This article was coproduced with Williams Equity Research.

Investing contains few absolute truths. And when – no matter what we say out loud in philosophical or academic discussions – we’re all looking for such certainty in what we do and how we do it…

It’s easy for individuals to slide toward one extreme or the other. The middle path is a lonely one.

Take New York City, which is at an unusual (dare we say “unprecedented”) crossroads. Optimists see heavily-discounted real estate. Bears are busying underwriting permanent impairments not yet realized.

If bears are correct, the ripples through the city’s economy have just began. And the city’s already elevated valuations are only now staring their descent.

Bulls, meanwhile, point toward Great Recession-level pricing vs. the relative health of large financial services companies. Their conclusion is to stick with the extremely durable mantra, “This too shall pass.”

But will it? Can it possibly be that easy?

The profitable answer might very well lie somewhere in between.

NYC’s Largest Office Landlord

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Up until four months ago, every real estate company in modern history would be envious of the title “New York City’s largest office landlord.” And why not?

It was New York City! Enough said.

In which case, “enough said” about the title holder, SL Green Realty (SLG) too. It describes itself like this:

“Manhattan’s largest office landlord is a fully integrated real estate investment trust, or REIT, that is focused primarily on acquiring, managing, and maximizing value of Manhattan commercial properties. As of March 31, 2020, SL Green held interests in 102 buildings totaling 49.4 million square feet. This included ownership interests in 28.8 million square feet of Manhattan buildings and 19.6 million square feet securing debt and preferred equity investments.”

New York City is facing something between a major and an existential crisis. The number of people leaving the city is astounding.

And, again, why not?

Most employers have extended work from home through the end of 2020. Several, such as Facebook (FB) and Google (GOOG) (NASDAQ:GOOGL), have made the option permanent for most roles.

Why stay in a city the media has marked for death if you don’t have to?

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Both office and residential rents alike in Manhattan remain the highest in the nation by far. That’s because they seem preferable to so many against long daily commutes.

Yet despite that, the amazing attractions and the fact that residents were enjoying a relatively safe environment with much lower crime compared to previous eras… approximately 100 people were leaving the city per day in 2018 and 2019.

And that was then. Now?

Clearly, that trend hasn’t decreased, at least for the time being…

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The New York City Situation Today

For starters, rents have yet to fall materially, with most residents locked into traditional 9-18 month leases to begin with. And prominent firms – such as JPMorgan (JPM) and Goldman Sachs (GS) – are not only permitting but even encouraging New Yorkers to work from home.

Manhattan also has slowly but surely become a second home to tech companies in the past decade, which also have permitted workers to work from home.

As such, reduced commute is no longer a factor for the time being. And nobody knows if this will persist for several months or several quarters.

We do know the average renter is absorbing rental rates $1,500-$2,500 above the average U.S. metro. That could pay the mortgage on a decent house close to major cities in Florida or Texas.

Most New Yorkers didn’t seem to care before. But times, they change.

Instead of having access to some of the best restaurants and parks in the nation, New Yorkers are now among the most restricted in their movements. On top of that, certain types of crime (including murder) are up significantly – and will likely get worse before improving.

It’s no wonder then that, per the latest figures, approximately 250-350 people are now leaving. Daily.

The New York Times, whose city-specific loyalty needs no explanation, has estimated that 420,000 of 18.8 million residents exited the metro between March and the end of May.

If those figures can be believed, that’s 2%-3% of the population.

On our end, we’re a bit skeptical. Other data, such as the 70% drop off in restaurant visits prior to the lockdowns, suggests it may be more dramatic.

Regardless, there’s no doubt that many businesses are gone with little hope of returning. And if those more cyclical industries don’t recover, offices won’t be far behind them.

SL Green and Other New York REITs

It’s no secret that NYC has overcome tremendous challenges in the past. And I hope that cycle repeats. But we can’t let irrational optimism or skepticism cloud our judgement.

Therefore, this analysis of SLG contains information and perspectives that impact other NYC-oriented REITs, such as:

  • Vornado (VNO)
  • Empire State Realty Trust Inc. (ESRT)
  • New York REIT (NYRT).

Source: 2020 NAREIT SL Green Realty June Presentation

For SLG specifically, it’s a small- to medium-sized REIT with a market capitalization of $3.6 billion. It owns 88 properties generating $1.7 billion in revenue equating to $7.30 in annual funds from operations (FFO).

At last check, SLG closed at $46.74, or an unusually favorable 7.40 FFO multiple.

While it yielded 3.85% at the end of 2019 – which was close to its historical average – it now sports a 6.95% annual distribution. These figures broadcast deeply-troubled sentiments.

Are they valid?

So far, SLG hasn’t been downgraded by a major rating agency. But its current position just two notches away from junk status is at risk if current trends continue.

Portfolio and Rent Collection

SL Green ended Q1 with $579.5 million in cash after selling its 609 5th Avenue and other properties that increased liquidity. It also spent $44.1 million on share repurchases at an average price of $41.88.

These are attractive statistics.

Source: 2020 NAREIT SL Green Realty June Presentation

In terms of Q1 rent collections, SLG did better than many expected. To be fair, this period shouldn’t have been problematic outside of retail.

Office, residential, industrial, and other property landlords should have been able to sustain themselves minus a few weeks’ worth of missed rent payments.

(Arguably, that should have been the case for retail too. But that’s another story.)

That’s not to understate the damage. It’s simply common-sense understanding of long-term financial commitments.

SLG’s management clearly understood that, since its office, residential, and suburban properties maintained strong rent collection of around 90%, not only in Q1, but also in April and May.

Retail, however, struggled at about 60%, which wasn’t worse than other retail REITs were posting with geographically diversified portfolios.

Source: SLG Q1 Supplemental

As the chart below demonstrates, 83.7% of SLG’s portfolio’s total operating and development net operating income (or NOI) comes from Manhattan.

Source: SLG Q1 Supplemental

Due to its property sizes, a proper analysis can be a bit cumbersome. But SLG breaks down lease terms by tenant.

In which case, it has a fair amount expiring before 2022. But the remaining terms are spread out all the way through 2038.

Therefore, we classify releasing risk as moderate.

Source: SLG Q1 Supplemental

As we’ve often written during the current crisis, the businesses attached to leases are more critical than ever to understand. SLG’s portfolio scores well here, with 13% exposure to retail (by annualized contractual cash rent) and 5% to arts, entertainment and recreation.

These are the two least stable areas of its portfolio. And while that’s enough to detract from portfolio-level FFO, it isn’t enough to sink it.

Key Projects

The risk differences between fully occupied properties and development strategies is perhaps most important in commercial real estate investing.

The highest credit-rated REITs – including Public Storage (PSA), Simon Property Group (SPG), Realty Income (O), and AvalonBay (AVB) – allocate only a small percentage of their resources toward development projects.

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That’s because, when the economic cycle inevitably ends, development projects quickly become expensive albatrosses.

Along those lines, SLG’s largest project from a capital commitment perspective is One Madison Avenue.

On the positive side, it has the National Pension Service of Korea as a buyer for 49.5% of the development. Tenants won’t be paying rent until 2024, however. And that’s assuming demolition, foundation, and construction goes as planned.

Source: 2020 NAREIT SL Green Realty June Presentation

SLG is committing $520.9 million to the deal: 15% of its current market capitalization. With that said, WER’s lead portfolio manager know the Hines organization well and considers it a top-tier firm.

Source: 2020 NAREIT SL Green Realty June Presentation

One Vanderbilt Avenue is another key project, and it’s well underway. Construction costs are about $100 million under budget. And construction remains on schedule, with an expected opening in October of 2021.

As shown above, the project is approximately two thirds leased to the likes of TD (TD), The Carlyle Group (CG), and SLG itself.

185 Broadway and 410 10th Ave. also are under construction, with existing metrics looking good. These two projects should come online in mid to late 2021 too.

A plus for SLG and other New York City development projects has been the ability to qualify for full staffing despite the restrictions implemented in other businesses. That’s how construction progress has remained on time despite the assortment of challenges.

COVID Impact

The impact of the coronavirus goes far beyond current lockdowns and work-from-home mandates. So it’s helpful to divide it appropriately.

Short term, SLG has aggregated lease and transaction delays directly attributable to COVID-19. Frankly, no one knows how to perfectly define this variable, but we appreciate SLG’s well-intentioned attempts to provide transparency nonetheless.

Source: 2020 NAREIT SL Green Realty June Presentation

We can gauge that approximately one third of total leases are negatively impacted by the existing crisis. And a full half of term sheets for property transactions are now in a holding pattern.

The bottom line will be how many delays turn into cancellations. We must assume a good portion of these transactions won’t take place in the near term unless an unexpected cure develops almost overnight.

As realists, we expect considerable political and drug production back-and-forth for months about any cures. Make no mistake about it: Q2 will be devastating for NYC retail.

Worse yet, the increasing probability of a “second wave” would detract further from any Q3 or Q4 improvements saving flailing retailers from a 2020 demise.

The local population’s estimated 25%-35% immunity level (the highest in the nation, by far) may also help mitigate this risk. While reliable and conclusive scientific data is unusually hard to come by, estimates of exposure rates to achieve herd immunity are as low as 43%.

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Long term, finding tenants for unleased development projects won’t be enjoyable. Although SLG has strong tenants lined up for several projects, the local market could really struggle from here.

Rents will continue to come down on existing buildings, adding lease-up risk to new developments. And already low cap rates on NYC development projects will suffer.

The only question is to what degree.

Progress Made

Source: 2020 NAREIT SL Green Realty June Presentation

To its credit, SLG has worked very quickly to reduce liabilities. Total preferred equity and debt outstanding was $1.82 billion at the end of Q2.

And that’s expected to fall to $1.38 billion at the end of June.

Source: 2020 NAREIT SL Green Realty June Presentation

Plus, if you think its situation is tricky now, consider if the coronavirus hit our shores in 2018. That was back when its land and construction and retail segments represented over one fourth of the portfolio.

These improvements and its total liabilities have enabled it to avoid a credit downgrade and higher interest expense. This is a big deal given its other challenges and the uncertainty of the current economic and political environment.

Source: 2020 NAREIT SL Green Realty June Presentation

The maturity schedule above isn’t what we’d call ideal, admittedly. But it’s still better than it was the end of last year.

The firm’s 2021 maturities won’t be an issue. Plus, 2022’s should be similarly manageable, even if the local and broader economy remains fractured.

It’s not until we get up to 2023’s $3.8 billion in credit facility and secured debt coming due that we face a legitimate risk. Management will likely be providing updates on that in upcoming quarterly and annual filings.

It’s true that SLG’s maturity schedule and overall debt stack isn’t as well structured as heavy weights like W.P. Carey (WPC) or Realty Income. But it has sufficient maneuverability to withstand a long period of distress.

Right now especially, that means a lot.

SLG Guidance

Source: 2020 NAREIT SL Green Realty June Presentation

Manually calculated from SLG’s financial statements, FFO will likely be $6.25-$6.65 for 2020. (The company’s estimate is for $6.60.) For context, Q1-20 generated $2.08 in FFO, or $8.32 annualized.

The real question isn’t 2020, however, but rather 2021 and beyond.

SLG is a near perfect example of investors’ need to identify time horizons and risk profiles. In short, its buyable status is on your shoulders.

Attaching worst-case scenario negative rent growth through 2022 puts the cyclical FFO trough at $5.75-$6 in 2022-2023. That’s considerably lower than estimates from BMO Capital Markets and other third-party sources.

The “base case” is the midpoint of our $6.45 2020 FFO estimate.

Source: SLG Q1 Supplemental

Historically, FFO and FAD payout ratios have been about 50% and 85%, respectively. This is interesting, since the FFO payout ratio is well below its peer average, and therefore safer. Yet FAD is in line.

This clearly indicates that capital expenditure items are more significant to SLG than your average REIT.

2020’s FFO payout ratio using 2019’s $0.85 quarterly dividend barely moves to 52.7%. FAD, however, is in the 90%-95% payout ratio range. The most conservative modeling of cash flow going forward still sees a favorable peak FFO payout ratio of 60-65% though FAD reaches 100%. From a dividend perspective, SLG is surprisingly well situated.

Source: SLG Q1 Supplemental

Leverage and fixed-charge ratios are more mixed. All of the coverage ratios shown above are lower than we’d prefer – which is probably why SLG isn’t rated higher than BBB.

A 2x fixed-charge coverage ratio over the past 12 months is rather weak. Though this also is attributable to NYC’s unique dynamics.

If cash flows drop throughout 2020, SLG will see this figure slide further. It’s therefore clear why management steadfastly reduced liabilities year-to-date.

SL Green’s Balancing Act

Mitigating the balance sheet risks is how lower-leverage benefits haven’t yet impacted SL Green’s financial statements. Also, despite New York’s challenges, it continues to be a major hub of institutional investor interest.

This maintains SLG’s properties as being among the more valuable in North America.

Several recent transactions – including its securing of a $510 million mortgage on East 42nd Street – are a tribute to NYC’s near-term resiliency. (Interestingly, the sale of this same property failed in March, as detailed here).

Source: SLG Q1 Supplemental

SLG is one of few companies making meaningful buybacks at attractive prices. Though the stock hasn’t rebounded much its lows, the average repurchase price of under $42 is compelling against current values.

In addition, efforts to reduce leverage and the share count bolster SLG’s future financial performance. Its weighted average interest rate is 3.70%, a great figure for a geographically concentrated, small-to-midcap, BBB-rated REIT.

Source: SLG Q1 Supplemental

The firm’s covenants and key debt ratios are provided above. Its 42.8% total debt to total assets is in line with the peer average.

More problematic is its 56% maximum unencumbered leverage ratio compared to the requirement of <60%. We think it can get there, but the status quo does present a risk.

No other covenants on the revolving credit facility or unsecured notes are at material risk of being breached.

Source: SLG Q1 Supplemental

Another concern is SLG’s exposure to floating rate debt. That’s worked well to date. (Remember how low the weighted average cost of debt was? This is another contributor.) But SLG doesn’t have a ton of room for error in its fixed-charge and interest-coverage ratios.

If the Manhattan office sector were to deteriorate while interest rates rose, SLG would doubtlessly feel the pain from its 48.9% floating debt.

Valuation Considerations to Contemplate

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Although a volatile market, SLG’s Manhattan occupancy remains near 95%. As already stated, rent collections have remained around 90% at the portfolio level. Retail rent collection has suffered, but it remains above 50% and represents less than 15% of what’s due.

It’s essential to keep those facts in mind as we complete our critique.

Applying the cyclical FFO low point from our conservative case that expects multiple years of rent declines, SLG still trades at a highly appealing 7.9x FFO.

Most of the portfolio is leased to solid companies that don’t have the option of negotiating rent for years. Yet the scenario above prices in a total disaster for every lease not connected to a very strong tenant with contractual rent bumps through at least 2028.

That may seem extreme. Then again, many would describe Manhattan’s office outlook as nothing less.

Our 2020 base case of $6.45 FFO per share results in a 7.25x FFO multiple. This is approximately half the average BBB-rated REIT’s cash flow multiple.

At first glance, SLG’s 7.5% yield doesn’t seem all that against WPC’s 6.3% or National Retail Properties’ (NNN) 6%. After all, they have higher credit ratings, more geographically diversified portfolios, and better dividend track records.

But this is a function of NYC property cap rates, which are among the lowest in the nation. As a simple example, a Dollar General (DG) store might trade hands at a 7.5%-8.5% cap rate today, with expectations of near double-digit annual cash flow yield.

For high-quality Manhattan properties near a bull-market peak, buyers are often willing to receive just 3%-4% in annual cash flow yield due to liquidity and capital gains potential.

In which case, SLG’s current cash flow yield tells us we’re obtaining it at 50%-60% of fair value in a strong market.

Source: Yahoo Finance

This Is Our Conclusion. How About Yours?

SLG has its fair share of challenges, it’s true. But the market is cognizant of this.

We’re not ignoring the estimates of 25% rent decreases that could drive local rent prices lower. And there are unique risks associated with any geographically-concentrated REIT.

Even so, we believe SLG currently offers a convincing opportunity for those craving exposure to one of the most valuable, liquid, and popular commercial real estate markets.

As such, we’re upgrading SLG from a Hold to a Strong Spec Buy. We’re also adding shares to the Cash Is King Portfolio.

Source: FAST Graphs

Author’s note: Brad Thomas is a Wall Street writer, which means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.

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Disclosure: I am/we are long SLG, ESRT. 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.

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