mr. Roth has changed his stance, and the value proposition is too good to pass up. If his feeling was different, my opinion is that he would disperse the capital through the dividend, not allocate it to buybacks.

Seeking Alpha

One of the major headlines around commercial real estate, offices in particular, is debt coming due. VNO finished Q1 2023 with $890.96 million in cash on the books, with another $142.99 million in restricted cash, and $276.65 million in U.S. T-bills. This places their on-hand cash liquidity at $1.31 billion, and VNO has another $2.63 billion in investments in partially owned entities. VNO has $22 million of debt maturities coming due in 2023, and another $396 million in 2024. By the time 2025 rolls around, I expect interest rates to be lower, and VNO will be able to refinance at favorable rates. The debt repayment schedule wasn't an issue in my initial analysis, and it isn't an issue now.

Vornado

VNO leased 7.4 million sq feet in Q1, and Michael Franco (VNO CFO) said that the availability rate of newly constructed properties has substantially declined, with much of the new trophy space now largely absorbed at record level rents. He indicated that VNO's portfolio is filled with Class A buildings that are filled with amenities and near transportation in Midtown and on the West Side. He also indicated that the new trophy space is being absorbed in record rent levels. This plays directly into my thesis about consolidation in Class A assets in Midtown near Grand Central and on the West Side outside of Penn Station.

During Q1, VNO completed 22 leases totaling 777,000 square feet , with some rent starting at $101 per sq foot. VNO closed a full building 585,000 sq foot deal with Citadel at 350 Park Avenue and 82,000 square feet at PENN1 with $92 starting rents. Excluding the Citadel deal, VNO closed 21 leases totaling 192,000 at $83 per sq foot with 13.1% cash mark-to-market. VNO has more than 400,000 square feet of leases in negotiation plus an additional 1.4 million square feet in its lease line. VNO is also seeing momentum in the PENN 1 project as rents are in the high $90s and low $100s per sq foot in the tower floors, which reflects tenant attraction to trophy assets.

When I look at VNO, its book value is $23.50, and shares are trading at $13.33. Shares are trading at a -43.28% discount to book. Hypothetically, let's say that VNO's assets are re-rated and take a 30% haircut, it would place its book value at $16.45, which would still place shares at a -18.97% discount to book.

Steven Fiorillo, Seeking Alpha

I could be wrong, but I see an opportunity in VNO. After looking into the transit numbers for NYC to validate what my eyes are seeing, I do not see an evaporating office environment. VNO has trophy assets positioned optimally near Grand Central and Penn Station. If the story unfolds how I think it will, with businesses condensing their footprints into Class A buildings, VNO could be a long-term winner. The higher rate environment won't be here indefinably, and VNO has minimal debt owed in the next two years and substantial liquidity on hand to ride out the storm. Commercial real estate is an area I am looking for deals in, and VNO is at the top of my list.

This article was written by

Analyst's Disclosure: I/we have a beneficial long position in the shares of VNO, SLG either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Disclaimer: I am not an investment advisor or professional. This article is my own personal opinion and is not meant to be a recommendation of the purchase or sale of stock. The investments and strategies discussed within this article are solely my personal opinions and commentary on the subject. This article has been written for research and educational purposes only. Anything written in this article does not take into account the reader's particular investment objectives, financial situation, needs, or personal circumstances and is not intended to be specific to you. Investors should conduct their own research before investing to see if the companies discussed in this article fit into their portfolio parameters. Just because something may be an enticing investment for myself or someone else, it may not be the correct investment for you.

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