SL Green Realty (SLG 5.50%) is a real estate investment trust (REIT), a corporate structure designed to invest properties and to pass on most of its taxable income to shareholders. That it would have a high yield is hardly surprising.
But at 13.5%, the dividend yield for the office-space REIT is worryingly elevated. Here's what's going on and why investors might want to tread with caution.
The lingering pandemic hit
Even in good times, it is expensive to operate a portfolio of offices. Historically speaking, office REITs have had modest payout ratios because of this. As an example, every time a tenant vacates a space, landlords like SL Green have to look for a new tenant and (here's the expensive part) provide improvements to the location to get the new tenant in the door.
In competitive office-space markets, such as SL Green's New York City home, the time and expense can be quite significant. Selling properties can be equally time-consuming and difficult.
Adding to the complexity is the fact that office buildings usually have multiple tenants, so there's always space being vacated and filled. At the same time, SL Green has to keep current occupants happy. And it has to deal with taxes and other costs, such as maintaining its buildings. Even in good times, offices are one of the more challenging property types to manage.
If only we were in the good times. When the pandemic started in 2020, the office sector was upended. The trends of social distancing and working from home to slow the spread of the illness left many offices vacant.
Tenants often continued to pay rent, but clearly things were changing -- perhaps not in a particularly good way. Three years after the start of the pandemic, working in an office remains a source of contention between employers and employees.
There are a couple of key trends here. First, there are some jobs that will never return to the office because they really don't need to. Second, even when companies ask employees to return to the office, they are often only requiring three or four days of attendance per week. The end result is that less office space is needed, and it's increasingly looking like this has caused a permanent shift in demand.
It's been bad
For SL Green, the end result of all this upheaval was a dividend cut at the end of 2022. The reduction was relatively modest at roughly 13%. That's the good news.
The bad news is that even after the reduction, the shares have continued to fall, suggesting that investors don't think the reduction was enough. The yield is still troublingly high, as noted above.
Last year's performance wasn't exactly terrible. For example, occupancy was 91.2%, including signed leases for spaces yet to be occupied. And adjusted funds from operations (FFO) were $6.76 per share, compared to $6.63 in 2021. The 2022 adjusted FFO payout ratio was a very modest 55%, excluding a special dividend paid early in the year. From this perspective, SL Green would seem to be a fairly healthy company.
Except that the cash rent level of new leases was lower in three of the last five quarters. Rent concessions have been notable as well, with high-single-digit months of free rent and high-double-digit dollar spending per square foot to pay for tenant upgrades.
SL Green is clearly facing a difficult market. And although the 91.2% occupancy statistic wasn't terrible, it was down from 93% a year ago. Things are not getting easier.
The REIT's ratio of financial debt to equity (which uses market cap instead of shareholder equity) hasn't been as high as it is today since the Great Recession. It is also above the levels of some of the company's closest peers. So it appears to be highly leveraged.
And the Great Recession also was the last time SL Green cut its dividend. If a recession arrives in 2023, as some expect, the REIT will face an even more difficult operating environment.
Hold off for now
Leasing activity is hard to quantify because a few big transactions can skew results. But most investors would probably be better off watching SL Green until it strings together at least a few good operating quarters.
Yes, the yield is attractive and by some metrics looks safe. But the recent dividend cut, leverage, and enduring office headwinds suggest that there's considerable risk here. And a recession, a very real possibility, would only make matters worse.