Rising Interest Rates Weigh on Highly Leveraged SL Green; Reducing Our Fair Value

Equity Analyst

Suryansh Sharma

SL Green is a real estate investment trust engaged in the acquisition, development, repositioning, ownership, and management of commercial real estate properties, principally office properties. Most of the companies' properties are in the Manhattan area. The company held interests in approximately 35 million square feet, which includes ownership interests in 26.7 million square feet in Manhattan buildings and 7.2 million square feet securing debt and preferred equity investments. The strategy of the company is to maintain a high-quality portfolio of buildings in desirable locations and focus on creating value through new developments, capital recycling, and joint-venture investments. As an instance, SL Green's $3 billion megaproject One Vanderbilt was completed amid the pandemic and has already achieved high occupancy rates. 

The economic uncertainty emanating from the pandemic recovery and the remote work dynamic have created a challenging environment for office owners. Employees are still hesitant in returning to the office as office utilization remains around 45% of the prepandemic level. The vacancy rate for office spaces in Manhattan was recorded at 22% in the fourth quarter of 2022, which is roughly 1,000 basis points higher than prepandemic levels. On the supply side, approximately 10 million square feet of office space, which amounts to around 2.5% of the total inventory is currently under construction in Manhattan and would be added to the market in upcoming years. We expect this additional supply to further pressure fundamentals in the market. The Manhattan net absorption rate remained negative as of the fourth quarter of 2022 and rental growth figures are disappointing, especially given the highly inflationary environment. 

Having said this, we are seeing an increasing number of companies requiring their employees to return to the office. In the long run, we believe that remote work and hybrid remote work solutions will gain increasing acceptance, but offices will continue to be the centerpiece of workplace strategy and will play an essential role in facilitating collaboration, harnessing innovation, and maintaining the company culture.

Business Strategy & Outlook

We assign a no-moat rating to SL Green Realty. Given the availability of substitutes within the realm of Class A office space, limited supply restrictions in Manhattan, the uncertainty in demand associated with the remote-work dynamic, and the ease with which competitors can lure tenants away with concessions, we view a large proportion of properties as replicable and, therefore, do not believe that the company has a maintainable competitive advantage. 

The company’s portfolio contains high-quality assets that are strategically located in metropolitan areas with good growth potential and supply constraint characteristics. However, the remote-work dynamic is putting significant pressure on the owners of office real estate. The pandemic has massively accelerated the remote work trend and it has shown us that technology-enabled solutions can help employees collaborate and maintain productivity even as they work remotely. A significant proportion of the U.S. office-going workforce has now worked remotely for over two years and employers are struggling to get them back to the office. As per Kastle Systems weekly work barometer, the average physical building occupancy of office buildings remains around 40%-45% of prepandemic levels as of the end of April 2022. We expect physical building occupancy rates to improve with time, but we do not see them reaching prepandemic levels anytime soon. Technology-enabled hybrid and remote work solutions have improved materially over the past few years, and we can expect them to keep improving with time. Office owners are now not only competing with other office owners, but they are also competing with technology-enabled communication and collaboration tools that have called into question the future of the industry. This dynamic presents a significant source of uncertainty for office real estate owners. 

The dire predictions about the death of office space in the early days of the pandemic have not really materialized. Multiple surveys have shown that employers want their employees to come back to the office. We are already starting to see companies sign long-duration leases, demonstrating confidence in the long-term future of the office. In the long run, we believe that offices will continue to be the centerpiece of workplace strategy and will play an essential role in facilitating collaboration, harnessing innovation, and maintaining the company culture. 

Having said this, hybrid workplace policies are now increasingly becoming the norm in corporate America and present a very significant challenge to future office demand. As companies adopt hybrid work policies, workplace management solutions like hot-desking can materially reduce the square footage per employee, leading to further stress on office demand. We can already see some evidence of this dynamic playing out as companies are starting to track the utilization rate of various spaces in their portfolios and then using tech solutions to optimize the utilization. These solutions can have a structural long-term impact on the demand for office space. For instance, if a certain company predicts that on average their employees will return to the office two days per week, then they can shrink their existing office footprint to maximize space utilization. They can also use the services of flexible office space providers to plan for days when a high percentage of employees come to the office. 

The impact of the hybrid work-related disruption can be seen in office real estate fundamentals like vacancy rates, net absorption, and rental rates. The national vacancy rate for office spaces was recorded at 17.5% for first-quarter 2022, up approximately 5% compared with prepandemic levels. The vacancy rates for office buildings in Manhattan are even worse. Cushman & Wakefield reported a vacancy rate of 21% for office buildings in Manhattan. To put this number in context, the prepandemic average office vacancy rate in Manhattan was approximately 10%. The Manhattan net absorption rate remains negative as of first-quarter 2022 and rental growth figures are disappointing especially given the highly inflationary environment.

Efficient scale is the primary moat source for real estate investment trusts. This moat source refers to situations where companies are effectively serving a very limited market size, and potential competitors have little incentive to enter the market because by doing so, they would lower the industry’s returns to below the cost of capital. We do not see any evidence of these competitive dynamics in Manhattan for office properties. 

First, we think that the market size for office buildings in a particular submarket is poorly defined. The built-up nature of central business districts across the country allows for a significant concentration of fungible office square footage within a limited area. However, the definition of an office market can in some senses be extended to an entire metropolitan area, as evidenced by the prevalence of corporate relocations within a given region. In other words, the demand for office space within a particular submarket is not fixed as potential office space occupiers can easily move to other submarkets within a region. 

Second, the owners of office buildings do not have pricing power because the office markets are highly fragmented, with no single entity owning a significant share of inventory within a given geography. Despite SL Green being one of the largest office REITs in Manhattan, we estimate that it owns less than 7% of the total office inventory in the Manhattan market. This limited market share prevents the company from achieving the pricing power necessary to achieve an efficient scale moat source. 

Last, when assessing an efficient scale moat source, we typically look for a material cost to enter a market and the necessity of a significant market share to make these fixed costs worthwhile. Although large office properties can be costly to develop and acquire, no additional barriers are preventing new players from entering a market. Each property can operate on a stand-alone basis, and the benefits of accumulating properties in a single location are limited. This allows markets to remain fragmented and encourages new entrants when excess returns are to be had. 

We estimate that SL Green has an average lease term of around eight to nine years. We do not think the mere length of these contracts constitutes a switching cost for the firm, given that our time horizon for a narrow moat is 10 years. Contract terms are negotiated by companies that will assess their business needs over the time horizon of the lease. The preponderance of comparable substitutes prevents the company from dictating favorable lease terms. Furthermore, leases are not fully binding and can be terminated by tenants, with termination income not constituting enough of a financial sum to constitute switching costs.

We would also like to point to the broker-driven nature of the commercial real estate market as further evidence that SL Green lacks pricing power. Brokers such as JLL and CBRE negotiate on behalf of tenants to ensure that the terms of lease agreements are priced appropriately. Because of the third-party broker arrangement, there is little opportunity for the company to directly influence a leasing decision, and leasing terms tend to be specified to meet client needs and reflective of current market rates coordinated through the brokers. This dynamic is reflected in SL Greens' inability to charge a premium on its properties on a rent per square foot basis as compared with properties of similar quality and location. This points to the commodified nature of office space, supporting our assertion that SL Green lacks a moat. 

SL Green invests primarily in central business districts in New York City, the nation’s largest metropolitan area, with over a fourth of business district office space in the country. As compared with suburban markets, these urban markets are considerably more land constrained and are subject to more stringent zoning restrictions limiting construction. These restrictions are informal, with proposals for development being subject to a bureaucratic and opaque approval process. We think these limits make CBDs a more attractive location to own office space, we do not view the restrictions as sufficient to constitute a regulation-driven intangible assets moat source. 

SL Green has strategically concentrated on central business district properties in New York City in a bid to benefit from the city’s supply constrained nature and its preeminence as a global talent hub. Indeed, the New York City market faces significant geographic constraints, with the island of Manhattan particularly immune to the sprawl that characterizes other large metropolitan areas, such as Houston. In addition, a relatively stringent zoning code creates a market with considerable supply constraints. Nevertheless, we posit that New York is in fact not the most supply constrained metropolitan area in the U.S, with markets such as San Francisco exceeding it in that regard. Furthermore, recent history shows that supply additions are not hard to come by despite the scarcity of vacant land in the metropolitan area. 

In fact, we would point to the Hudson Yards megadevelopment, which is projected to add about 10 million square feet of mostly Class A office space, as a prime example. Additionally, the recent emergence of submarkets such as downtown Brooklyn and the Chelsea Market demonstrates that adjacent neighborhoods always represent a potential source of new supply in a particular region. Although zoning constraints often pose a challenge, the rezoning of Hudson Yards and Midtown East are salient examples demonstrating that such changes are infrequent but not impossible. Therefore, we think SL Green’s focus on New York City central business district properties is prudent but does not merit a moat rating. Over the long run, office markets tend to see supply additions commensurate with additional demand. We think that SL Green and its competitors have benefited modestly from supply constraining regulations but do not view this as an enduring and strong enough dynamic to support the generation of excess returns over the next 10 years.

Additional supply is added to the market via new developments, but also redeveloping older buildings to meet the latest needs of the market. Many developers focus on redeveloping Class B and C properties to Class A properties to sidestep limits on new construction. The investments into redevelopment are often accompanied by strong returns. Firms can pump $100-$200 per square foot into building renovations and achieve rent increases of $10-$20 annually. We see this as a substantial source of new supply for high-quality inventory as the company’s core markets are littered with eligible redevelopment opportunities. For example, Class B property in New York provides plenty of candidates for redevelopment, with Class B asking rents often in the neighborhood of $55-$65 per square feet, much lower than their Class A counterparts which command upward of $80 per square feet. 

We use an adjusted ROIC calculation to determine whether a company has shown or is forecast to have the characteristics of an economic moat. After adjusting the ROIC calculation to use maintenance capital expenditures instead of accounting depreciation, we calculate that over the past few years, SL Green has averaged an adjusted ROIC of approximately 290 basis points below our 7% weighted average cost of capital. We expect the adjusted ROIC of the company to remain materially below the WACC over the next decade. Therefore, we believe there is currently not enough quantitative or qualitative evidence to support a moat for SL Green.

None

Economic Moat

SL Green Realty

SL Green Realty Corp. operates as a real estate investment trust. The firm engages in the acquisition, development, ownership, management and operation of commercial and residential real estate properties. It operates through the Real Estate, and Debt & Preferred Equity Investments business segments. The Real Estate segment consists of security, maintenance, utility costs, real estate taxes, and at certain properties ground rent expense. The Debt & Preferred Equity Investments segment includes cash flow from operations, cash on hand, and other forms of secured or unsecured financing. The company was founded by Stephen L. Green in June 1997 and is headquartered in New York, NY.

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SL Green Realty Corp. is a real estate investment trust, which engages in the acquisition, development, ownership, management, and operation of commercial real estate properties and principally office properties. It operates through the Real Estate, and Debt and Preferred Equity Investments segments. The company was founded by Stephen L. Green in June 1997 and is headquartered in New York, NY.

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