“Grief is nature’s most powerful aphrodisiac” – Chazz Reinhold (Will Ferrell), Wedding Crashers (2005).
Back in 2005, I watched in disbelief while apartment leases were being broken left and right as residents began to purchase homes at a frenzied pace. While the economy boomed, the apartment industry suffered. Now, some have begun to whisper about the formation of a new bubble stimulated by the zero-rate environment established by the Federal Reserve to prop up an economy battered by the pandemic. In a surreal world where low wage service workers struggle to pay rent, more affluent renters have the sugar rush of cheap money to feed a new home-buying surge. Throw in a desire for more space to work from home and host dinner guests in the backyard, and buying a house… well, as Owen Wilson would say, “just, wow”.
Back in August (which was eight months ago in pandemic time), I decided to look at quarterly results from publicly traded apartment owners to gain insights into where the market was heading. Third quarter results have been posted, so I revisited three of the biggest apartment real estate investment trusts: Equity Residential (EQR), AvalonBay (AVB) and Mid-America Apartment Communities (MAA).
The stocks have continued to trade at discounts to their March peaks and their dividend yields exceed 3%. The announcement of a vaccine breakthrough earlier this week sent the stock prices higher by 10%. The recent price increases have largely erased the deep discounts to net asset values, but they remain attractive as liquid income-producing investments. Their dividends are well-funded, leverage is manageable, and it is hard to envision further downside. EQR is the riskiest of the three because of the company’s high exposure to struggling urban markets, but MAA remains the star of the group due to its focus on sunbelt cities.
The attached article contains brief comments on the quarterly results, a numerical comparison of income and asset values as well as a back-of-the-envelope “stress test” to determine the safety of the dividend payments. Finally, I offer a few observations on the Omaha market where home purchases have caused increased turnover and vacancy.
Sunbelt Success Continues
Mid-America exhibits the divergence in the apartment industry: urban coastal cities are losing residents and many are relocating to dynamic growth centers in the south. As they had in August, executives exuded confidence in their quarterly call. Occupancy exceeded 96% and traffic was positive. Rent growth was muted due to increasing supply and competition from home purchases but remained positive. MAA is a standout performer because of its concentration in sunbelt cities throughout the southeast and Texas. The stock has nearly recovered its losses for the year.
Suburban vs. Urban
AvalonBay and Equity Residential noted positive leasing trends during October but reported that rent declines and move-outs exceeded expectations in urban markets, particularly Manhattan, Boston, and San Francisco. Rent declines surpassed 10% in big coastal cities. Occupancy dropped below 90% in central San Francisco – a stunning figure. Meanwhile suburban properties performed well. Overall occupancy at both firms was at the 94% level. At AvalonBay, rents declined 6% for the quarter on a year-over-year basis and 2% on a sequential quarterly basis. At EQR, rents declined 7.5% for the quarter on a year-over-year basis and 2.7% on a sequential quarterly basis. Collections remained strong – above 97%, but turnover increased. There were some glimmers of hope in the New York City core where major rent discounts and incentives have enticed bargain-hunters to seek upgrades within the market.
Similar Trends in Omaha
In large measure, the observations made by the leading apartment executives on their earnings calls mirror our experience in Omaha. Occupancy levels which had been above 95% for the past two years have fallen dramatically over the past 90 days – approaching 93% in many areas of the city. Effective occupancy may be even lower as one month of free rent has become a common incentive.
Home Purchases Pressure the Top End
The top end of the Omaha apartment market has been hammered by an acceleration of home-buying. Low interest rates are spurring a race to purchase houses despite rising costs amid a tight inventory and expensive lumber prices. There is a 2005-feel to the environment with a high number of lease-breaks. It has not reached a mania level, but loose credit has allowed buyers to emerge who probably wouldn’t have qualified for a mortgage at the beginning of the year. In certain submarkets, added new apartment supply is also depressing the leasing environment.
More Space
All three firms have noted an increase in demand for larger apartments as working from home seems to have spurred a choice for bigger apartments. Studios are difficult to rent across the country, and Omaha is no exception. EQR reported that many of their Manhattan buildings have experienced transfers to larger units within the same property.
Students and Lower-Income Challenges
EQR and AVB reported serious challenges in their Boston and Cambridge properties due to a lack of students in the area. Omaha is no different. Although UNO has strong enrollment figures, many have opted to remain at parents’ homes. International students are a major driver of central Omaha apartment demand, and they have not returned. Rent delinquencies had vanished over the summer, but have made a growing re-appearance as stimulus payments have been exhausted. Workers in the service sector are seeking assistance once again. Delinquencies are not catastrophic – probably running 1%-2% higher – but the trend is worrying.
Stress Test
Last quarter, I used a hypothetical 5% income decline to determine whether the firms could continue to fund their distributions. I increased the pressure to 10% this time around. The dividends appear safe but would certainly come close to being curtailed in such a scenario. It should be noted that the 10% reduction of rental income was taken from an annualized rental figure that already incorporates two quarters of rental declines. The annualized figures are simply the aggregation of results through September 30, 2020 plus an assumption that 4th quarter results will match those of the 3rd quarter.
Note: This article contains the opinions and observations of the author. No investment recommendations are being provided and no representations are made to the accuracy of the content provided.
Bert Hancock
November 12, 2020
The Covid19 pandemic has caused distress in hospitality and retail assets, but apartments have largely been spared. However, a subset of the multifamily sector has been placed under pressure: student housing. University enrollments had already been declining steadily over the past 8 years and the pandemic has accelerated the decline. Indeed, demographic trends foretell an ominous future around the year 2026 as the peak level of children born in 2008 pass through college. High school graduations will peak in 2025.[1]
University enrollments have declined by 1.8% nationally according to the National Student Clearinghouse Research Center. Generally, enrollment is better than many had feared in April with enrollment posting gains at many public four-year institutions. Meanwhile, enrollment at many private institutions has dropped significantly. International enrollment is down 11.2%. Although student participation is better than expected, the prevalence of virtual learning means that many campuses are ghost towns. The loss of international tuition and housing revenue has added to government budget cuts to produce a shortfall in higher education that exceeds $120 billion by some estimates. For further reading, Michael Nietzel at Forbes has a grim look at the budget cuts hitting colleges across the country. I recommend his articles.
The pressure on universities translates into a rough environment for student housing providers. With empty rooms at many campuses, mortgages secured by the housing are now among the rising list of economic casualties. Commercial mortgage-backed securities secured by the loans to student housing complexes have shown a significant increase in delinquencies.
Source: Trepp Research
Trepp Research has highlighted the Wolf Creek Apartments in Raleigh, NC which serves North Carolina State University and The View at Mongomery serving Temple students in Philadelphia as two of the largest distressed assets, with $43 million and $83 million mortgage balances outstanding respectively.
Fitch Ratings had already warned about the possibility of an oversupply of student housing in 2016:
“Even prior to the pandemic, student housing was identified as a subsector of concern in the Fitch-rated CMBS 2.0 universe since 2016, due to the greater performance volatility and operational expertise required compared with traditional multifamily. Both student housing occupancies and property-level net operating income (NOI) performance have lagged traditional multifamily.”
In addition to supply concerns, Fitch noted that student housing carries the added risk of nearly 100% annual resident turnover and higher maintenance expenses.
While many retail and hospitality properties may never
recover from the pandemic, student housing will likely rebound. However,
long-term demographic trends will mean that universities will need to find ever
more creative ways to boost enrollment and fill housing.
[1] Justin Fox, Bloomberg, May 30, 2019. Fox relies heavily on the work of Nathan D. Grewe, an economics professor at Carleton College and his landmark study: “Demographics and the Demand for Higher Education”.
Commercial real estate is under pressure. Hospitality properties are in distress and many retail assets are struggling amid restaurant closures and the acceleration of online shopping. Thus far, long-term leases and high-quality tenant rosters have spared Class A office properties from pain. Second quarter results for major publicly traded office real estate investment trusts offer insights into the office markets of large cities, and their discounted stock prices appear to be attractive.
The second quarter results for three office REITs were reviewed for this report: Boston Properties (BXP), SL Green (SLG), and Kilroy Realty Trust (KRC).
Boston Properties is the nation’s largest office REIT with over 51 million square feet owned directly, and another 7 million owned through joint ventures. BXP has concentrations of properties in New York, Boston, Washington, D.C., Los Angeles and San Francisco. SL Green owns nearly 30 million square feet in New York City with roughly half-and-half split between direct ownership and joint ventures. SLG also holds nearly $1.2 billion of mortgages, mezzanine loans and preferred equity positions in other New York properties. Kilroy Realty Trust has over 17 million square feet based on the west coast. It has a larger suburban portfolio than the others, and its stock has performed comparatively well.
All office REIT executives believe their companies are well-prepared to weather the shift towards work-from-home arrangements. They have raised capital at low interest rates and bolstered their balance sheets. Lease expirations are minimal in the near term. Stocks are trading at considerable discounts to underlying asset values and offer hefty dividend yields. The ability to sustain dividend payments for the next two years seems likely and the discount to net asset values offers downside protection. Technology companies continue to lease new space. However, clouds hang on the horizon. A reduction in office floorplans seems inevitable. Financial firms may reduce headcounts as they reckon with tighter interest rate spreads and a rising collection of distressed assets in their portfolios. Meanwhile, working from home may not prove to be the revolution once envisioned in April, but certain jobs will remain permanently remote.
Note: This paper contains the opinions and interpretations of the author. No representations are made regarding the accuracy of the material. The views do not represent investment recommendations. All readers should perform their own due diligence before making an investment decision.
Occupancy and Collections of Rent in the Second Quarter
All companies collected over 90% of rents during the second quarter. BXP suffered from vacancy at its hotel properties, and both BXP and SLG reported rent collections only slightly better than 50% for their retail square footage. Yet office rent collections were better than feared. BXP and KRC collected 98% of office rents and 96% of SLG’s office tenants paid during the second quarter. Overall occupancy at the end of the June period stood hovered near 93% for all three firms. However, the actual staff presence in the buildings was minimal, with only about 10-15% physical occupancy for BXP and SLG and 25% for KRC estimated during late July.
Financing
BXP and KRC took advantage of the decline in interest rates to raise significant capital during the past six months while SL Green sold two assets for over $600 million to bolster the balance sheet. In August, Kilroy raised $425 million in senior notes at 2.5% due in 2032, and Boston Properties issued $1.25 billion in senior secured notes at 3.25% maturing in 2031. Kilroy raised $247 million in a March share offering. No new senior debt was issued at SLG, although a couple of properties were refinanced. Fitch did affirm a BBB credit rating for SL Green but revised its outlook to “negative”.
Shareholder Benefits
All CEO’s believe that their balance sheets are well-positioned for the next two years. Kilroy increased its dividend by 3% in August and SL Green purchased $163 million of stock during the second quarter.
Leasing Activity
Despite the pandemic, leasing activity did continue at muted levels. All three companies renewed about 1.5% of their portfolio with an approximate retention rate of 50%. BXP signed a major new lease for 400,000 square feet with Microsoft at its Reston, Virginia property. BXP and KRC have minimal lease expirations over the next three years with KRC at roughly 4% per year through 2022 and BXP closer to 6%. Kilroy has 85% of its space concentrated in low and mid-rise buildings. SL Green has minimal exposure in 2020 but faces a worrying 11% expiration level in 2021.
Kilroy and Boston Properties are bullish on markets where technology and life science businesses are showing resilience and even growth during the pandemic. While Facebook, Google and Amazon grab the most headlines, the emergence of laboratory needs in the biotechnology and pharmaceutical industry is equally fascinating. These companies are viewed as more likely to take up new space in coming years as the office environment remains necessary to foster collaboration and company culture. Both firms show interest in the Seattle market while BXP seeks further growth in the technology hotspots near the Los Angeles beaches. A notable bright spot during the doom and gloom of New York City’s pandemic challenges was Vornado’s signing of Facebook to a 730,000 square foot lease in the former post office building near Penn Station.
Development Activity
All three REITs have significant development activity which accounts for between 9-15% of the total square footage inventory for each company. While these developments pose risk should they fall short of targets, all CEOs noted that they had adequate liquidity to finish the projects. 90% of KRC’s pipeline is leased while BXP has 74% leased in their upcoming projects. SL Green has higher leasing risk, as was cited in the Fitch ratings downgrade, with 50% of new square feet committed. Among all three companies’ projects in development, the most prominent is the 77 story SL Green tower known as One Vanderbilt – a 1.5 million square foot building near Grand Central Station which is 70% leased and opens this week. The project is a landmark $3 billion asset. The opening generated enough excitement to propel the stock upwards by over 10%. SL Green is also partnering with a Korean pension fund on the $2.3 billion redevelopment of One Madison Avenue. The space is not scheduled for delivery until 2024. Kilroy is in a strong position with its development projects. KRC will soon be opening a 355,000 square foot building in Hollywood fully leased to Netflix and another 635,000 square foot building in Seattle 100% leased to a Fortune 50 company. Another 285,000 square feet in San Diego will come online in 2021 with 91% of the space leased.
Sublease Risks
One of the factors most likely to suppress future rents is the likelihood that surplus space is placed on the market by current tenants. These subleases become phantom vacancy that is nearly always offered at below-market rents. CEO John Kilroy did not view the subleasing environment as overly worrying. In reference to San Francisco in particular, he offered, “Sublease space in the market right now is about 5 million square feet… 2.3 million was added during Covid… to put that into perspective, the direct vacancy rate in San Francisco right now is about 5.4% and sublease is 2.5% of that. To compare that to the dot-com bust, direct vacancy was 8.3% and sublease space with 6.8%.” However, despite the CEO’s comments, Kilroy identified sublease space in its 10-Q, the first time in several quarters such information was broken out. 849,000 square feet in the portfolio was listed for sublease, or nearly six percent of the portfolio. About half the space was noted as vacant. In late July, DropBox announced it would list 270,000 sf for lease, nearly 1/3rd of its offices, in the newly opened Kilroy development in Mission Bay, San Francisco. Meanwhile, Boston Properties was impacted by the bankruptcy of Ann Taylor’s parent company which occupies 340,000 sf in Times Square. It would seem likely that even if a bankruptcy restructuring is successful, surplus space will find it’s way onto the market.
SL Green Challenges
SL Green is the most difficult office REIT to analyze. Nearly half of the company’s square footage is held in joint ventures which are not consolidated in the operating revenues and expenses. The company also has a complicated portfolio of first mortgages, mezzanine loans and preferred equity positions in various properties in New York. SLG also owns many properties encumbered by ground leases.
Indeed, some mezzanine loan positions appear to be under pressure. On September 2nd, it was reported that SL Green bought the $90 million first mortgage for 590 Fifth Avenue after Thor Equities defaulted on a $25 million mezzanine note. The property is a 19 story 100,000 sf building. The mezzanine business cuts both ways for SL Green. A distressed developer who falls behind on their mezzanine financing could present an opportunity for SL Green to pick up assets for the value of the first mortgage. In most cases, these will be bargain acquisitions. Unfortunately, the impairment of a mezzanine loan is in itself a damaging blow to the balance sheet and the need to muster capital to protect a junior debt position could require deeper pockets than the company anticipates.
While two asset sales reinforced cash positions, the failed $815 million sale of the Daily News Building in March offered an indication of the challenges valuing New York office assets in a post-pandemic world after Deutsche Bank pulled financing for the deal. SLG was able to refinance the property in June with a $510 million mortgage from a lender consortium. SL Green is also considering the sale of its two multifamily properties.
Investment Evaluation
SL Green has seen its stock hammered by the pandemic. Down by nearly 50%, SLG’s dividend yield exceeds 7%. Boston Properties has faced a 40% decline and offers a yield of 4.4%. Meanwhile, Kilroy lost 35% since its pre-Covid highs and yields 3.45%
In the process of evaluating the stocks, I made simple assumptions. Some may argue that these are too elementary, but the exercise was intended to discover whether the public market is significantly undervaluing the underlying assets by a wide enough margin to provide an element of downside protection. I was not intent on arriving at a precise valuation of the businesses.
My method was to annualize pro forma income simply by taking second quarter revenues and multiplying them by four. This may prove generous in the event further occupancy problems arise; it also is punitive for the companies. For example, the methodology assigns no future income for the Mission Bay/DropBox property placed in service. It also ignores the 70% occupancy of One Vanderbilt placed in service by SLG. It gives no value to the new BXP leasing in Virginia. In all cases, the exercise merely values the development assets at cost. The only upside “help” that was given by the author was a slight uptick in hotel revenues attributed to BXP during the balance of two quarters.
I capitalized the net income at 5.0% for KRC due to its high level of low and mid-rise buildings, 5.25% for BXP, and 5.5% for SLG. Certainly, before the pandemic, these cap rates would be considered high for trophy office properties in major urban areas. I added the cash on the balance sheet and subtracted debt to arrive at a net asset value. All in-progress development projects were added at cost. Joint venture assets were included in the income statement computations to the extent that they were reflected in the ownership percentages. The result is a 70% value discount for SLG, and a 38% discount for BXP. KRC is selling for a 17% discount. On the income side, I calculated the dividend coverage ratios: BXP stands at 1.6x, SLG 1.7x and KRC 1.8x.
Next, I performed a stress test analysis that reduced revenues by 10%. In the case of SL Green, I also deemed their property loan portfolio to be 50% impaired. Even with this penalty, SLG appears to trade at par to net asset value. Meanwhile BXP would seem to be 24% below value as well. KRC with its under-estimated future income looks to be valued at par after the stress test. In this example, BXP and KRC could continue to comfortably fund their dividends but SLG would be under pressure to reduce shareholder payments.
Paradigm Shift
While all three companies trade at steep discounts, one can’t help but wonder if the world will look back at this moment and ask why real estate experts underestimated the paradigm shift of working from home. If it worked pretty well for 6 months for most office workers, why can’t it work permanently? If nothing more, workers got 1-2 hours of their days back by not facing a long commute into the city center. This increase in productivity alone is tangible.
Of course, as the weeks have dragged on, frustration has set in with the arrangement. JP Morgan CEO Jamie Dimon has summoned traders back to their desks and recently noted a decline in productivity among employees at the banking giant. Zoom meetings can’t replace the 80% of communication that occurs through body language, and even a micro-second lag on a call is maddening after the third time someone interrupts. The office is a vital asset in our knowledge and information-based economy. Ideas and culture are the engines of growth. But data entry, call centers, accounting and routine back office functions seem to need nothing more than a good workstation in the den along with a high-speed data connection. Office leases will take 2-5 years to expire, but what if all companies simply reduced their footprints by 10%? My stress test may prove to be too light.
Conclusion
Kilroy and Boston Properties are the most appealing investments. The balance sheets have been fortified and leasing activity for the companies’ new developments is robust. Kilroy’s exposure to suburban markets offers a hedge against central business districts in major cities, and BXP has a well-diversified geographic portfolio. Meanwhile, despite the steep discount, SL Green appears to be the riskiest of the three REITs. The concentration in New York City is worrisome. While some may argue that the risk is reflected in the added discount, it is worth noting the SL Green executives had been appealing to investors as recently as the fall of 2019 that the stock traded at an unjustified discount of 25% to its peers. A risky mezzanine portfolio and the complexity of its joint venture arrangements could pose future challenges.
The most encouraging future for office properties lies in the technology and life sciences industries. Despite recent sublease announcements, Both Kilroy and Boston Properties are aggressively pursuing these vanguard companies with visible degrees of success. Meanwhile, the transformation of New York City into a technology hub is well under way. The question is now raised: can technology employment grow fast enough to replace the shrinking office needs of remote workers?
Bert Hancock, September 15, 2020
bert@alchemydevelopment.com
Appendix: Exhibits
