A Fresh Look at Office Real Estate

We have updated our opinion of the five office real estate investment trusts we cover after taking a fresh look at the industry. Despite tweaking our fair value estimates, we are maintaining our no-moat and stable trend ratings for each of the companies. Although we agree that the central business districts where these companies operate face supply constraints, we think new construction can eventually come on line to correct any supply/demand imbalances over the long run. We would highlight SL Green Realty SLG as undervalued, as we think pessimism regarding a recent influx of supply in Manhattan is unwarranted. We consider Boston Properties BXP and Kilroy Realty KRC to be fairly valued.

We think Vornado Realty Trust VNO and Empire State Realty Trust ESRT, the two other New York City-focused REITs we cover, are also undervalued. Investors are spooked by concerns that the Manhattan market will become overwhelmed by supply additions coming from the Hudson Yards megaproject, Midtown Manhattan, and Lower Manhattan. Indeed, Hudson Yards represents one of the largest development projects in the United States and is scheduled to add more than 10 million square feet of mostly Class A office space to the Manhattan market once completed. Although we think these supply additions may cause a temporary overhang, we ultimately think New York City will endure as the premier hub for global talent, with new demand eventually emerging to absorb supply.

SL Green Realty is our favorite pick, as we fundamentally disagree with investor trepidation regarding the Midtown Manhattan submarket where most of its properties are located. These concerns stem from the belief that Hudson Yards will draw high-quality tenant demand away from Midtown, which has historically been Manhattan’s premier submarket. We think that there is enough demand from high-quality tenants to sustain the success of both submarkets and that the enviable location of its properties will continue to drive SL Green’s success. With the marquee $3 billion One Vanderbilt development also located in Midtown, we are encouraged by management’s continued belief in its core strategy. We view the shares as materially undervalued compared with our $100 fair value estimate.

Vornado is a New York-focused office REIT with a sizable retail portfolio. In addition to its New York portfolio, the company owns the Merchandise Mart in Chicago and 555 California Street in San Francisco. Vornado boasts a high-quality roster of office and retail tenants, which gives us confidence that the company will perform well despite supply additions in Manhattan. Vornado has notably made a concentrated bet by pursuing developments around Penn Station adjacent to Hudson Yards in a bid to benefit from the knock-on effects of the megadevelopment. With our fair value estimate at $68 per share, we view Vornado as undervalued.

Empire State Realty Trust, which also manages its namesake Empire State Building observation deck, owns a portfolio of mostly Manhattan office properties. This company has focused on redeveloping older building stock to attract higher-quality tenants and boost occupancy rates. While this strategy has been mildly successful, the company still possesses a portfolio of lower quality compared with the other office REITs we cover. Nevertheless, we think the magnitude of investor pessimism surrounding Empire State is unwarranted, and we consider the shares to be undervalued compared with our $15 fair value estimate.

Boston Properties is the largest office REIT we cover, operating in five of the largest coastal U.S. markets. In addition to its geographic diversity, the company has diversified its sector exposure, serving high-quality tenants across different parts of the economy. In the most recent cycle, Boston Properties has focused heavily on development, recently completing the Salesforce skyscraper, which has left an indelible mark on San Francisco’s skyline. Although we think the company’s prospects are solid, we view the shares as fairly valued with our fair value estimate at $139.

Kilroy Realty is a West Coast-focused REIT that has seen impressive performance in recent years amid a boom in technology jobs. Although we applaud management for repositioning its portfolio to take advantage of the tech-driven growth, we worry that it is making an overly concentrated bet and could struggle, should the sector experience difficulties. Nevertheless, we expect Kilroy to continue to post impressive rent growth figures as supply struggles to keep up with demand all along the West Coast. With our fair value estimate at $82 per share, we think the market has fully appreciated Kilroy’s growth potential.