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Long only, value, hedge fund manager, REITs
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Summary

  • New York Realty Trust is significantly undervalued.
  • NYRT trades at a 20% discount to implied cap rate of comparable REIT.
  • Implied cap rate parity should exist for REITs that own properties in the same market.

Office Building Cap Rate Valuation

When valuing an office property, often cited is the cap rate which represents the annualized operating income of the property divided by the valuation of the property. When one properties' cap rate is lower than another's, it is an indication that the property with the lower cap rate is expected to have either higher operating income growth in the future or the capital costs associated with sustaining that operating income are expected to be lower than that of the building with the higher capitalization rate. Similarly this is the case with a portfolio of office buildings in that the portfolio with a lower capitalization rate is expected to have higher rent growth or lower capital costs in aggregate than the portfolio with the higher capitalization rate valuation.

Implied Cap Rate Valuation of REIT owned Properties

One can apply this principal to the valuation of publicly traded REITs to determine the relative valuation between them. Complicating this analysis is that REITs do not report their performance at the property level aggregate, they report on the performance of their equity. However adjustments can be made to get a good estimate of what the market is valuing their underlying properties at in terms of a capitalization rate. The calculation of the property level implied capitalization rates of the REITs cited in this article are detailed in an appendix to this article as the implication of the parity assertion made in this article is predicated upon the correct economic calculation of the implied capitalization rate of properties owned by REITs.

NYC REITs

The three publicly traded REITs cited in this article are SL Green (NYSE:SLG), Empire State Realty Trust (NYSE:ESRT), and New York Realty Trust (NYSE:NYRT). The reason for the comparison between these REITs is that the significant majority of each of these REITs' properties are located in Manhattan. The maps of each of these REITs' properties are shown below. It should be noted that each of these REITs also own properties outside of Manhattan but still within the New York City Metro area. Nevertheless the overwhelming majority of the value of properties owned by these REITs is located in Manhattan.

New York Realty Trust's property map

SL Green's Property Map

Empire State Realty Trust's Property Map

The closing stock price of SLG, ESRT, and NYRT as of Friday, August 15, 2014 was $109.83, $16.49, and $10.45 respectively. This translates to an implied cap rate of 4.98%, 5.03%, and 5.63% for SLG, ESRT, and NYRT. The implication of these implied cap rates is that the NOI growth and capital required to sustain this NOI growth is similar for SLG and ESRT but the NOI growth will be slower or the capital required to sustain this NOI growth for NYRT will be greater than SLG or ESRT's properties.

NOI Growth

In order to consider the possibility of higher future NOI growth for SLG and ESRT, it is advisable to bifurcate NOI into both revenue and expenses at the property level.

Expenses

Property level expenses are comprised of taxes, utility expense, cleaning, security, maintenance, and other sundry expenses. All buildings located in Manhattan pay taxes to the same taxing entities, receive power and water from the same utilities, and likely employ similar cleaning, security, and maintenance services from competitively bid third party providers or in house providers. In projecting NOI growth in the future, it is not important what the expenses are currently, but the future rate of change of these expenses. Considering the similarity of expenses all Manhattan buildings share, it is considered unlikely that one REIT's pool of properties will have materially less growth in expenses than another REIT's pool of properties.

Rent Revenue

As depicted in the maps of each REIT's properties, the properties of all three REITs are located in proximity to each other in Manhattan. Therefore these buildings are often competing with each other for the same tenants. Tenant representatives work with office tenants to get the best economic deal for office space for their clients. This keeps the market for rental office space quite efficient as tenant reps shop for office space for a living. Similarly to expenses, it is not important what the rental rate of each building is, but the rental growth rate differential between buildings that is important when assigning a capitalization rate valuation to a building.

It is conceded that some areas of Manhattan are more desirable than others and thus command higher rents, but it is unlikely that one large pool of office properties, represented as those owned by a publicly traded REIT, located in Manhattan will be able to sustain rent growth materially higher than another large pool of office properties. Therefore the assertion implied by a differential in implied cap rates of public REITs that one pool of office properties located in proximity to another pool of office properties, that are competing for the same tenants, will be able to sustain higher rent growth is deemed spurious.

Capital Expenditure

One justification for assigning a lower capitalization rate to a building over another is that the anticipated future capital expenses to sustain the income return will be lower for the building assigned the lower capitalization rate. This makes sense when a new building is sold that has long term leases in place as the costs to maintain a new building is expected to be lower than that on an older building and the costs associated with getting tenants into a building such as tenant improvements and leasing commissions will be lower for a new building that has long term leases in place.

When considering a pool of buildings, this is much less likely as the tenant roll over schedule for a pool of buildings looks much more uniform than that of a single building. Similarly, the average lease term of pools of buildings located in proximity to each other are likely to be similar as tenant representatives are shopping the same tenants between these competing buildings. Therefore the likelihood of one pool of properties located in proximity to another pool of properties having materially lower capital expenditures is unlikely.

Parity Condition

With the discussion of the implication of differing implied cap rates of publicly traded REITs as background, one can consider the present pricing of public REITs. As stated earlier, the implied capitalization rate as of August 15, 2014 of SLG was 4.98%, of ESRT was 5.03%, and of NYRT was 5.63%. In order to economically justify its significantly lower implied capitalization rate, NYRT would need to achieve materially lower NOI growth or higher capital expenditure on its pool of office buildings compared the pool of office buildings owned by SLG or ESRT.

In light of the discussion of what would need to happen for this to materialize, it is considered unlikely that the pools of properties owned by SLG and ESRT will outperform the pool owned by NYRT and therefore NYRT offers significantly more value than either SLG or ESRT due to its much higher implied capitalization rate. In order for NYRT to achieve implied capitalization rate parity with SLG and ESRT, its implied capitalization rate would need to move to 5.00% and to do this, its shares would need to trade at $12.43 or an increase from its present value of 18.9%.

Calculation of Market Implied Cap Rates

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Source: New York REIT: Significantly Undervalued Compared To SL Green And Empire State

Additional disclosure: Mr. Bollinger runs a long only private investment fund that invests in publicly traded REITs that own office properties