Description

Thesis

I believe SLG is an $800m market cap with a very high probability of going to zero over the next 12-24 months.  This is a very compelling risk/reward for the following reasons: 

• Expensive Valuation: The market is valuing this business at an 8.5% cap rate and 10% dividend yield (based on trailing #s that will be seriously impaired)
• Highly Levered: SLG is levered over 11x (Net debt/Ebitda-Maintenance Capex) with interest coverage of under 2x. A 10% hit to their revenue base and they will break their fixed coverage covenant.
• Business Model is Broken: Its bonds trade at 15%+ YTMs which implies zero equity value and at current financing rates, its business model is uneconomic
• Extremely Fragile Tenants & End Markets: 85% exposure to manhattan and 15% exposure to suburbs around NY. 40% of tenants are in the financial services industry
• Fundamentals are Deteriorating: Vacancies have already started to increase and rents are falling. We could easily see vacancies double and rents decline by 40%+.
• Poor Capital Allocators: SLG spent north of $6b (after netting out sales) between 2005 and 2007 buying property for an average of ~$680/sq ft. This is over 2x the private market value of this property today.
• Limited Downside: Even if we are wrong, NOI and dividends will be under pressure over the next few years. 10% dividend yields (with significant risk of BK) are not very appealing on an absolute or relative basis in the current environment.

Analogy:  Current dynamics could play out just as they did in Manhattan in the early 90s or as they did in SF post the tech bust.  Similar rent declines and vacancy levels would cause SLG to go BK.

Why Opportunity Exists

Sell side and other investors seem to be hard wired into believing that:

• 1) There will always be a strong bid for manhattan real estate
• 2) As long as tenants are in long term contracts, SLG is unlikely to experience a significant decline in NOI

We believe that there will be a structural hole in demand for manhattan office space and NOI is likely to be down 30%+ in the next 12-24 months as vacancies double and tenants renegotiate leases down to spot levels even before leases are up for renewal.  This type of NOI decline kills a highly leveraged business model.

Key Points

Expensive Valuation:  SLG is being valued in the market today at an 8.5% cap rate and 10% dividend yield.  Historically, cap rates have averaged a spread of ~75bps wider than investment grade bonds and have reached peak levels of a 200bps spread to IG bonds (and that was during a period of time where NOI had a nice secular tailwind and was growing).  Dividend yields have averaged a spread of 100bps wider than 10yr treasuries and have reached peak levels of a 400bps spread.  Today, SLGs cap rate has a spread to BAA bonds of 0bps and a spread to treasuries of 800bps.  Given the massive leverage here, I think looking at this valuation on a cap rate basis makes a lot more sense than on a dividend yield basis.  Assuming a 200bps spread to investment grade bonds implies a 10% cap rate which also implies no equity value.  I would also argue that given the opportunity set available to investors today, even on an absolute basis, an 8.5% unleveraged return on SLGs assets seems likes a pretty poor alternative given the risk of significant deterioration in earnings power.

Highly Levered:  SLG has alittle over ~9% cap rate through their debt so anything above that level leaves no value for the equity holder.  In addition, if you look at EBITDA-Maintenance Capex divided by interest, they have a coverage ratio of under 2x.  Given the operational and financial leverage in this business model, a ~20% hit to the top line and SLG will not be able to cover their interest payments.  I believe there is a high probability they see this type of hit to the top line in the next 12-24 months due to the fundamental dynamics explained below. SLG also has covenants on its debt that it is at risk of breaking.  They have to maintain a 1.5x fixed coverage ratio and are at ~2x today.  A 10% hit to revenues and they are breaking their fixed coverage ratio test.  This could happen in the next 12 months.

Refinancing does pose some risk to SLG although not huge.  SLG has ~$280m of debt due in 2009 and $870m due in 2010 and $700m of cash on the balance sheet.   This could be a problem for them in 2010 as there is a good chance they start burning cash in 2009.  In addition, ~$200m of that debt is JV debt that is due in 09/10 which means there will also be a few hundred million of debt that their JV partners may need to pony up if banks decided to push back on them as NAVs have fallen so dramatically.  A few of SLGs JV partners look highly questionable (ie Gramercy). 

Extremely Fragile Tenants & End Markets:  They have 85% exposure to manhattan, 15% exposure to suburbs around NY and 40% of their tenants are in the financial services industry.  With the financial services industry likely to contract by 30%+ and a low probability of new demand being created in the next few years to fill this hole, SLG is likely to see a significant rise in vacancies. More on this below.

Fundamentals are Deteriorating:  As an analogy, I think it makes sense to look back to what happened in Manhattan in the early 90s and the 01/02 downturn as well as what happened in SF after the tech bust. 

In Manhattan, in the early 90s, we experienced rents that were ~$25-40/sq ft and vacancies that hit 16-20% depending on location.  After the 01/02 downturn, we saw rents decline from $50-70/sq ft to $30-50/sq ft or 30-40% rent declines and vacancies increase from ~5% to approximately 12-15%.  Today, rents in Manhattan are already off their peak levels and are still ~$55-90/sq ft and vacancies are ~10%.  Given the fact that financial services/professional services jobs make up ~30% of employment in Manhattan today vs closer to 20% in the early 90s, this downturn could be much worse than the early 90s for the office market.  It may also take longer to recover this time around given the structural (vs cyclical) contraction we could see in the financial services industry.  I believe there is a good chance that rents and vacancies return to early 90s levels which  implies rent declines of over 50% and vacancy rates of 20% vs 10% today.  As a quick data point, the amount of vacant space has increased in Manhattan by over 10% in the past month so the run rate implies that we could see a return to 20% vacancies in the next 12 months.

Leading up to the tech bust in SF, rents increased by close to 3x (slightly greater increase than we experienced in Manhattan up to its peak) and vacancies dropped precipitously down to 3%.  After the tech bust, rents returned almost back to early 90s rent levels (ie declines of 60%+) and vacancies went much higher than in the early 90s, reaching levels as high as 30% in some areas.  One of the biggest contributors to this significant increase in vacancies was the significant % of sq footage occupied by small tech firms with under 100 employees (~50% of SF sq ft).  If you look at the comparison today, ~43% of sq ft in Manhattan is occupied by firms with under 100 employees and I don't have the data, but I suspect that there is very high exposure in that group to financial and professional services businesses that will be greatly affected by this financial lead downturn. 

Using these analogies as a proxy, it is not hard to see how SLGs revenues could get hit by 20% which makes the likelihood of BK very high.  SLG has ~13% of their rents rolling in 09/10 and 25% rolling between 09-12.  I think there is a very good chance that they see significant rent declines from those tenants who roll rents in 09/10 which could easily hit revenues by 5%+ (assuming 30%+ price declines) and I think that many tenants that have leases coming due in the next few years will likely renegotiate leases down today in return for extending the lease term out to a later date (this could easily hit revenues by another 5%).  Our research indicates this is already happening.  Other tenants that have many years left on their lease terms will be willing to either break lease contracts or push to renegotiate rents down to more reasonable levels as everyone's business will be facing a new level of demand for some time.  We saw this happen in 01/02 and in the early 90s and it will happen again.  These negotiations have already started. 

As levered landlords are forced to liquidate their properties and distressed buyers step up to buy these properties at very high cap rates, they will be willing to lease out space at significant discounts to the spot market.  This along with a massive amount of sublease space already hitting the market will cause the spot rate to return to early 90s levels.  On top of the hit to rents which could easily hit SLG revenues by 10%, vacancies will increase dramatically as tenants that still have many years left on their leases will be forced to close their doors.  It will be very hard to fill this vacant space. 

A 20% hit to revenues will cause SLG to start burning cash and eventually file as asset sales will be very difficult except at very high cap rates.

Poor Capital Allocators: SLG spent north of $6b (after netting out sales) between 2005 and 2007 buying property for an average of ~$680/sq ft.  This is over 2x the private market value of this property today.  Even if you believe the market is currently giving the proper valuation to SLG, that implies their property is worth ~$340 per sq ft which means management threw away billions of dollars buying into the peak of the market.

This is the same management team that formed and helped run Gramercy Capital (ticker: GKK) in mid 2004 to invest in and manage commerical properties "net leased primarily to financial institutions and affiliated users..."  as well as invest in CRE whole loans, CMBS, mezz debt, etc.  This business baically has zero equity value left today and will probably file for bankruptcy.  They also increased SLGs allocation to structured finance exposure by 4x (from $200m to $800m+) right into the peak of the market between 2004 and end of 2007.

Risks: Key risks to this short include:

• 1) General tightening of credit spreads or thawing of the credit markets which increases the probability of refinancing at lower rates and causes cap rates to decline
• 2) Landlords are able to find new demand to fill the financial services void
• 3) Significant $s are sitting on the sidelines that are willing to step in and buy Manhattan property at sub 8% cap rates
• 4) Vacancies are slow to pick-up and rents are only negotiated down as they come up for renewal which extends the real NOI pressures into the future (don't think you lose much in this scenario though)

 Disclaimer:  Please make sure to do your own work to confirm that all the stats in here are accurate. 

Catalyst

Key Signposts:

• 1) Tenants reducing rents (30%+ reductions) well before leases are up for renewal
• 2) Increasing sublease space hitting the market at big discounts
• 3) Increased BKs and contraction in the financial services industry
• 4) Distressed sellers forced to sell properties at 10%+ cap rates