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The Strain Is Showing for NYC’s Two Biggest Office REITs

The pandemic, followed by an economic downturn, has created a perfect storm for the office market. The national office occupancy rate passed 50 percent for the first time since the pandemic began. But it’s been a long slog to reach that milestone, and occupancy numbers are still low compared to pre-pandemic levels. There are signs of resilience among office REITs amid this turmoil, but the overall outlook remains grim.

The Hoya Capital Office REIT Index tracks 23 such REITs, and they say that despite the pandemic, office leasing activity and REIT earnings have been surprisingly resilient. But recent data is indicating occupiers are increasingly shortening lease lengths and sizes. Companies won’t pay for half-empty space indefinitely, and they’ve been using the weak market to negotiate generous concession packages.

The fact that many are bearish on office REITs isn’t breaking news, of course. The sector has struggled since early in the pandemic. For example, Boston Properties’ stock is down nearly 34 percent from last year, and despite robust leasing activity, its occupancy numbers are falling. From June 30th to September 30th last year, Boston Properties lost 60 basis points in occupancy. No matter how resilient that REIT is, it’ll be difficult to deliver a strong financial performance if occupancy rates keep sliding. Boston Properties is leaning into life sciences to weather the storm, but remote work remains a fierce headwind.

The office REITs facing the most pressure are ones heavily focused on gateway markets like Chicago, San Francisco, New York City, and Los Angeles. In other words, REITs like Boston Properties, Vornado Realty, and SL Green might struggle the most. Prospects for office REITs more focused on the Sunbelt and secondary markets are looking, well, sunnier. One example is Highwoods Properties, a REIT focused on offices in the business districts of markets like Raleigh, North Carolina, Nashville, Orlando, and Charlotte. 

Highwoods’ focus on southern cities has led to better performance, as their preferred markets have seen some of the nation’s highest employment and business growth. Despite also taking some hits, Highwoods has had one of the best financial performances of any office REIT since the pandemic started. For office REITs that are heavy on high-population gateway markets, there’s speculation their valuations could fall below that of even more troubled sectors like Class B and C malls. 

Tangled up in Penn  

One office REIT that is particularly caught in the middle of the post-pandemic storm is Vornado Realty Trust. Vornado operates nationally, including in markets like San Francisco and Chicago. But its main investments are in New York City, where it generates 83 percent of its net operating income and is the city’s second-largest commercial landlord. Vornado is especially focused on Midtown Manhattan, where it manages or owns more than 19 million square feet of office space.

The impact of the turbulent office market recently led Vornado to decrease its quarterly dividend by 29.2 percent, climbing interest rates and questions over the long-term demand for office space create further challenges. Vornado will likely face declining office utilization rates and many occupiers are struggling to justify their existing leases. The REIT has more than one million square feet of office leases expiring this year, and it expects to re-sign only about half of them.

These challenges prompted Fitch Ratings to downgrade Vornado to BBB- last summer and forecast a negative outlook. One concern for the REIT is its aggressive spending on development. Vornado is a key stakeholder in the project to revitalize the Penn Station area in Midtown Manhattan. Before the pandemic started, a project of this scope would seem to be a no-brainer. But times have changed. Vornado has committed $2.4 billion to the Penn District plan, which will significantly increase the office space in the area at a time when office demand is softening. The Penn District project is a major long-term commitment, expected to develop over the next decade. Vornado’s development costs rose from $270 million in 2021 to $420 million last year. Due to the rise in construction costs, there’s the risk the REIT’s development expenditures could keep swelling and could lead to a weaker return on investment.

The Penn District project is already underway. Vornado CEO Steve Roth said during the firm’s 2022 third-quarter conference call that the Penn 1 lobby and amenities are complete, and the Penn 2 building facade is coming along. “Broker and tenant reactions have been truly outstanding,” Roth gushed. Hotel Penn is coming down with demolition scheduled for the fourth quarter of 2023. But there are also indications that Vornado is pumping the brakes. Roth said the company was “cautious” about construction going into 2023, but he didn’t discuss whether that would alter the Penn District plans. “I must say that the headwinds in the current environment are not at all conducive to ground-up development,” he said. A promised tax break from New York could help move things along. Vornado could secure up to $1.2 billion if all the sites around Penn Station are developed, according to the watchdog group Reinvent Albany.

Vornado is also reportedly considering a prized New York City casino bid. They’d look to build the casino near Madison Square Garden at the site of the soon-to-be-demolished Hotel Penn. The company, which rarely speaks to the press, even broke its silence and offered a comment. A spokesperson said Vornado is studying the possibility of applying for a license but currently has no deal in place. If Vornado decides to apply, it would face off against SL Green and Related Companies, among others, for one of the coveted licenses.

Storm clouds over yonder

Vornado’s capital structure is also a concern. The REIT has more than $3.5 billion of floating-rate debt, another aggressive strategy given the rising interest rates. Floating rate debt gets more expensive as interest rates rise, so Vornado may face the double-whammy of higher interest expense and falling property values. “Vornado has to be careful with spending on development versus paying down debt,” said Peter Siciliano, a director at Fitch Ratings. This is one of the reasons Fitch views Vornado’s leverage as above their sensitivities.

It’s not all bad news. Vornado’s office portfolio has some of the highest-quality buildings in Manhattan, and they’ve been the beneficiary of record-high rents for prime assets. Like fellow New York office REIT and rival SL Green, Vornado is at the forefront of Manhattan’s flight to quality trend. Vornado’s trophy assets include 731 Lexington Avenue and the 1290 Avenue of the Americas. It also owns and manages the Bank of America Tower in San Francisco. 

JLL reported 190 leases of at least $100 per square foot in Manhattan last year, and Vornado has reaped some of these rewards. Its buildings by Penn Station have signed tenants, with 300,000 square feet leased at the Penn 1 building alone last year. Bloomberg has leases rolling at 731 Lexington Ave. in 2029, and Vornado may court them for the replacement tower at Penn 15. Apple is also Vornado’s tenant at Penn 11, another possible candidate for Penn 15. 

The recent wave of tech layoffs could be a concern, but perhaps not a major one. Vornado signed Meta to a 700,000-square-foot lease at The Farley Building in 2020, the largest New York office deal that year, but Meta is now notably shrinking its office portfolio. Though Meta hasn’t backed out of the Farley Building, it did recently vacate 250,000 of office space at Hudson Yards. Meta also recently laid off nearly 900 employees in Manhattan, including workers at the Farley office. Fitch analysts told me they’re not overly concerned with Vornado’s exposure to tech tenants, but whether Meta second-guesses the Farley lease is a question moving forward.

While the outlook for Vornado is generally seen as negative, there’s a mixed bag of strengths and weaknesses. Despite its stock price taking a major beating, Vornado’s third-quarter revenue in 2022 came in stronger than expected. Compared to the second quarter, total office leasing in the New York market was down 134,000 square feet. But Vornado reports approximately 1.5 million square feet of leases in advanced negotiation stages with primarily new and expanding tenants in non-tech sectors like private equity and financial services. Vornado’s recent dividend cut will help its cash flow this year. And the company also has strong liquidity going into 2024, with $3.3 billion at the end of 2022’s third quarter and few near-term debt maturities.

Last year was brutal for office REITs, and 2023 will likely be another challenging one. Vornado is faring similarly to other office REITs like rival SL Green, but it’s not exactly the best company to be in right now. SL Green’s stock is down more than 43 percent compared to last year, at levels not seen since 2009. Vornado’s stock price has also plummeted nearly 41 percent since last year. SL Green reported a net loss of $93 million for all of 2022, its occupancy rate fell noticeably at the end of December, and it signed far fewer leases in the fourth quarter of 2022 than it did in the fourth quarter of 2021. 

SL Green CEO Marc Holliday put a positive spin on his company’s 2023 outlook during its recent earnings call, but the cracks are showing. High vacancy rates across Manhattan, where Vornado and SL Green are the biggest office landlords, are putting downward pressure on rents and increasing the concessions required to retain tenants. Like Vornado, SL Green was also recently downgraded to BBB- by Fitch Ratings and was given a negative forecast. 

A recession could make things worse, further softening office demand as layoffs mount among occupiers. For REITs like Vornado and SL Green, their top-quality portfolios may act as a buffer against the headwinds. Having a trophy asset like One Vanderbilt certainly helps SL Green, which now represents 14.3 percent of its annual rent share, but it can’t cover everything. Because of the nature of most office leases, when demand is down, the performance of REITs lags behind the downturn. Vornado rents out its office space for 11 to 13 years on average, so it somewhat insulates it from swings in office demand. Vornado and SL Green have remained resilient thus far, but more leases are expiring. If smaller office lease sizes and lengths are here to stay, that storm out on the horizon could be approaching New York’s biggest office REITs sooner rather than later.

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