Vornado Realty Trust Shares (NYSE: VNO) have been hammered over the past year as questions persist over the viability of office space. In addition, rising interest rates have affected a wide range of real estate stocks and, given the nature of its debt, VNO is particularly exposed to it. Although the shares offer an outrageous dividend yield of 9.5%, this payout is not well hedged in the future and investors should be cautious.
In Vornado’s second quarter, it earned $0.19 and generated adjusted funds from operations (AFFO) of $0.83, which was actually an increase from $0.69 last year. Net operating income increased 7.1% from a year ago and 8.4% on a comparable basis, as several commercial leases started and the environment improved compared to it a year ago when many sites and offices were still closed due to COVID. As the overwhelming majority of VNO’s operations take place in New York, it has felt the impact of the pandemic hard.
One thing that has helped his business is that office leases tend to be quite long. While you typically rent an apartment for a year, Vornado rents its offices for an average of 11-13 years. This helps to insulate its business somewhat from fluctuations in demand for office space. It also means that during a period of declining demand, VNO results will lag the downturn. In other words, they will remain resilient until the leases expire and will not be renewed. We may be starting to enter this cycle.
Office occupancy in New York fell to 92.1% from 92.2% at the start of the year. The total occupancy rate in New York rose from 91.3% to 90.8%. Given the nature of its long-term leases, occupancy will be very slow. However, Vornado has over 1 million feet of (ex-Penn) office space expiring next year, and it expects about half to re-sign. This could reduce office occupancy by around 2-3%. Over the next two years, VNO will face the headwinds of a declining office market.
Ultimately, part of your perspective on VNO will come down to where you think “back to the office” and “remote work” end. Although it has increased, office occupancy is still low in New York at 48%. While many businesses have a hybrid schedule (which seems to be a widespread norm), over time they may seek to rationalize their real estate space. Do you really need 100% of the space if you never have more than 75% of your employees in the office on any given day? While the outlook isn’t as bleak as when occupancy was 25%, 48% is still well below VNO’s 92% occupancy. Given the high quality of its buildings, VNO should be able to outperform the commercial real estate market, but re-letting over the next few years could gradually strain cash flow.
If there is an economic downturn in the next year, businesses will likely be looking to cut real estate costs as space is underutilized. Also, if the numbers go down, there is simply less need for as much space. We see this weakness developing nationwide. According to the National Association of Realtors, the office vacancy rate has increased over the past year and rent growth is very slow. It is the big laggard of the commercial real estate sectors.
While I see challenges for its existing real estate portfolio, what worries me is that Vornado is expanding aggressively as it is a key player in the Penn District project to revitalize the Penn Station area of downtown Manhattan. Vornado has committed $2.4 billion to this plan, which will significantly increase office space in the region. With office demand already facing headwinds, the quality of this project, or whether it simply cannibalizes existing buildings, is a major unknown. VNO is spending aggressively, and in the first half of this year, development costs have risen from $270 million last year to $420 million. Given rising construction costs, there is also a risk that this megaproject will become more expensive and result in a lower return on investment for VNO.
Beyond the headwinds facing VNO’s core real estate rental business, I’m concerned about its capital structure. The company has more than $3.5 billion in floating rate debt. This is an aggressive strategy because long-term interest rates help determine property values. As rates rise, properties are worth less, but if a property owner borrows through long-term fixed rate debt, the benefit on debt covers the lost value of the property. Variable rate debt is more expensive as rates rise, so not only are property values impacted, but VNO faces higher interest charges. This double whammy will be evident as higher rates trickle down to interest charges. Compared to the second quarter, this will represent a headwind of more than $140 million for the company over the next year, reducing revenue and FFO by approximately $0.80. Additionally, $750 million of floating rate debt is hedged through October 2023, but will then float, increasing the impact thereafter.
Right now, its quarterly dividend of $0.53 looks well covered by $0.83 in AFFO. But holding everything constant, given rising rates, AFFO will fall to $0.63 next year, offering just 1.19x dividend coverage and leaving little cash flow to fund its large growth expenses. , meaning it will rely on additional debt financing at a time. higher interest rates. If occupancy drops another 2% next year, that will have an additional $0.05 impact, leaving the company dangerously close to not having enough AFFO to cover its dividend.
Because of its balance sheet policy, you don’t have to believe that the office market will weaken so much for its dividend coverage to come too close for comfort. Now, if you think the Fed will flip-flop soon, then that higher interest charge will be a short-lived factor that Vornado can push through. Because much of its debt is floating while its leases span a decade, VNO’s cash flow is more quickly affected by rates than office market conditions. Given rising rates, this creates a significant short-term headwind, while weak demand for office space will, in my view, be a significant long-term drag on equities. I actually think investors would be better off if VNO cut its dividend to pay more of its cap-ex with cash flow and reduce its leverage, but I view that as unlikely.
Now value investors can note that Vornado has a book value of $27.19 per share, a 20% premium to its current share price. This essentially implies that VNO’s real estate assets are worth $1 billion less than their book value, or about 10%. Given the higher interest rates and contested leasing demand, it doesn’t really seem dislocated to me. VNO risks being an asset with steadily declining cash flows, first as interest rates bite, then as its leases gradually expire and reset at lower rates, or are not renewed. at all. With about $2.20 in AFFO next year, stocks are trading at 10x.
Given the potential for continued downside, I would expect an AFFO return of 12% or $18.33 per share, which would also imply a 20% decline in VNO’s real estate assets from their load level. At this level, investors are compensated for the risk that Vornado is a “melting ice cube”. In the meantime, investors shouldn’t be sucked into the stock given its current dividend yield, which will see little buffer next year as higher rates weigh on cash flow.