The COVID-19 pandemic has ushered in all sorts of predictions about the death of dense urban office buildings. According to Savills Research, Manhattan offices had a 15.1% vacancy rate at the end of 2020, the highest in more than 20 years. Despite the grim news and the general acceptance of work-from-home arrangements, office real estate investment trusts (REITs) like SL Green (NYSE:SLG) are optimistic. What explains the apparent disconnect?
The largest office landlord in Manhattan
SL Green is the biggest office landlord in Manhattan. As of Dec. 31, it held a financial interest in 88 buildings, containing 38.2 million square feet. In addition to office properties, the company also has exposure to residential and retail. Roughly a third of SL Green's tenants are in the financial-services business, while another 22% are in the technology, advertising, media, and information businesses. The financial and tech sectors account for over half of New York City's office demand.
For the fourth quarter, SL Green reported $1.56 per share in funds from operations (FFO, the REIT equivalent of earnings) and $7.11 for the full year, compared to $1.75 and $7.00 per share for the fourth quarter and full year of 2019. Part of the decline in FFO was due to losses on certain debt and preferred equity investments that were sold and reserves against some retained investments. Same-store net operating income (NOI) decreased by 5.9% in the fourth quarter compared to the fourth quarter of 2019. That said, same-store NOI was up 4.6% for the full year. Of the 1.2 million square feet in leases signed in 2020, about 900,000 were replacement leases for expiring ones. Those leases had average starting rents of $66.57, which was a decrease of 3.6%.
A recovery is getting close
That said, SL Green sees this as a blip and believes New York City is on the road to recovery. On the earnings call, CEO Marc Holliday gave some color on the economic backdrop to the story:
The financial and tech sectors in New York City, which account for over half of the office space demand, are doing extremely well and they added 5,000 office using jobs in December alone. The city is forecasting a significant amount of new office jobs in 2021, such that we would return to pre-pandemic office employment levels by the fourth quarter of this year, recouping all of the 165,000 office jobs lost at the outset of the pandemic.
Note that he is talking about financial- and tech-sector jobs, not all private-sector jobs. New York City forecasts a return to pre-pandemic levels for office jobs by the end of this year. Non-office jobs (especially in hospitality and restaurants) have been hit much harder, and normalcy should return there sometime in 2023. Still, the potential financial returns for SL Green are the highest in over 10 years, if you look at cap rates minus the 10 year Treasury. Cap rates describe the expected income from a property, and the 10-year yield can be used as a proxy for borrowing costs. The bigger the difference, the better the opportunity. At the end of the third quarter of 2020, SL Green saw the spread close to 4%, which is a great rebound from two years ago, when it hit its low of 1.3%.
In December, SL Green's Board of Directors authorized a $500 million increase to the size of its share repurchase program, bringing the program to a total of $3.5 billion. The fact that FFO was slightly up for the year is encouraging given that 2020 is a year most REIT investors would love to forget. The stock also pays a monthly dividend of $0.303 that yielded 5.8% at Friday morning's prices, and it recently issued a special dividend. Income investors who are optimistic about a business rebound for New York City might find SL Green worth a closer look.