We are raising our rating on Vornado Realty Trust (NYSE: VNO) to BUY from HOLD. VNO shares are down 44% year-to-date due to the pandemic, and in our view offer a favorable entry point.
Despite this underperformance, we see a number of positive catalysts that could boost VNO shares, including the appointment of new CFO Michael Franco, the January 1 opening of the new Moynihan Train Hall in New York; headcount reductions that will reduce compensation by $35 million annually, and generally positive vaccine news.
We are also impressed by the high selling prices of the company’s luxury apartments at 220 Central Park South in Manhattan. The Penthouse at 220 CPS sold for $240 million in 2019 – setting a record for the most expensive home ever sold.
We also believe that REITs have the potential to outperform the broad market, as the Fed has lowered interest rates and dividend yields may be attractive compared to bonds. Although VNO recently lowered its quarterly dividend to $0.53 per share ($2.12 annually), the yield still looks healthy at 5.9% – above the peer average of 4.6%.
VNO shares trade at a blended 2020-2021 forward price/AFFO ratio of 14.1, below the midpoint of the five-year range of 8.7-21.5 and below the peer average of 16.0. Given the company’s improving outlook and above-average dividend yield, we think that the shares should trade at a higher multiple. We are setting a target price of $42, implying a blended price/AFFO ratio of 16.0, in line with the peer average.
The beta on VNO is 1.31.
VNO recently reported third-quarter results that fell short of analysts’ expectations. The consensus called for AFFO of $0.64 per share. The decline in AFFO was the result of straight-line write-offs, tenant receivables deemed uncollectible, the continued closure of the Hotel Pennsylvania, and redevelopments in the PENN district. These negatives were partially offset by lower interest expense. Revenue fell 22% to $364 million due to the headwinds noted above.
During the 3Q conference call, the company indicated that it was marketing several key assets, including 1290 Avenue of the Americas in New York and 555 California Street in San Francisco. It may also consider using a JV to sell minority stakes in these two properties.
On August 3, the company announced that Facebook would lease 730,000 square feet at the Farley building in the Penn District of NYC. The lease makes Facebook the sole tenant of the Farley building, as the lease covers all of the building’s available office space. The terms of the lease have not been disclosed.
EARNINGS & GROWTH ANALYSIS
The New York market accounts for approximately 85% of Vornado’s NOI, with the remaining 15% coming from its hotels and subsidiaries and from office properties in Chicago and San Francisco. With management pursuing the sale of its San Francisco property, Vornado is essentially a REIT with single-market geographic exposure.
Key operating trends and forecasts for the company’s business lines are as follows:
Occupancy. Third-quarter occupancy trends reflected the bankruptcy of retail tenant JCPenney. New York retail occupancy ended the quarter at 79.9%, down from 94.5% at the end of FY19. New York office occupancy ended the quarter at 95.8%, down from 96.9% at the end of FY19. Total Chicago occupancy (theMART) was 89.8% at the end of the third quarter, down from 91.4% at the end of 2Q20 and 94.6% at the end of FY19. Total San Francisco occupancy (555 California Street) was 98.4% at the end of the third quarter, down from 99.0% at the end of 2Q20 and 99.8% at the end of FY19.
Acquisitions/Dispositions. The company did not make any acquisitions in 3Q. On the disposition front, it sold 19 condos at 220 Central Park South for $591 million, resulting in a net gain of $215 million. In January 2020, VNO sold its shares in PREIT, a Mid-Atlantic shopping center REIT, for $28 million and incurred a loss of $5 million.
Construction. At the end of the quarter, the company had seven projects under development, all of which are in the Penn District of New York. The Moynihan Train Hall and extension of Penn Station are scheduled to open on January 1, 2021. The modernization of the Farley Building, which will have Facebook as a tenant, will also be completed in 1Q21. PENN1 and PENN2 have target in-service dates of 2022 and 2023, respectively. Although construction was halted during the worst days of COVID, it has since resumed. On the balance sheet, the line item for development costs and construction in progress rose 1.5% in 3Q, to $1.51 billion.
Lease Expirations. In 2022, 4.3% of office and 1.6% of retail leases are set to expire.
Pricing. The new leases primarily consisted of the Facebook lease and a 348,000-square-foot lease for New York University at One Park Avenue. At theMART in Chicago, Vornado leased 44,000 square feet at $59.38 per square foot.
We are raising our 2020 AFFO forecast to $2.46 from $2.43 per share. We are also boosting our 2021 estimate to $2.81 from $2.66 per share, based on our expectations for recovery in 2H21.
FINANCIAL STRENGTH & DIVIDEND
VNO’s debt is rated investment grade by Moody’s and S&P, with respective ratings of Baa2 and BBB. At the end of 3Q20, VNO had $1.4 billion in cash and equivalents. The company’s debt/total capitalization ratio was 52% at the end of the quarter, roughly in line with peers. EBITDA covered interest expense by a factor of 5.6, above the peer average of 4.9.
VNO recently lowered its quarterly dividend to $0.53 per share, or $2.12 annually, for a yield of about 5.9% – well above the peer average of 4.6%. CEO Steve Roth indicated that the firm may re-evaluate the dividend, leaving the door open for another cut. The previous quarterly distribution was $0.66, or $2.64 annually. Our dividend forecasts are $2.38 for 2020 and $2.12 for 2021.
MANAGEMENT & RISKS
In early December, Vornado announced that Michael Franco would replace Joseph Macnow as CFO. Mr. Macnow will remain with the firm in an advisory role. Mr. Franco joined Vornado in 2010 after working at Morgan Stanley for 20 years in real estate banking, and has overseen $20 billion in real estate transactions over the course of his career. In addition, the company announced plans to eliminate 70 staff positions. The moves are expected to result in 4Q severance costs of $23 million, but to generate $35 million in annual cost savings going forward.
Steve Roth has been the chairman and CEO of Vornado since 1981.
Investors in VNO face a range of industry and company-specific risks. These include the company’s growth strategies; the results of bidding on properties; the redevelopment of older properties; the acquisition of other office developers or REITs; property sales and their timing; re-leasing; interest rate trends; the funding of projects; and competition. There is also the risk of oversupply in New York.
Vornado Realty Trust is a REIT focused on the New York office property market.
VNO shares are trading toward the low end of their 52-week range of $28-$69. They also trade at a blended 2020-2021 forward price/AFFO ratio of 14.1, below the midpoint of the five-year range of 8.7-21.5 and below the peer average of 16.0. Given the company’s improving outlook and above-average dividend yield, we think that VNO shares should trade at a higher multiple. We are raising our rating to BUY with a target price of $42, implying a blended price/AFFO ratio of 16.0, in line with the peer average.
On December 29, BUY-rated VNO closed at $35.99, down $0.99