Description

PGRE - Paramount Group

Price Target: $18.00 (35%)

The Paramount Group is a class-A, gateway city office REIT that is down nearly 30% since 2014, reflecting negative sentiment towards its primary market (midtown Manhattan). While the sentiment is justified, the price action is overdone – Paramount is trading at a 35%+ discount to NAV and a 20%+ discount to liquidation value. Management is strong & aligned, and there are several catalysts on the horizon. We think the situation is highly asymmetric from here with multiple ways to win.

Paramount is a class-A, gateway city office REIT with ~$10bn in assets.  It has no (re)development exposure. It wholly owns eight office towers, with partial stakes in another ten (it is effectively the GP for these ten partially-owned buildings, and it earns management fees from its partners that help defray some of the REIT’s G&A expenses).  Geographic exposure, on a pro rata basis, is ~75% Manhattan/~25% San Francisco with two small buildings in DC accounting for <5% of NOI. Leverage is a bit higher than we would like (8-9x EBITDA), but this is within range for the office REIT peer group, and it is below 40% LTV.  All debt is mortgage debt.

The predecessor to Paramount was founded in 1976, when Werner Otto, the patriarch of one of Germany’s wealthiest families, purchased 1633 Broadway, which remains PGRE’s largest asset today.  Werner Otto passed away in 2011 (at the age of 102!), paving the way for PGRE to become public in November 2014, selling $2.5bn worth of stock, in what was the largest REIT IPO to date. The Otto family still owns a teens-% stake, with Katharina Otto-Bernstein (54) serving as the family’s representative on the Board. The company has been led by CEO & Chairman Albert Behler (67) since 1991.  He owns nearly 3% of PGRE and is well-regarded.

The stock has returned -15%, net of dividends, since the start of 2015, compared to +40% for the REIT market and +15% for office REIT bellwether BXP. NAV is over that period is flat-to-modestly-up – we estimate at $21-22ps versus a stock price of $13ps.  So what has happened?

In short, the public market is negative on the fundamentals and believes that prices will come down.  This is likely true, and a bit has taken place already. There is a robust pipeline of new supply in Manhattan (e.g., Hudson Yards) that more attractive to tenants: better light, more open floorplans, shifting submarket preferences, etc.. This new supply is absorbing all the new demand, as well as soaking up some of the demand that would otherwise be going to more traditional midtown corridors.  This means that the older locations are not getting the benefit of market rent growth and/or they are needing to spend heavily on upgrades to attract & keep tenants. And this is not a short-term phenomenon: tenants have demonstrated a willingness to pay greater spreads for newer, better located space, meaning that the supply pipeline should remain robust.

This fundamental setup is also visible in the data, where net effective rental growth in older buildings in traditional midtown corridors has been flat-to-negative for several years. The two CRE PE majors (BX & BAM) have both highlighted these issues publicly and are not buyers at these prices, though they still hold midtown office properties. However, Manhattan is a deep office market with many other buyer pools and recent transactions that show very little erosion in property values or cap rates.  Nevertheless, this pessimism is reflected in the stock of PGRE, as well as the other three NYC-focused office REITs: SLG, VNO, and ESRT. This negative outlook on midtown office has become consensus and is reflected in the REIT shareprices.

Against this backdrop, we think the setup here is attractive & asymmetric.  Consider the following:

• Share Price Implies GFC-level Valuation: The PGRE share price implies a cap rate for the Manhattan properties in the high-6%s.  Manhattan cap rates for high-quality office haven’t been this high since the GFC, and they were at that level for less than a year.  They haven’t been above 5% since 2011.
• Share Price Implies Entire NYC Portfolio is Obsolete: Paramount’s NYC portfolio is composed of six well-maintained, fully-occupied, Class-A midtown skyscrapers, each commanding rents in excess of $70psf. Some of these would be considered trophy properties.  Yet, the current share price implies valuing Paramount’s entire NYC portfolio at the sum of the next six years’ cash flows, plus the greater of each buildings’ mortgage or GAAP land value – as if they were slated to be demolished and rebuilt from the ground up!
• NAV is Real: In a deep & liquid market like Manhattan office, there are plenty of comps to reaffirm market cap rates (this isn’t like US Malls where there is no real private market to reference). For example, consider the recent transactions table from SLG’s September investor deck: they have a median cap rate of 4.6% and a median price per square foot of $1,043. None are perfect comps (they are generally a bit smaller), but one is adjacent to PGRE’s 712 Fifth, and there are three others that are within four blocks of the Paramount portfolio.
• NAV is Pricey but Defensible: If you assume a long-term CapEx burden of 30% of NOI is necessary to preserve functionality, a 4.5% cap rate equates to a 3.15% cash yield, which is a 100bps spread over the 30-year and a 150bps spread over the ten year. The spreads over Japanese & European long bonds are much wider. Add to that the inflation protection, and it’s not hard to see how prime Manhattan office buildings can command such rich valuation from large foreign & financial institutions. Finally, prime Manhattan office cap rates are not at their peak – they have widened 25bps over the past few years, and they were 100bps tighter at the peak of the last cycle (when interest rates were much higher).
• Trophy Should Always Trade Above Economic Value: Premier properties have two sources of value: (1) a high level of confidence in durability & growth; and (2) the prestige that comes with owning a trophy property. That second source is frequently scoffed at, but it is real. A CRE PE fund pitchbook with a trophy office on the front will raise more money than the same pitch book with a strip center on the front. Similarly, the head of CRE at a large insurer (or other financial institution) will look better in front of his/her boss having bought a beautiful new building two blocks away. There are some more quantifiable elements, as well.  Prime office comes with longer duration leases & better credit tenants than other forms of commercial real estate, which is helpful in securing mortgage financing. There is also value in being able to deploy $1bn in one single transaction rather than in 20 separate ones. These sources of value may not show up in any model, but they are nevertheless real and persistent.
• Forget NAV, PGRE is trading below Liquidation Value: To liquidate, they would incur 3% NYC transfer taxes, in addition to 2-3% fees & other frictional costs.  Assuming a brisk-but-orderly liquidation means realization at a 5% discount to GAV, the liquidation price would be 15% lower than NAV: ~$18ps.  That still implies 35% upside from here!
• Upcoming IPO Anniversary Removes Some Tax Impediments to M&A: November 2019 will mark the five year anniversary of the IPO, at which point some FIRPTA rules affecting the Otto family (and other offshore pre-IPO investors) will no longer apply to a sale of the company. This event also improves the flexibility that a buyer may have in “flipping” assets immediately post-acquisition.
• Public-to-Public M&A is an Option: Blue chip office REIT BXP could offer $17-18ps for PGRE in a stock/cash combo that would be NAV-neutral (both buyer & seller @ 15% NAV discounts). This would be value-enhancing for BXP, which could upgrade its portfolio, gain additional scale, and further enhance value by trimming a couple assets upon consummation. For PGRE, it would give shareholders the opportunity to exit around liquidation value – realizing a 35% premium – while other shareholders could choose to continue holding a more diversified & liquid office REIT with similar exposures, no value diminution, and no tax consequences.
• Consensus Negative Outlook is a Coiled Spring: There isn’t much room for sentiment on midtown office to worsen.  On the other hand, there is plenty of room for it to improve, in which case we could see a sharp reaction.  I’m not expecting anything, but it’s a nice setup.
• Meager Free Cash Flow: Paramount is cheap on a NAV, stressed NAV, and liquidation basis; however, it is not cheap on a FCF basis (maybe ~20x on a fully-leased, normalized basis).  That’s just the nature of prime office assets, and it is our point of greatest discomfort.
• West Coast Pivot Underway: Paramount was 20% SF a few years ago; it is 25% now, and it is under contract to increase that ratio.  If it were to sell one of its Manhattan properties, that ratio would increase further. SF is a much more attractive office market than NYC, with plenty of room to run. The market views PGRE as a Manhattan office REIT, but it is 2-3 transactions away from being 50:50, which could trigger a re-rating.
•  Henri Bendel Vacancy: One of Paramount’s six midtown buildings is 712 Fifth Avenue (Fifth & 56th) – an ultraprime street retail location. The ground floor retail was recently vacated by Henri Bendel, who was on a lease signed decades ago at 75%+ below market rents.  Prime upper Fifth Avenue rents are so gaudy that we estimate that bringing this rent to market should increase AFFO of the REIT by 20%.
• Strong Team & Strategy: While the stock chart may not show it, this is a strong and aligned team. Behler is well regarded and has a strong track record leading Paramount for decades pre-IPO. From 1995 to 2014, he boasts an 18% unlevered IRR on 16 exited investments. As a public company, they have sold a couple of buildings in DC (at impressive prices), and bought a few in SF, bringing in JV partners to eliminate the need to issue dilutive equity. They have been thus far successful in their strategy of buying assets with large impending vacancies, creating value in the lease-up.
• Share Buybacks: The company began executing a leverage-neutral buyback program in late 2018, and they have since retired over 3% of shares outstanding at a weighted-average price below $14.
• Prefer PGRE to other NYC Office REITs: While we think PGRE is the cheapest of the four NYC office REITs, VNO, SLG & ESRT aren’t far behind, and one could legitimately argue that any one is the best value, based upon specific portfolio positioning. We prefer PGRE because we think it is the lowest risk, the most “acquire-able,” and has the most optionality/potential catalysts. On risk, VNO has a large redevelopment pipeline, ESRT has the most concentrated exposure to a single asset (the Empire State Building & Observatory), and SLG has more leverage. On “acquire-ability,” both VNO & SLG are double PGRE’s size; taking these private would be a stretch, and they are too big to liquidate.  I don’t think anyone is willing to pay [anything close to] full price for the Empire State Building, given the headwinds it faces, and the abnormally low leverage of ESRT makes less room for a would-be acquirer to pay a meaningful premium but still get an attractive deal. Furthermore, the other three are NYC pure-plays, while PGRE’s 25% SF exposure (and even more of they were to buy in the JVs) should entice potential acquirers. Finally, in addition to being the most “acquire-able,” PGRE also has the most other potential catalysts: it should have the highest growth rates; it could bring its NYC exposure below 50% with just two asset sales; and it has an upcoming (tax) milestone which may enhance liquidity for Otto family members.

Catalyst

Conclusion: why does this opportunity exist and how does this play out?

There are two key points why this opportunity exists.  First, there are fundamentally sound reasons for which private market buyers are willing to pay a higher multiple (than the public market) for the prime office assets that Paramount owns. Second, the company’s short history has made the market sleepy/doubtful about management’s ability to do anything about it.

Our thesis is that the falling share price has lowered the downside to a point where there is little price risk in the status quo, while we view the recent buyback, ongoing pivot toward San Francisco, and upcoming five year anniversary as indications/events that management is on the right path. We don’t know whether that path is one of liquidation, privatization, merger, or simply a re-rating upon dialing back Manhattan exposure, but we think they all lead to a materially higher share price.