Vornado: A Premier Play on Manhattan

05/29/2019 5:00 am EST

Focus: REITS

Kenneth Leon

Global Director of Industry & Equity Research, CFRA Research

Our latest Focus Stock is Vornado Realty Trust (VNO), which carries CFRA's highest investment ranking of 5-STARS, or Strong Buy, explains Kenneth Leon, an equity analyst with CFRA Research, in the firm's advisory service, The Outlook.

VNO is a premier office REIT that offers investors a secular growth tenant base with the defensive characteristics of a high-quality REIT. VNO has plans to redevelop $2.5 billion of midtown Manhattan properties with $1.6 billion already expended. The majority of these buildings will be occupied at higher rents in 2020.

We view VNO as an attractive play on the Manhattan office market, the largest U.S. market representing nearly 20% of total U.S. office new construction.

While VNO has concentration risk with most of its office/retail properties, mostly in Manhattan, we think social media, entertainment and technology firms are showing strong demand as new tenants to Hudson Yards and Midtown West.

Midtown represents nearly two thirds of total Manhattan office space and more than 90% of new offices under construction in Manhattan.

The Penn Plaza/Midtown West districts are 72% of Midtown new construction, Grand Central (9%) and other districts like Park Avenue and Time Square (23%), as sourced from JLL. In 2018, Midtown had a lower average vacancy rate than most other Manhattan districts — except Midtown South (i.e. Chelsea, Flatiron/Union Sq. and the Hudson Square/Meatpacking districts), which offers smaller and older offices with unique character.

VNO is undertaking one of the largest office/retail redevelopment projects in the country. Its portfolio is nearly 85% located in Manhattan with a few large properties outside like the Mart in Chicago (showroom/trade show) and three offices in San Francisco. VNO has major projects near Penn Station, as well as part of the new Midtown West area of NYC that is seeing significant development.

In 2019, new developments include redeveloping the James Farley Post Office (adjacent to new offices) near Penn Station to serve as the new train station for Amtrak and the Long Island Railroad. The redevelopment of three large offices (Penn 1, Penn 2, Penn 11) and Hotel Pennsylvania (1,700 rooms) next to Penn Station, represents a combined total of 6.2mm sq. ft.

The company today is actively redeveloping the James Farley Post Office complex and Penn 1 with plans in the next year to redevelop Penn 2. Once the Penn office buildings are redeveloped, with one of them having a new retail mezzanine level wrapping the building, VNO will consider building a new office tower to replace the Hotel Pennsylvania, a low-quality property.

Plans not activated yet are to replace the hotel with 15 Penn Plaza, a newly designed 68-story tower that may be a mixed plan of office/hotel in the future across from Penn Station.

VNO's redevelopment strategy could generate higher EBITDA and adjusted FFO growth in 2020, in our view, with higher rents from its 6.2 million sq. ft. Penn Plaza district.

The high rent districts in Manhattan West/Hudson Yards are commanding rents in excess of $100 per sq. ft. VNO's footprint with the James Farley Post Office office/retail complex and the Penn Station office buildings are directly adjacent to Hudson Yards, the largest new construction projects in the country.

The refacing of Penn 1 and Penn 2 are a vast improvement with added new retail/restaurants in an extended newly-constructed mezzanine level covering a city block over the street below. Most of the James Farley project is getting funded by condo sales at 220 Central Park South, one of VNO's few non-office real estate investments.

We think these redevelopment plans will bring the live-work-play vision of Hudson Yards to the adjacent Penn District, next to the busiest U.S. transportation center. Together Midtown West will have an unparalleled offering of office, retail, residential, hospitality and cultural properties.

Conservatively, we think VNO can get office rents in the $80 to $90 per sq. ft. range once these Penn District redevelopments are complete. We are confident VNO's Penn District portfolio can move closer to quality Class A buildings versus their current status as Class B quality.

VNO's debt maturities support our positive view of increased EBITDA and FFO growth in 2020. Management has laid out a debt maturity schedule that indicates debt maturity payments of only $96 million in 2019, then rising to $2.1 billion in 2020, $3.4 billion in 2021 and $1.8 billion in 2022 on total consolidated debt outstanding of $9.9 billion, as Penn district redevelopments are completed.

VNO's total debt to total capital ratio was 62.7% at year-end 2018, down from 63.1% in 2017, while its total debt to EBITDA was 9.8x versus 9.5x for the same periods. The company believes it has a strong balance sheet with $3.35 billion in liquidity, reasonable debt leverage and well extended debt maturity schedule.

On April 18, 2019, VNO announced it transferred a 45.4% common equity interest in its portfolio of retail assets on Upper Fifth Avenue and Times Square, premium properties in our view, to a group of institutional investors advised by Crown Acquisitions Inc.

The transaction values the portfolio at $5.6 billion at a 4.5% cap rate. VNO is the general partner of the joint venture formed to own the assets, and the company will own 51.0% of the common equity.

Net cash proceeds to VNO from the transaction will be about $1.2 billion, after debt repayments on a $390 million mortgage loan on 666 Fifth Avenue and a $144 million mortgage loan at 655 Fifth Avenue. VNO will have a tax gain of approximately $735 million.

Our 12-month target is $80, using a forward P/FFO of 18.6x our 2019 FFO estimate, a premium to the office REIT average at 16.9x, given VNO's well located properties in Manhattan with many properties being redeveloped near Hudson Yards. Just above their 5-year low at $60, VNO shares currently trade at one of the highest discounts to net asset value (NAV) at 26.0% versus office peer average at a 15.3% discount.

We estimate funds from operations (FFO) of $4.30 in 2019 and $4.55 in 2020. Our outlook assumes stable occupancy levels and rental rates with contributions from new development projects. Risks to our opinion and target price include much higher interest rates and an economic decline that weakens office tenant demand.

Our Strong Buy rating is based on our view VNO is at a turning point in 2019 leading to accelerated FFO growth in 2020, driven by major redevelopment projects near Penn Plaza/Midtown West.

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