Description

Note:  Net debt and TEV numbers in the table above are based on PGRE’s proportionate share of consolidated and unconsolidated debt.

The common stock of Paramount Group, Inc. provides the opportunity to purchase a portfolio of well-located New York City and San Francisco Class A office buildings at a 7.6% cap rate and $565 per square foot (less than 60% of replacement cost).

PGRE is a self-managed REIT that owns and operates Class A office properties in New York City and San Francisco.  blaueskobalt pitched PGRE in 2019, pre-Covid.  While the macro and industry environment have changed significantly since then, PGRE’s operations have changed far less, and I refer readers to blaueskobalt’s excellent writeup for more background.

Office Portfolio.  PGRE owns seven Class A office properties in New York City, all but one located in midtown Manhattan. Five of the New York properties are owed either in their entirety or through consolidated joint ventures, and two are owned through unconsolidated joint ventures.  PGRE owns six Class A office properties in San Francisco, three in their entirety or through consolidated joint ventures, and three through unconsolidated joint ventures.  Its properties are 90% leased with an average annual rental of $85 per square foot.

A list of PGRE’s properties follows:

Capitalization.

Leverage.  At over 10x EBITDA (net debt/EBITDA over 9x), PGRE’s leverage is optically high.  However, PGRE has zero debt at the corporate level (a $750 million revolving credit facility is undrawn).  All debt is at the property level, non-recourse to PGRE. Furthermore, three properties with an aggregate of over 2 million square feet, all of which are 100% owned by PGRE, are owned free and clear.  With respect to PGRE’s encumbered properties, there are no maturities in 2022 and three mortgage loans come due in 2023.

Valuation.  At an implied cap rate of 7.6%, PGRE’s portfolio is valued at close to the financial crisis lows.  At an implied value per square foot of $565, PGRE trades at less than 60% of replacement cost without regard to land cost.  And at a trailing FFO multiple of 8x, it trades at barely over half of its 10 year average FFO multiple of 15x.

Risks.  There are two long term risks to the thesis.  First, the extent and permanence of remote working practices.  And second, the economic and municipal governance risks unique to San Francisco.  (Note:  I am not ignoring the risks of rising mortgage rates and the possibility of an impending recession; it’s just that I view those risks as short-term to medium term headwinds that do not affect the long-term valuation of PGRE’s portfolio.)

Remote Working.  At its peak, the pandemic resulted in the vast majority of the office workforce working remotely rather than at the office.  In the throes of the pandemic, much ink was spilled speculating on the permanence of this shift in working behavior.  Now that we are on the other side, people are still speculating.  To date, “return to the office” has not happened with the same intensity as the return to leisure travel and live concerts.  According to Kastle Systems, as of June 15 physical attendance (measured by card swipes) was 42% in New York City offices and 35% in San Francisco.

If 40% physical occupancy is the “new normal,” PGRE is not a long, and the entire office sector is in serious trouble.  However, I do not believe 40% is the new normal; rather I believe that physical occupancy will recover over time, even if never to pre-pandemic levels.

First, I believe institutional inertia is a powerful force.  Over time, I believe more and more institutions will require their workforces to be physically present in the office a majority of the time.  While this will leave room for some remote work, it will not lead to a significant reduction in the space required by institutions, even after taking hot desking into account.  This is not a rigorous data-based opinion on my part; rather it is a “world view” based on experience and observation combined with private conversations with professionals in a variety of industries and the public statements of executives in various industries.

Second, and more objectively, the volume and pricing of large leasing and sales transactions over the past eighteen months show that sophisticated market participants do not believe that the office workplace is dead.  Take a look at various office REIT investor presentations and you will see a host of large block, long-term, high dollar psf leases since the beginning of 2021.  That’s not to say there isn’t softening (transaction volumes are clearly lower than pre-pandemic) but rather it’s to say that tenants are not behaving and spending consistent with a view that 40% physical occupancy is the new normal.  The investment marketplace tells a similar story.  While transaction volumes are down, Class A office assets, when they do trade, generally do so at cap rates beginning with a “5.”  And at the corporate level, Columbia Property Trust, with a portfolio similar to PGRE’s, was acquired by PIMCO in late 2021 at 15x FFO and at an implied 6% cap rate.

Finally, to the extent physical occupancy does not recover fully to pre-pandemic levels, I believe PGRE’s Class A portfolio is well situated to handle reduced overall demand.  There appears to have been a “flight to quality” in the current leasing environment, and PGRE should be able to capitalize on that at the expense of Class B and Class C properties.  (I acknowledge that this only goes so far; the worse the recovery the less protected is PGRE.  While its assets are definitely Class A, they are inferior to product constructed in the past decade, for example Hudson Yards.)

San Francisco Risks.  Apart from the remote working risk facing all office markets, I do not believe the New York market faces unique headwinds.  To the contrary, New York remains the financial capital of the United States and a major global financial center.  And based on a wealth of anecdotes combined with hotel occupancy and apartment rental data (see the CLPR thread on VIC) it’s not unreasonable to say that New York City is “back.”

San Francisco is a different story.  The bursting of the most recent tech bubble is bleeding through to the office sector and will continue to do so.  While not all of the former highflyers were based in the Bay Area, many were, and the venture capital community is centered there.  For reference, in the aftermath of the dot com bubble bursting in the early 2000s, San Francisco office vacancies peaked at over 20%.  Current vacancies (including available sublease space) have already surpassed 20%.  This creates additional headwinds for PGRE’s San Francisco assets beyond the remote work headwinds discussed above.

If the tech bust was the only idiosyncratic risk facing the San Francisco portfolio, I would probably group it with the recession and interest rate risks discussed above, making it a near term (albeit impactful) impediment to performance that will eventually abate.  However, it is not the only risk; San Francisco’s ability to (1) recover from the tech bust and (2) overcome the headwinds created by the move to remote working is exacerbated by municipal governance that can charitably be described as dysfunctional.

San Francisco’s municipal governance problems have been well documented in the press.  Homelessness, rampant low level property crime, perceived lack of public safety (or, at a minimum, public decorum) in many parts of the city, and a perception that authorities are nonresponsive and unsympathetic to the needs of residents and business are all real issues.  To the extent these issues are not addressed, I believe there is a real risk that the value of PGRE’s San Francisco portfolio could be permanently impaired.

That said, I believe there are grounds for optimism.

- The Bay Area remains the global center of the tech industry – one of our most important industries and one that is not in secular decline.  This is not (at least not yet) the Detroit of the 1970s.

- San Francisco has inherent advantages that haven’t disappeared:  it is a gateway to Asia, it has a temperate climate and is geographically adjacent to a wealth of natural beauty and recreational opportunities, and Stanford and UC Berkeley are still there.

- San Francisco has enormous civic pride.  (As a resident of Southern California, I often view it as excessive civic pride.)  This can be a powerful force to arrest and eventually reverse the city’s decline.

Thus, I think it is reasonable to believe that San Francisco can overcome its current problems and regain its stature as a world class city.  But it is not guaranteed.  With respect to PGRE, San Francisco represents less than 30% of the portfolio.  Given how cheap the stock is, a permanent impairment in San Francisco values is not fatal to the thesis although it does reduce the upside.

Monarch Bid.  In February 2022, Monarch Alternative Capital filed a 13D announcing it had accumulated a 5% stake in PGRE and making a non-binding offer to acquire the company at $12 per share.  PGRE rejected the bid in March.  Since then there has been no further public activity with respect to Monarch’s bid although Monarch retains its 5% stake in PGRE.  Monarch’s bid follows a rejected bid in November 2020 by Bow Street to acquire PGRE for between $9.50 and $10.00 per share.  The thesis does not depend on PGRE being sold; however, I believe the Bow Street and Monarch bids provide support for the view that, at $7.68 per share, PGRE is undervalued.

Catalyst

M&A

Time