The Buy Thesis

An investment in SL Green (SLG) offers a rarely seen blend of quality and value. Its properties are top-notch and its management is among the best of any REIT. These qualities are largely agreed upon, yet SLG trades at about 7X FFO and only 51% of NAV. The discount has been generated by a broadly-held misconception that SLG is extremely high leverage. Let us begin with an overview of SLG’s portfolio and operations and follow with a discussion of the NYC office outlook.

Portfolio Overview

SLG owns a large portfolio of Class A and trophy office assets concentrated in New York City.

Source: SNL Financial

It also has a small number of multifamily assets and uses the first floors of many of its office properties for retail which is a common practice in NYC.

NYC Office Outlook

New York office is going through a challenging period as NYC was among the hardest-hit areas by COVID and the city remains partially shut down. Even as offices have been allowed to reopen at reduced capacity, many workers are choosing to continue working from home as the public transportation required to get to the office remains dangerous with regard to COVID spread. It will likely be a challenging operating environment for the next few quarters until a vaccine is ready for widespread use.

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We own SLG with full awareness that there will be some bumps and I think the bumps are already more than priced into the stock.

More important to me is what happens to NYC office after COVID and for this we can turn to fundamentals. NYC had excellent demand growth coming out of the financial crisis and supply did not keep up which caused the price of existing properties to rise dramatically.

NYC office price growthSource: Marcus & Millichap

Price per square foot soared from $400 in 2010 to just over $600 in 2019. At this new price point, development started to look quite attractive and supply growth started to pick up. Demand growth remained robust in 2019 and was forecast to be strong in 2020 (prior to COVID), but new supply of about 20mm square feet in 2019 and 2020 combined is likely to cause a slight increase in vacancy. Given that COVID is preventing or delaying the incoming demand, the increase to vacancy will be a bit more substantial.

Net absorption followed by net supplySource: Marcus & Millichap

NYC was an excellent office market but given the uptick in supply it looks more like an average office market going forward. As the business hub of the world, NYC is likely to have perpetual demand generation, so over time it can absorb supply shocks and it will eventually recover from the demand dip resulting from COVID.

I think my outlook on NYC office is likely similar to that of other market participants. The key difference is in how we think this will impact SLG. Specifically, there are 2 factors that make me substantially more bullish than the market on SLG.

  1. Operational excellence
  2. Debt is not as high as people think

Operational excellence

Most REITs have the capability to hire skilled property managers, but the skill of SLG’s personnel is enhanced by focus and market share. SLG is the largest office landlord in NYC and their presence conveys advantages when it comes to leasing.

  • Tenants who need more space than their current building can accommodate can be referred to other SLG properties.
  • Deep market knowledge allows SLG to know exactly how far they can push rates without losing tenants.
  • Geographical concentration of properties helps SLG in cost efficiency of running the portfolio.

These advantages show up in the numbers. NYC was already a somewhat challenging market in the first quarter of 2020 due to supply, but it was still getting favorable leasing. According to the earnings release of SLG:

Signed 30 Manhattan office leases covering 316,154 square feet in the first quarter. The mark-to-market on signed Manhattan office leases was 12.6% higher for the first quarter over the previous fully escalated rents on the same spaces.”

The rollups on these leases caused overall same store NOI to increase mildly in the quarter.

Same-store cash net operating income, or NOI, including our share of same-store cash NOI from unconsolidated joint ventures, increased 0.7% for the first quarter”

In order to see how this compares to the market, we can look at Vornado (VNO) which is a fully capable operator. Its NYC portfolio had negative -1.9% same store NOI growth in 1Q20 year over year and -9% QoQ.

Source: VNO earnings

SLG’s operational advantages also show up in rent collection through the crisis.

As of June 1st per a press release

SL Green’s April rent collections reach 95.1% and May collections are at 91.1% to date; expects May collections to increase further, as some tenants are taking longer to make payments than they have historically.”

In contrast, Vornado only got 83% collection in April. We suspect April collections have improved slightly since then, but are still likely below the SLG number.

The idea here is not to pick on Vornado. VNO is not underperforming the NYC office, rather SLG is outperforming the NYC office.

SL Green’s Leverage

Some of the numbers are a bit shocking at first glance. SLG’s debt + Preferred to total enterprise value is 79.56%.

Appearance of high leverage for SLGSource: SNL Financial

Debt to gross properties is at 73.38%.

Apparent high leverage at SLGSource: SNL Financial

On either metric this is very high and I think the market is seeing these metrics and concluding that SLG is a heavily debt-burdened REIT. When this perceived high debt is combined with the genuine challenges of the office sector in this crisis, it is understandable that the market is fearing SLG. With so many market participants regarding SLG as dangerous at this time, shareholders have fled to the hills causing SLG to drop 45% or nearly 3 times as far as the REIT index.

Source: SNL Financial

If SLG was as leveraged as those metrics make it look, I think this would have been the appropriate response. However, those metrics are severely distorted and upon looking deeper it is clear that SLG’s balance sheet is quite healthy.

How is Debt + Preferred to EV Distorted?

Enterprise value is affected by market price of the stock. If a stock falls to $0, debt + preferred to EV will be essentially 100%. SLG’s stock fell about 50% from its highs which severely diminished the enterprise value as it is calculated. A stock price falling does not increase the company’s leverage, it merely increases the appearance of leverage as this metric uses market capitalization as an input for the denominator.

How is Total Debt / Gross Properties Distorted?

This metric correctly does not use market prices so it does not become distorted by changing stock prices, but it instead gets distorted by the interaction of GAAP accounting rules with a changing fundamental environment. Certain GAAP accounting rules are highly unfavorable to REITs, causing debt to consistently appear higher as a percentage of assets than it really is.

Most are familiar with how depreciation affects REITs and know that book value of assets is not the right number to use as REIT assets usually maintain value far better than the depreciation schedule implies. This metric uses gross properties, so it correctly avoids the depreciation issue, but it still runs into the problem of one directional impairment.

Under GAAP accounting, when an asset is impaired its value will be written down on the balance sheet. However, when an asset increases in value there is no accounting entry to increase its value on the balance sheet until the asset is sold. When looking at a portfolio of assets, some succeed and others do not perform well. Those that fail get impairment charges, reducing their balance sheet value and those that succeed are still recorded at purchase price as far as the “gross properties” metric is concerned. Thus, while the successes balance out the failures in actual value they do not balance out on the balance sheet.

In SL Green’s case, the successes massively outweigh the failures in terms of actual value. Recall the chart from earlier in this article showing that since 2010 the price per square foot of NYC office assets increased from $400 to just over $600. Well, SLG’s portfolio consists of a substantial number of long tenured trophy office towers in NYC. The actual value of the properties has increased dramatically beyond the gross property value recorded on the balance sheet. Therefore, the debt as a percentage of actual asset value is far lower than it appears based on this metric.

As evidence of this, SLG just closed on a $510mm mortgage on the News Building which it acquired in 2003 for $265mm. Mortgage lenders in this environment are unlikely to lend at extremely high loan-to-value so we can anticipate the value of that building was deemed to be somewhere around $800mm. This property has nearly tripled in value since SLG bought it.

So now that we understand the inaccuracies of these metrics, what does SLG’s leverage look like?

As of 6/1/20, SLG has $1.18B of cash due to a couple asset sales.

Substantial cash reserves at SLGSource: SLG REITWEEK presentation

The cash balance along with the asset values allowed it to secure an investment grade rating. As of 6/1/20, SLG has a BBB credit rating from Fitch.

Source: SLG presentation

And it maintains a BBB- from S&P.

Source: SNL Financial

To us, the most important debt metric is EBITDA coverage of interest expense as it is a measure of the sustainability of cash flows. SLG’s debt interest coverage has improved nicely to 3.72X which is a reasonably healthy level.

Source: SNL Financial

EBITDA will likely decline a bit during the crisis but there is enough of a cushion here that we don’t foresee issues. Once the economy normalizes we would anticipate this ratio springing back up to the high 3X range.

Valuation

Most REITs have pulled their guidance because of the murkiness of the shutdown and uncertainty of when things will reopen. SLG is among few that still has official guidance and it was able to put out guidance because its rent collection is sufficiently high that it has decent visibility. The challenging environment has dropped guided FFO to a range of $6.60 to $7.10 with most of the damage coming from a couple of impairments in SLG’s debt/preferred investments and reduced revenues from holding so much cash on the balance sheet.

Quite simply, when a company is holding $1B in cash, that money is not generating the revenue it used to before the sales completed. Once the economy stabilizes, this cash will be put back to work in a combination of share buybacks and debt paydown which should spring FFO back up to the low $7 range.

At a market price of $48.73 this puts SLG at about a 7X FFO multiple. This is extraordinarily cheap relative to history. Below is a chart of SLG’s FFO multiple over the past 5 years.

Source: SNL Financial

SLG is a blue-chip REIT and it used to trade as such with a multiple usually in the 15X to 20X range.

The fear caused by the combination of COVID and the market’s perception of high leverage is causing SLG to trade at an unprecedentedly low multiple. We view this as a great opportunity to get into a strong company at an unreasonably low price. We own SLG fully aware that the NYC office market is challenged from the combination of heavy supply and the work-from-home environment inspired by COVID. However, strength tends to prevail. Its assets are largely trophy caliber properties in one of the highest demand office markets in the world. SLG’s management has proven its stewardship of shareholder capital through salary cuts and accretive share buybacks. SLG will survive and I think it is likely that in 3 years it is once again regarded as a blue-chip REIT.

Once the fear subsides and the environment normalizes, we see minimal impediments to a much higher FFO multiple. Even at the low end of its normal multiple range it represents a double. This fair value estimate is backed up by NAV as SLG is trading at about half of NAV.

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Disclosure: I am/we are long SLG. 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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