Analyzing Vornado (ticker VNO) provides an opportunity to delve into the world of real estate porn. Specifically VNO is developing 220 Central Park South which is a condo building being developed just south of Central Park on "Billionaire's Row." It was recently announced that the penthouse of the building is being offered for $250M which equates to $10,870 psf.
While this pricing makes this listing worthy of being real estate porn, what makes this more interesting is that VNO is the developer and as a publicly traded company, VNO can be owned by anyone and therefore one can be on the receiving end of these sky high prices. If we look at VNO's 1Q16 supplemental release shown below, we see that 220 CPS is projected to have an all in cost of $2.15B or $5,422 psf.
We can then look on the website for the Attorney General for New York State and see that the building is currently registered for a sellout price of $3.17B or a $1.02B over cost. The screen shot from the website is shown below.
Debt on 220 CPS
We can further check the financing that is being employed on the development and we see that a floating rate loan of $950M is being used to construct the project that is currently set to 2.43%.
220 CPS ROE
While the cash return on 220 CPS is healthy, the equity return is likely to be higher as depicted in the table below. Shown is the cost compared to the sellout price which yields a cash profit of $1.02B. The total equity invested will be $1.20B equating to a return on equity of 84.7%.
Present value of 220 CPS
If we then look to value the 220 CPS project, we see that there is a remaining cash outflow of $1.30B for development costs and anticipated revenues of $3.17B which is the sellout price. The development is not expected to deliver for 2 years so the development costs will be spent over the next two years and the sales will close subsequent to delivery. We can assume that our cost of capital includes debt whose cost is incorporated into the project cost and equity which we can estimate to be 8%. We can then greatly simplify the timing of the future cash flows by assuming they all happen in 2 years at the delivery of the project which gives us a present value of the project of $1.71B for Vornado. For those who prefer to complicate the valuation process by using more precision to estimate either the equity cost or the timing of the future cash flows, note that any tinkering will add complexity and will not lead to any material difference in the present value calculation.
The rest of Vornado
In addition to its development projects, VNO owns properties in New York, DC, San Francisco and Chicago. It also owns stock in other publicly traded REITs including Alexander's (ticker ALX), Urban Edge Properties (ticker UE), and Pennsylvania REIT (NYSE:PEI). To analyze VNO's current valuation, VNO's assets will be separated into its development projects, land, cash, inter-REIT investments, and its operating properties. We can then compare the calculated value of VNO's operating properties to the income return generated by these properties and compare this metric to similar metrics such as NCREIF properties' cap rate and recent property sale comps.
As discussed above, 220 Central Park South is the marquee development for VNO but there are other developments and land assets owned by VNO as depicted in the chart below from their 1Q16 Supplemental. As discussed above, we will assign a value to 220 CPS of $1.71B owing to its anticipated future cash flows. We will value the remaining projects at their book value.
VNO owns several land assets which are shown in a table pulled from the 4Q16 Supplemental. The 1Q16 supplemental did not include the basis in each property so we pull this information from the 4Q16 supplemental. Land is notoriously hard to value due to its volatility but using the land's basis is a reasonable way to value it which we will use.
It is quite convenient that the other REITs owned by VNO are also publicly traded. So to value them it is a matter of multiplying the shares owned by the price of the stock to get the total valuation of their inter-REIT investments.
Other non-NOI generating Assets
The other largest non-income generating asset owned by VNO is cash. Therefore $1.673B in cash is separated out from the income generating assets owned by VNO as that is the amount reported in VNO's 1Q16 supplemental.
In projecting future NOI for VNO's operating properties, we need to understand what the historical NOI was for the properties presently owned by VNO. If VNO had not purchased or sold any properties in the past 12 months, this would make the task quite easy. But VNO has had numerous acquisitions and dispositions in the past 12 months as depicted in the summary of acquisitions in 2015 below pulled from their 4Q15 Supplemental.
For each acquisition or disposition, an adjustment can be made to the trailing 12 months (NYSE:TTM) NOI to reflect the NOI that would have been generated had the property been owned for the past 12 months. For instance for 265 West 34th St, the property was acquired for $28.5M. In a perfect world each acquisition or disposition announcement would include a disclosure as to the anticipated NOI that will be generated by the property in the next 12 months but that is generally not the case. So a reasonable assumption can be made as to the NOI generated by each property if its NOI is not disclosed. Therefore we can assume a 4% cap rate for the purchase of 265 West 34Th which would imply $1.14M of NOI is generated each year. By 1Q16, almost 2 quarters of financials have included the NOI contribution of 265 West 34th so only 2 quarters of its NOI contribution need to be estimated which is a contribution of $0.57M of NOI that is not included in the TTM NOI.
Transactions subsequent to most recent quarter
Some transactions are made subsequent to the most recent quarter's financial disclosures so adjustments need to be made for these. For instance, VNO recently announced they sold a 47% interest in 7 West 34th St. at an implied price of $561M. Therefore an upward adjustment in cash for the $264M paid was made along with a downward adjustment in TTM NOI of $10.5M based on an assumed 4% cap rate.
VNO's Income Producing Assets
When we make adjustments for VNO's non income generating assets and mark their stock price to market based on a closing stock price of $95.78 on June 7, 2016, we get a total of $28.3B of income producing assets for VNO.
GAAP Income Return Generated
If we calculate the GAAP NOI generated by VNO's share of their income generating properties in the TTM along with adjusting for acquisitions and dispositions, we get a GAAP NOI of $1,507.2M. It should be noted that this number does not include any fees associated with financing, impairment charges, or other non-property level costs. This is what allows for the comparability to NCREIF data and property sale comps.
Cash Income Return Generated
GAAP income returns include the effect of straight lining rents. In practice, leases generally have built in rent escalations so if a lease starts at $50 psf and ends a $60 psf after 5 years, the GAAP revenue will be a uniform $55 PSF over the lease term. The net effect is that cash NOI is generally around 6% lower than GAAP NOI. In addition, if there is a free rent period at the beginning of a lease, GAAP income starts immediately whereas cash income return starts when the free rent period expires. Ideally the best way to calculate a REIT's cash NOI would be to adjust for straight line rents but add back in free rent as free rent is not recurring and is volatile.
Unfortunately VNO does not bifurcate the effect of straight line rent into the effect of free rent and the remaining straight line adjustment. We can look to the reporting of SL Green (ticker SLG) which does present this bifurcation of straight line adjustments. We calculate that the effect of straight line rent, not including free rent, was a downward adjustment to GAAP NOI of 6.5% in 1Q16. This is lower in comparison to the downward adjustment on GAAP NOI that would result from adjusting for all of the effects of straight line rent of 12.7% for VNO in 1Q16. So if we adjust the TTM GAAP NOI, including the effects of acquisitions and dispositions, with a downward adjustment for 6.5% for straight line rents less free rent, we get $1,405.6M in cash NOI.
TTM GAAP and Cash NOI
When we calculate the implied cap rate on VNO's properties using TTM GAAP and cash NOI, we get implied cap rates of 5.33% and 4.97% respectively as shown in the chart below. But for valuation purposes we need forward looking implied cap rates so we need to make NOI growth rate estimates.
Signed Leases not Commenced
In projecting VNO's forward looking NOI growth rate, it is informative to review the transcript of VNO's 1Q16 earnings call. Specifically the comment by Steven Roth:
Steven Roth: As of today from this leasing, we have $200 million plus of incremental additive cash NOI on deck, not yet in our numbers, which will be recognized between now and 2018 as follows: $41 million in the remainder of this year; a $120 million in 2017; and another $39 million in 2018, all from signed leases which have not yet commenced paying cash rent… The equivalent GAAP increment that has yet to come into income over that period is $83 million.
Later in the call analyst Alex Goldfarb asked:I think you mentioned $83 million of GAAP but can you just -- how we should think about that $83 million was this year or was that something else? And then second is while you have the $200 million of NOI that you laid out, what should we think about as far as move-outs that would offset that amount over the next -- this year and next?
Steven Roth: With respect to the timing of how the $83 million of GAAP that is yet to be recognized -- Steve, I don't have that. Steve, do you or Joe have it.
Joseph Macnow: We do. Alex it's Joe. That's approximately $53 million this year and $31 million next year.
Alex Goldfarb: And then, what should we be thinking about as far as lease move-out that would offset the $200 million?
Steven Roth: Well, the answer to that is none. Now, let me explain that to you. The $200 million of cash NOI that is yet to be recognized on our book is totally additive. So, there is no move-outs that will offset that… we have $200 million of additive cash NOI that will feed in -- as I mentioned, so much this year, so much '17, and a little bit -- and little tail in '18.
So the result from a modeling perspective is that we can expect an additional $83M in annual GAAP NOI and $200M in annual cash NOI to manifest itself in the next two years as a result of signed leases not commenced which represents contractual income as opposed to speculation or projections. Due to the economics of office real estate in which operating expenses are largely fixed, we can interpreted the increased NOI as an increase in revenue.
Contractual Lease Bumps
Office leases generally have annual built in rent escalations and in my experience a good estimate for this is 3%. It would be helpful if REITs reported the weighted average annual lease escalation so this could be cited by analysts and used for projections but they do not so a reasonable estimate of 3% is assumed. Expenses can be assumed to grow at 3% a year and historical GAAP expenses can be used to project both forward GAAP and cash expenses as there is not an ongoing material difference between the two as there is with revenue.
Projected NOI Growth
Shown below is the source of projected both GAAP and cash NOI growth for VNO in the next 2 years. It is the combination of the additional signed leases not commenced (SLNC) revenue and the estimated annual 3% rent bumps.
If we then use these projected growth numbers, we can calculate that the current implied GAAP cap rate for VNO's income producing properties using the projections above is 5.64% and in one year the current pricing will result in an implied GAAP cap rate of 5.94%.
Similarly the current implied cash cap rate is 5.47% and in one year the current pricing will result in a cash cap rate of 5.98%.
Now that we have calculated the forward looking GAAP and cash implied cap rates for VNO, we can compare these to other market metrics.
NCREIF Properties Comparison
The National Council of Real Estate Investment Fiduciaries (NCREIF) tracks the performance of 1,414 institutionally owned office properties in the United States with an aggregate value of $181B as of 1Q16. As part of their reporting, they report both the income return and capital return generated by these properties as a percent of the total value of the properties. Because the income return is based on GAAP accounting, it is directly comparable to the present GAAP NOI we calculated for VNO's income generating properties above.
To improve the precision of this comparison, we create a synthetic portfolio of NCREIF tracked properties that has a similar market concentration to VNO. VNO reports EBITDA by market which we can use as a proxy for the market concentration of VNO's properties. We can then use the income return generated by properties in each of these markets in 1Q16, annualize them, and take the weighted average to get the weighted average GAAP cap rate of a NCREIF portfolio with a similar market concentration to VNO. The result is a GAAP cap rate of 3.94% as shown below.
We can then compare this to the GAAP NOI generated by VNO in 1Q16 thereby creating an "apples to apples" comparison. The annualized implied GAAP cap rate in 1Q16 is 5.26% when VNO's stock price at $95.78. If VNO's GAAP cap rate were at parity with a similar NCREIF portfolio, its stock price would be $145.28 or an increase over its current price of 51.7%. We can then make this same calculation for the current projected GAAP NOI and the 1 year forward projected GAAP NOI. VNO's stock price would need to increase 63.0% and 74.3% respectively to be at implied GAAP cap rate parity with the synthetic NCREIF portfolio.
Office Sales Price Comps
The data for office sales comparable comes from SLG's June 2016 REITWeek presentation and are summarized in the table below. What it shows are a total of $9.2B in transactions that have a weighted average cash cap rate of 4.1%. 70% of VNO's EBITDA is in New York so this is a reasonable set of comparables for these buildings. VNO also owns properties in DC, Chicago and San Francisco where properties are selling at similar cap rates so this set is deemed reasonable for VNO's whole portfolio. Building a more robust comparables set from the other markets in which VNO owns properties would not likely lead to a material change in the cap rate calculation.
These sales comparables are quoted in cash and therefore are directly comparable with the current cash NOI. We can then calculate the increase from VNO's current price required to make VNO's implied cash cap rate move to parity with these sales comp for the current cash NOI and the projected 1 year forward cash NOI. As shown below, an increase in VNO's stock price of 49.0% and 66.9% would be required to move VNO's cash implied cap rate to parity with these recent office sales.
Why VNO should move to Implied Cap Rate Parity
After making the robust argument that VNO is currently priced significantly below both GAAP and cash implied cap parity with privately owned office properties, the question becomes why should this parity relationship exist and will it move towards parity. The answer is that VNO's management can exploit this mispricing by selling its properties for significantly more than where VNO's stock price values them. Recently VNO sold a 47% interest in 7 West 34th Street for a price that implied the building is valued at $1,176 psf. Unfortunately VNO did not publish the anticipated year 1 NOI for this building so calculating an implied cap rate is not possible but it is likely in line with the average 4.1% cap rate seen in recent Manhattan transactions.
VNO's management could also help move VNO's valuation to implied cap rate parity with its properties by foregoing acquisitions in lieu of repurchasing their own stock. From a capital budgeting perspective, if their stock offers more value than the acquisition of a property, which appears to be the case based upon the large disparity between VNO's implied cap rate and the cap rate at which similar properties are trading, then VNO should forego acquisitions in favor of stock repurchases until their stock price moves to a price at which VNO's stock offers similar value to a property acquisition.
Finally, institutional investors who own office buildings similar to ones owned by VNO should consider selling their buildings and investing the proceeds in shares of REITs such as VNO that offer significantly more value than direct property ownership. In theory investors should demand an illiquidity premium to hold an illiquid asset such as an office building but currently they are paying a large premium to have neither price discovery nor liquidity.
In an investment environment where GAAP earnings are decreasing and S&P 500 companies tend to have regularly recurring "non-recurring" expenses as depicted below, VNO offers something investors should be interested in, growth in free cash flow to equity. Per our earlier calculations, VNO has contractual rents that are expected to increase their free cash flow to the firm (FCFF) by 9.6% over the next 2 years. We can calculate that VNO's economic leverage is currently 45.6% and if debt costs stay the same over the next 2 years, VNO's free cash flow to equity (FCFE) can be expected to increase by 15.4% annually over these 2 years. In addition to the anticipated increases is FCFE, the current valuation of VNO is much lower than the value of their underlying assets as quantified above. The combination of the anticipated growth in FCFE and the undervaluation of VNO in comparison to its assets makes VNO a very attractive investment option.
Disclosure: I am/we are long VNO, SLG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: VNO should be the primary ticker