The 10-Q Detective: Vornado Watch

This is the first column for BusinessWeek by David Phillips, who examines companies' financial statements and writes the 10-Q Detective blog.

Vornado Realty Trust (VNO) is one of the biggest players in what seems to be one of the least appetizing corners of the business world right now—commercial real estate. Despite a disappointing earnings announcement and gloomy prospects for commercial real estate, Vornado's stock has jumped 60% since Mar. 1. What investors may be overlooking is that the highly levered real estate investment trust (REIT) has a ratio of total debt to enterprise value of approximately 60%, and is struggling to juggle dividend payouts owed to stockholders, honor interest-coverage and maturing debt obligations, and stabilize decreasing spreads between new tenant and expiring rentals.

Vornado announced on Aug. 4 that recurring funds from operations (FFO) in its second quarter 2009 fell 53% year-over-year to $93.5 million, or 54¢ per share, due in part to lower investment returns (including $122.7 million of loss accruals on mezzanine loans and a $7.6 million lease termination due on its partial ownership interest in Filene's Basement), a 20% decline in profit at its Merchandise Mart office and retail showroom portfolio of Chicago properties, and higher vacancy rates and lower rents in Manhattan. (Initial rents on relet Manhattan office space are down by $19.15 a square foot, from $70 in December.)

The New York-based company is one of the largest publicly traded REITs in the U.S., with a real estate portfolio that includes about 36 million square feet of office space (almost all in Manhattan and the Washington, D.C., area), and another 22.4 million square feet of retail properties across the country. The company also has a 32.7% stake in Toys "R" Us and partial equity stakes in the two REITs Alexander's (ALX) and Lexington Realty Trust (LXP).

The big concern with Vornado, as disclosed in its 10-Q regulatory filing, is a growing imbalance between aggregate earnings and dividend distributions paid. At June 30, earnings were running a deficit to distributions paid of –$1.29 billion, up from –$527.2 million in the prior year, which suggests that the current quarterly dividend payment of 95¢ a share to stockholders is unsustainable going forward. To preserve cash (about $390 million annually), shareholders are being asked to make an election to receive this dividend in a combination of 40% cash and 60% Vornado common stock. A Vornado spokesperson said the company does not comment on forward trends.

Manhattan Office Vacancies It's no wonder that Vornado is becoming more cautious. Commercial real estate firm Cushman & Wakefield reported on July 14 that the vacancy rate for offices in Manhattan rose to 10.5% in the second quarter, a 4½-year high—and could possibly hit 15.5% within a year, as companies continue to shed jobs or hold back expansion plans. Not the best of news for Vornado, as a significant portion of its business dealings are in New York City and Washington. For the first six months of 2009, 70% of its pretax profits came from properties in these markets.

The 10-Q Detective notes the diversity of tenants located at many of VNO's Manhattan properties, which include such creditworthy clients as Charles Schwab (SCH) and JPMorgan Chase (JPM) at Two Penn Plaza, electronic retailing giant Best Buy (BBY) on Broadway in Greenwich Village, the U.S. Postal Service at 909 Third Ave., and Starbucks (SBUX) at Grand Central, 330 Madison Ave. Although the company's Manhattan office portfolio has less exposure than other New York property owners, such as Brookfield Properties (BPO) and Boston Properties (BXP), to rising vacancy risk resulting from the consolidation of the financial-services industry—only some 15% of its NYC rental base is finance-related—occupancy rates still declined 60 basis points year-to-date to 96.1%.

In addition, contrary to bullish consensus, the 10-Q Detective does not believe laddered leasing terms of its Manhattan office properties—ranging from five to seven years for smaller tenant spaces to as long as 15 years for major tenants—combined with periodic step-ups in rent over the term of the leases (e.g., $7.5 million in rent bumps for the recent quarter), will help to offset slowing revenue growth from a tepid leasing environment. To wit: The spread between initial rents on space being re-leased and rates on existing leases is narrowing. During the quarter, initial rent (cash basis) was $54.51 per square foot, vs. expiring rent (cash basis) of $50.83 per square foot—compared with a spread of $23.59 a square foot for the quarter ended December. Still, EBITDA of the New York City portfolio did squeak by with a gain of $147.7 million, up 1.7% from a year earlier.

D.C. Is a Bright Spot The Washington portfolio of office buildings remains a bright spot for Vornado, with occupancy rates up 40 basis points year-to-date to 95.4% and initial rents on relet space remaining relatively stable at $38.97 per square foot. The company also has more than 5 million square feet of leases with expirations going out to 2018 that carry rent bump-up clauses starting at floors ranging from $38 to $49 a square foot.

Agencies of the U.S. government, such as the General Services Administration, represent about 30% of D.C. rental revenues. The upward trend in occupancy rates is also being fueled by think tanks, lobbyists, and companies (like defense contractors) that see benefits to roosting near the hub of power—this demand for office space will help to absorb the 1.2 million square feet of expirations in D.C. this year and next. As of June 30, Vornado had approximately 2 million more square feet of office space in service—82 properties covering almost 18.1 million square feet—in D.C. than in NYC, yet the D.C. office portfolio earned (before interest, taxes, depreciation, and amortization) $37.4 million less than the Manhattan office portfolio. Absent stronger pricing power, it is doubtful that D.C. strength will ameliorate the landlord's slowing cash flows from its 28 NYC properties.

Vornado has generously rewarded common stockholders with annual increases in quarterly dividend payments, climbing from 76¢ a share in 2005 to the March-ended quarter declaration of 95¢ a share. As a result of lower net income, comparable six-month cash flow from operations declined 16.3% to $379.4 million. Cash outflows included $317.2 million in interest and debt payments and distributions of $126.2 million and $28.5 million for common and preferred shares. Given decelerating real estate market fundamentals, unless the company is willing to fund future payouts using its available cash and lines of credit, the 10-Q Detective believes a dividend cut is the prudent course of action.

Debt Repayment The company's repayment of approximately $12.4 billion in consolidated debt outstanding might appear to be a slippery marble to hold, but the debt repayment schedule and servicing of both look manageable, with $214.2 million, $1.02 billion, and $2.6 billion maturing in 2009, 2010, and 2011, respectively. In addition, Vornado is in compliance with all financial covenants required for its revolving credit facilities and senior unsecured notes:

The company owes $11.6 billion in fixed-interest debt with a weighted-average interest rate of 5.90%. The math is simple—should the company look to pay down some of that debt, or can it return to shareholders a total return greater than what it is paying out to its creditors? The total returns generated over the last five years, as shown in the table below, suggest that deleveraging might not be such a bad idea.

  Total Return Comparisons (through 6/30/2009 Time period Vornado Morgan Stanley REIT Index SNL REIT Index One year -47.10% -43.90% -42.40% Three years -48.50% -45.90% -43.80% Five years -3.80% -14.10% -11.10% Ten years 110.3% 67.8% 75.5%

At June 30, Vornado also held a carrying amount of approximately $1.2 billion in the marketable securities of other REITs, joint ventures (such as Filene's Basement - Boston), and partial interests in retailers (the largest being Toys "R" Us, with a booked value of $374.5 million). In particular, the 10-Q Detective believes that management should take advantage of recent market rallies to reduce its leverage by selling part—or all—of the company's partial ownership stakes in two REITs:

1. Vornado owns 32.4% of the outstanding common stock of Alexander's. Although the company receives more than $12.6 million in annual management fees for the leasing and development of Alexander's seven former department-store properties in Manhattan and New Jersey, the company is also sitting on an equity windfall from recent price gains in its common stock. Based on Alexander's Aug. 4 closing price of 294.38, the market value of its investment in Alexander's was worth $487 million (or $318 million in excess of the carrying amount on its consolidated balance sheet, excluding pro rata share of debt).

2. Vornado owns approximately 16.1% of the common equity of Lexington Realty Trust, a REIT focused on single-tenant real estate investments, at a carrying value of $4.81 a share. Lexington shares have rebounded from 2.38 on Mar. 31 to 4.65 on Aug. 4, reversing millions in recent carrying losses. Vornado's beneficial ownership in LXP is now worth about $75 million.

Premium Valuation To be sure, there is much to like about Vornado—balanced office portfolios in two world-class metropolitan regions, ample liquidity and credit capacity, and 22 million square feet of shopping space anchored by marquee retailers like Macy's (M), Home Depot (HD), and Wal-Mart (WMT). That said, there is danger to investors looking to buy in at Vornado's current lofty valuation. The stock has doubled in price, to 55.95 on Aug. 5, from a 52-week low on Mar. 6 at 27.01.

Vornado trades at almost 12 times full-year FFO consensus estimates of $4.50 to $4.60 a share. This premium valuation to its office REIT sector average of 7 to 9 times is unwarranted—given the possibility of a dividend cut (a no-no for income-oriented investors) and continued weakness in the portfolios of both the Chicago trade show and Manhattan market (which has an additional 700,000 square feet of office space expiring this year). Another bad quarter and investors will stop "partying like it's 1999" and start running for the exits.

Disclosures: The McGraw-Hill Companies (MHP), the owner of BusinessWeek, leases 479,557 square feet of office space from VNO, representing 0.8% of total VNO revenues through June 30.

The opinions expressed here represent those of the 10-Q Detective and not those of BusinessWeek. Columnist David Phillips does not hold a financial interest in any stocks mentioned in this article.

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