Description

2023.10.28 VNO 5.4% Series L Preferred Writeup

I believe the Vornado 5.4% Series L Preferreds are an attractive long.

Vornado is a REIT run by Steve Roth with a primary focus on Manhattan office, with particularly concentrations around Penn Station and the Plaza District.  The geographic mix totals 88% NYC (remainder Chicago and San Franciso).  The product mix is 80% office / 20% retail.

Vornado has 4 different perpetual preferreds that are pari passu.  I’ll focus on the Series L for this writeup.  The Series L pay a 5.4% annual coupon on the face value per preferred share of $25 for a total of $1.35 in preferred dividends per year at the rate of $0.3375 per share per quarter.

The Series L today are trading at $14.09 (or ~56% of face value), which represents a 9.7% strip yield.  They traded at or near par for much of their trading history but have traded down significantly over the past year as a consequence of both higher interest rates and especially fears around office fundamentals.

Vornado has found itself at the center of several bearish narratives of late.  Namely, fears over CRE and especially office; perceived excess leverage; a sense that financing markets are closed for office assets; work from home; excess supply driving higher vacancy, etc.  So it isn’t too surprising that over the past 21 months, all of VNO’s securities have traded off. 

VNO’s longest dated unsecured bond price is down 30%; the VNO Series L Pref price is down 44%; and VNO’s common stock price is down 52%.  So the preferreds are down almost as much as the common despite dramatically better fundamental downside protection, much higher current cash yield, embedded catalysts from the coupon payments, etc.  Perhaps the weakness in the preferreds’ share price is partially a technical dynamic as the overall preferred equity market has been hammered under the weight of the regional bank crisis – banks represent roughly half of the entire preferred market.

An overly simplistic and punitive way to look at VNO is look on a consolidated/at share basis – essentially treating all debt as implicitly fully recourse and cross defaulted.  This approach implicitly treats any equity value in underlevered mortgaged properties as netted off against and supporting any other overlevered properties in the portfolio.  On this basis, it appears that VNO is almost 8x levered (~13% debt yield) and that VNO common is trading at an implied cap rate of ~9%:

So at first glance, VNO looks overlevered at a time when most expect to see multiple years of market stress to come.  And at a time when financing for office assets are near impossible and expensive.  Negative headlines relating to office assets continue to be blasted out daily. 

But critically important is that unlike most of its REIT peers, ~85% of VNO’s net debt is non-recourse leaving net recourse debt at only ~15% of net debt.  The reality is there’s huge optionality from non-recourse mortgage debt on individual assets – especially when individual properties differ significantly.  VNO can dramatically improve implied cap rate, debt yield, and leverage multiples by walking away from (or renegotiating mortgages on) a handful of individual assets that are particularly overlevered.

Those embedded put options can create significant equity value that is obscured when looking top down at the consolidated financials.  An analysis of each individual asset with non-recourse debt is necessary.  From an economic perspective, it makes the most sense to roll up only the embedded positive equity value of each individual asset that has positive equity in it – while generally ignoring any assets with negative equity value.

That ability to cherry-pick and retain all the individual assets with positive equity value – but to reject those onerous non-recourse mortgages on assets with negative equity value where the mortgage exceeds the value of the property – is absolutely key to get a proper picture of the economics of VNO’s portfolio.

I can recall meeting after meeting ~15 years ago in which Steve Roth would explain why VNO would look different than many peers with a more convoluted capital structure comprised of so many individual non-recourse mortgages.  And why he’d happily pay an extra 50 bps a year in interest in the good times to get the non-recourse debt.  While it might appear unnecessarily cumbersome most of the time, in tough times it would make all the difference.

There’s also further optionality from VNO’s $1B+ gross cash balance.  And still further optionality from the additional $1.9B of undrawn liquidity on its revolvers.  Again, for years VNO would be criticized for its “inefficient” gross cash balances earning a negative arbitrage against gross debt balances.  And for paying small commitment fees on billions of undrawn revolver capacity.

But VNO never wavered on these critical points because when capital is scarce and unavailable, liquidity is all that matters in surviving to the other side and taking advantage of opportunities along the way.

Now here is an alternate way to look at VNO’s balance sheet.

It considers the unencumbered assets and unencumbered EBITDA only.  By ignoring all mortgaged assets, it implicitly assumes that every one of those assets has negative equity and will be walked away from.  I think that is a draconian and completely unrealistic assumption.

Even so, on that basis, we are creating the company through the preferreds at a 48% implied cap rate looking to unencumbered EBITDA only!

Another way to see how cheap the create value is through the preferreds is by considering the current fair market value of VNO’s unencumbered assets (slashed significantly from a few years ago) of ~$8 billion+ today.  That’s asset value at market today, not at cost.

On this basis, the create value of the preferreds is less than a quarter of the unencumbered asset value of VNO alone.  Again, no value whatsoever to all of the individual mortgaged properties with positive equity value in them. 

Over ¼ of VNO’s EBITDA is unencumbered – and I’d expect that % to grow over time as the tail end of the remaining Penn redevelopments are completed.  Penn 2 is largely out of service today during redevelopment and currently negative EBITDA but is getting leased up at big rents and will flip to significantly positive EBITDA.  Significant increases in cash rent are also coming on recently completed redevelopments like the Farley Building leased to META for >$100 / SF for 15 years as free rent period burns off.

Again, this analysis ignores individual assets with mortgages that are underlevered and have significant equity value.  It also ignores several hundred million dollars of excess cash and liquidity on the balance sheet of controlled but unconsolidated subsidiary Alexander’s (ticker ALX).  And it ignores an incremental $600mm of “hidden” net liquidity from VNO’s put right as part of a blockbuster deal struck with Citadel in January for their new NYC HQ to be developed at 350 Park Avenue.

Operationally, VNO’s business is doing fine and boasts significant stability from long term leases to credit tenants.  You can see in the core NY office business, the weighted average lease term exceeds 7 years:

Less than half of rent roll rolls off prior to 2030.  So even if it were a complete melting ice cube, it would decade the better part of a decade at least to melt.  For now, leasing remains surprisingly strong for VNO – as office market appears to be increasingly bifurcating between Trophy and truly Class A vs all the rest.  VNO is predominantly the true Class A buildings, even moreso by value than by number.

VNO’s Penn Area redevelopments are doing well – signing leases at ~$100 / SF.  Especially as Hudson Yards space has been largely absorbed with long term leases at rents sometimes approaching $200 / SF.

It’s a bit cliche, but there’s a notion that a few decades ago, a tenant in a commodity office on 3rd Avenue would jump across the street at lease expiration to an identical office to save a $1-2 / SF in rent on the new lease.  But nowadays, knowledge workers and top talent are demanding more of a luxury hotel type atmosphere to come into work.  Replete with open spaces and endless amenities, not to mention brand new state of the art LEED certified buildings to appeal to environmental sensitivities.  In that environment, we’ve seen tenants not move across 3rd Avenue, but rather relocate to Hudson Yards or One Vanderbilt or the newly redeveloped Penn district assets and pay double their prior rental rates.

With the part of its portfolio comprised of older but well located assets, VNO is also doing well.  In January, VNO signed a blockbuster deal with Citadel – taking rents above $100 / SF in the interim and setting up plans to create Citadel’s new NYC HQ at 350 Park.

VNO’s debt is very well laddered with limited near term maturities.  2024-2025 mortgage maturities should be refinance-able despite the environment.  Running through the largest ones, 280 Park is not unreasonably levered today, well occupied, and right next to JPM’s new multi-billion $ future HQ being developed at 270 Park.  731 Lexington has Bloomberg’s HQ lease extending through 2029 at triple digit rents per SF – so hundreds of millions of dollars of credit tenant NOI left there for the next 6 years.  Penn 11’s main tenants include Apple and Madison Square Garden.  888 7th and 4 Union Square South have high double digit debt yields.  The main 2026 maturities are assets with great tenants – like Whole Foods and NYU.

With over $1B of excess cash on balance sheet and almost another $2B of undrawn availability on revolvers, VNO has lots of options even if the office financing market is closed.  Plus $8B of unencumbered assets at today’s marked down market value.  And several recent office financings have closed on inferior assets at reasonable terms like SLG’s 919 Third Ave.  We are also increasingly seeing existing lenders extend mortgages at maturity, especially on overlevered assets with strong sponsors.

As VNO handles its debt maturities and the smoke clears relating to office assets, I would expect VNO preferreds to trade back to their historical spreads over USTs.  The following table shows prospective IRRs assuming a 7.5% exit yield:

We arrive at strong IRRs even if takes time for spreads to normalize.  If long term UST rates move down, then we’d be looking at much better exit pricing and IRRs.  If it turns out that UST yields continue to reprice higher such that exit yield is higher, the IRR won’t be as good but we should still make money over time and greatly outperform a market that likely gets crushed in such a scenario of much higher long rates.

To that point, here’s the breakeven price and yield on VNO prefs that would correspond to breakeven P&L after a hold period of 1 through 5 years:

As noted, I believe prefs are well protected based on valuation, liquidity, optionality, etc.  It is virtually impossible to conceive of how VNO could be forced into a bankruptcy given the way it is structured.  And the VNO preferreds are cumulative, unlike most of the pref universe which is non-cumulative.  VNO is also a REIT that must pay dividends to maintain REIT status (so long as it maintains positive taxable income) – a critical difference from most of the preferred universe that are banks and financials that don’t have similar dividend requirements.  Steve Roth also has a big chunk of his fortune in the common, so the preferred is senior to him.

Despite all that, anything can happen in terms of trading price in short term.  But to lose money here over time, these prefs would need to trade down to 40% of face in 3 years, for instance.  And in that case, the current yield at that point would have blown out to seemingly ridiculous levels and set up asymmetrically more attractive forward returns.

In summary, the crux of my thesis is pretty simple.  I believe the preferreds are close to bullet-proof from a credit perspective because the majority of VNO’s debt is single-asset, non-recourse debt, and the preferreds are further protected by their low dollar price.  The primary fundamental risk in my view is duration in that the preferreds have no set maturity date, but that is mitigated by the nearly 10% current yield and historically large spread above long dated UST yields at the moment. 

Catalysts

Refinancing / extensions of mortgage debt

Targeted asset sales

Targeted financing of unencumbered assets (i.e. Farley)

Renegotiations or walk-aways from a handful of overlevered single asset mortgages

Passage of time / improvement in operating outlook

Catalyst

Refinancing / extensions of mortgage debt

Targeted asset sales

Targeted financing of unencumbered assets (i.e. Farley)

Renegotiations or walk-aways from a handful of overlevered single asset mortgages

Passage of time / improvement in operating outlook