Vornado's Moving On Up

We were pleased with rental rates surrounding Penn Plaza, which climbed into the upper $60s per square foot in 2016 and the first half of 2017. We see this positive trend continuing, as half of lease expirations for 2018 are concentrated in One Penn and Two Penn Plaza, so next year serves as a real opportunity to renew leases at higher rates, given the greater appeal for that submarket.

We believe Vornado’s getting hit twice as hard as some of its peers in the past few months was unwarranted. Considering our outlook for its existing property position near the Hudson Yards project and a dividend yield around 3%, Vornado is trading at an attractive discount to our fair value estimate.

Vornado continues to sell assets as it looks to become a pure-play New York office and retail owner and operator. With single-digit vacancy rates for Manhattan’s office market, Vornado will be well positioned to attract top tenants willing to pay some of the highest prices per square foot in the country. It is poised to take advantage of Manhattan’s newest growth area with 6.5 million square feet of office space just east of the upcoming Hudson Yards project. This project should bring added foot traffic to Vornado’s retail locations and increase asking rents for its office presence.

Vornado is almost unrecognizable from its nontraditional past, free of minority investments in fledgling retail businesses and currently focused on a historically profitable region that continues to attract top tenants willing to pay top dollar for the best in Class A office and retail property. Following the spin-off of its Washington, D.C., assets in July, Vornado will achieve almost 90% of its EBITDA from New York, where it currently maintains office space occupancy of more than 95% with properties in densely populated areas near key transportation and other highly desirable features. The company does have investments elsewhere in the country, specifically San Francisco and Chicago; they are performing well and are in well-located central business districts. The CBD exposure for Vornado is promising, as we view this as the main growth area compared with portfolios with suburban properties.

Vornado’s tenants are some of the best names in finance, consulting, and technology and represent the ideal tenants for Class A office space. Additionally, these large and financially sound companies typically have an established presence in Manhattan. While the West Coast continues to produce technology jobs, we are confident that Manhattan will maintain its status as America’s central business hub and its expansion will have a positive impact on Vornado’s existing portfolio.

Vornado Lacks a Moat The primary moat source for REITs is efficient scale, where the company operates in a market of limited size that is effectively and efficiently served by one firm or a small number of firms. Despite Vornado's focus on Manhattan, which commands some of the highest office rents in the nation, we do not see any indicators of competitive advantages for Vornado. Manhattan contains about 400 million square feet of office space, and Vornado makes up only about 5% of the market. The depth of the market means there are numerous substitutes available for Vornado's Class A office space, and it is typically undifferentiated, meaning the competitive intensity for tenants is high. Given the broker-driven nature of the market, tenants have ample opportunity to compare space on features and obtain lease terms that suit their needs, and they will often leave for new buildings once leases expire due to better terms.

Supply and vacancy dynamics indicate a lack of pricing power for Vornado. New York CBD office space currently has approximately 45 million square feet of vacant office space with flat to slightly negative net absorption, meaning that supply is adequately meeting incremental demand. At current rates, we estimate that absorption will not close the gap on available office space over the next 10 years. In addition to the existing supply glut, the Hudson Yards project aims to bring 10 million-12 million square feet of more space, leading to further concern about the supply/demand outlook.

Recent leasing activity reveals that rent per square foot for Vornado’s properties is largely in line with market rates; thus, we do not see a difference between Vornado and its competition in terms of commanding a premium. Among Vornado’s competition are projects on the outskirts of densely populated areas, effectively expanding into new neighborhoods that attract workers away from the traditional areas of Manhattan and into new developments. Additionally, the high cost of development in the region ($1 billion-plus for trophy properties) provides a pricing umbrella for profitable redevelopment of older properties to meet the market’s needs. Redevelopment is a cost-efficient way to upgrade Class B properties to Class A status without demolishing a skyscraper. The owner can then inflate asking rent, increasing competition for Vornado and its Class A competitors. Manhattan office space has ranged between 380 million and 400 million square feet for the past 25 years, with projections reaching 410 million by 2020. Therefore, we see annual incoming supply at below 1% of current inventory, giving us more reason to believe that property owners will rely on renovations to bring more Class A office space to market in the near term. Class B office property in Manhattan can typically rent for $45-$55 per square foot, so we are seeing more property owners injecting tens of millions of dollars in renovations to bring their buildings to Class A level, where they can usually command rent in the $70 and up range. Therefore, new entrants could either build or redevelop identical properties at similar rates of return as Vornado.

The New York market is largely broker-driven and controlled, to a substantial extent, by brokers such as JLL and CBRE, which act on behalf of potential tenants. Companies seeking new office space reach out to the brokers with their needed criteria, price points, and desired features, and the brokers provide a list of properties to choose from. As a result, Vornado has minimal opportunity to directly influence leasing decisions, and leasing terms tend to be specified to meet client needs and reflective of current market rates coordinated through the brokers. Even an average lease length of 10 years for Manhattan office properties does not provide Vornado with switching costs, though it does help with overall stability of cash flows. These lengthy contracts also keep costs associated with attracting new tenants low. These can include anything from leasing activities, remodeling space, concessions, and lost revenue due to vacancies. While average lease lengths of 10 years for its Manhattan office properties provide recurring cash flows, they also lock the company into market rents for a long time, eliminating opportunities to realize lucrative leasing spreads. For example, we view the properties east of Hudson Yards as having the potential to significantly increase rent, although much of that coincides with lease expirations for the individual tenants in those buildings. Therefore, with longer leases, Vornado surrenders some opportunities to capture value in recovering markets and could be stuck with below-market rents for quite some time.

We do like several areas of Vornado’s portfolio in terms of growth prospects, but even trophy properties struggle to earn excess returns, given their enormous development costs. Certain costs have outpaced asking rents over the past several years. In 2011, concrete costs (including labor) were approximately $75 per foot; they are now approximately $90 per foot. The main concern going forward lies in the increasing cost of labor, given the rebound in multifamily construction over the past several years. We view the real opportunity for Vornado in the expansion of Manhattan’s far West Side, where the Hudson Yards project is attracting a new wave of tenants. Vornado has approximately 6.5 million and 455,000 square feet of office and retail space, respectively, a few blocks east of the upcoming $20 billion project, which should finish around 2023. While rents in the newly constructed towers should approach $100 per square foot, Vornado’s existing position should also capture value in the form of higher rents in the newly developed region, which is projected to bring 65,000 visitors a day and become one of Manhattan’s highest-growth areas.

Vornado’s high-end retail portfolio is among the best in Manhattan. It has 15 buildings with retail leases over $1,000 per square foot since 2013; no other company has more than eight for that period. Additionally, its retail portfolio is diversified across Manhattan, with 31% along coveted Fifth Avenue; 25% around Penn Plaza, which is perfectly positioned to benefit from the Hudson Yards project; 14% in Times Square; and the remaining 30% scattered across other lucrative areas, such as Madison Avenue.

We attempt to approximate Vornado’s economic returns through analyzing its adjusted return on invested capital. We accomplish this by adjusting our traditional ROIC calculation to include only an estimate of economic depreciation, which we approximate as annual operations capital expenditures, instead of accounting depreciation. By these steps, we calculate that Vornado has earned an adjusted ROIC slightly below its 6.9% weighted average cost of capital in recent years. While historical results might be obscured by a significant level of transaction and development activity, we expect adjusted ROIC to hover slightly below and above WACC over the next 10 years.

Big Bet on the Big Apple With new efforts to focus its portfolio on Manhattan, Vornado has essentially put all its eggs in one basket. While we view the area as promising, it's important to note westward migration caused by the increasing number of technology jobs in recent years. Vornado has exposure to San Francisco in its 555 California St. property, although this accounts for just 1.8 million square feet of rentable space in a city that has 50 million square feet and counting. Once driven by jobs in financial services, Manhattan has reached something of a ceiling in terms of attracting talent, with more millennials fleeing to West Coast tech positions. The most significant risk for Vornado is price-cutting among its competition in the highly fragmented office and retail space market. With staggering lease expirations, building owners are constantly trying to lure tenants with better pricing and more concessions.

A common concern among office REITs is the shrinking supply of the labor force. Fewer workers translates to a decreasing need for office space. Office and retail space providers depend on the macroeconomy, and there are concerns that the United States simply does not have enough qualified workers to backfill the aging baby boomer generation, the members of which are retiring in higher numbers. The labor force (ages 25-54) is projected to grow less than 2% from 2012 to 2022, versus growth of over 11% from 1992 to 2002.

Also affecting demand is the increasingly popular free-address concept used by many accounting and consulting companies, which are several of Vornado’s key tenants. While this practice is used by more client-focused companies whose employees typically bounce from office to office, it could gain popularity among companies looking to trim the amount of space they need.

As a REIT, Vornado is required to pay out at least 90% of its income as dividends to shareholders. We anticipate that management will increase the annual dividend, but not until it completes some reshuffling within its portfolio of properties. We also think the company will continue to tap the debt markets as its main source of financing, given its healthy appetite for expensive developments and cheap access to capital. Management continuously evaluates the portfolio and sells assets, which allows it to subsidize developments and not become overburdened with debt. We view the balance sheet, flushed of nontraditional investments, as a key driver of the company’s growth efforts.