Concerns about the commercial real estate sector have been festering for a while, and ground zero for commercial real estate woes is office properties. The COVID-19 pandemic proved the efficacy of work-from-home, and a tight labor market has given workers the upper hand in negotiations over a return to the office. This has kept office vacancy rates elevated, which has in turn hit office-property valuations. SL Green (SLG -0.53%) just reported second-quarter earnings that beat Street expectations. Is it time to dip a toe into the office real estate investment trust (REIT) sector?
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SL Green is Manhattan's landlord
SL Green is known as Manhattan's landlord, with a portfolio of 30 buildings with 33.1 million square feet of gross leasable area in office and mixed-use properties. Most of its assets are in the top tier of quality, known as Class A properties.
SL Green reported a big net loss for the quarter due to valuation write-downs. However, funds from operations (FFO) were positive at $1.43 per share. This compares to $1.53 in the first quarter of 2023 and $1.87 a year ago. Real estate investment trusts like SL Green prefer to report earnings using FFO instead of net income as calculated under generally accepted accounting principles (GAAP). This is because depreciation and amortization are big deductions under GAAP but aren't actual cash expenses. Nobody writes a check for depreciation and amortization. FFO provides a more realistic picture of the company's cash flows than net income as reported under GAAP. This also explains why REITs might look expensive on a price-to-earnings (P/E) basis.
Occupancy continues to decline
The biggest issue for SL Green has been declining occupancy rates. Properties of many REITs experienced a decline in occupancy during the COVID-19 pandemic. While a few have recovered, many REITs have not. SL Green is among this latter group. In fact, occupancy continues to decline. At the end of 2019, SL Green's occupancy stood at 94.3%. Since then, it has declined every single quarter to 89.8% at the end of Q2 2023.
If things don't improve, another dividend cut could be in the cards
SL Green was forced to cut its monthly dividend in December 2022 from $0.311 to $0.271. The problem is that FFO per share continues to decline as do funds available for distribution (FAD). The payout ratio (which is the dividend divided by FFO) has been steady in the 54% to 55% range. However, the payout ratio based on FAD has been moving up from 71% a year ago to 90% today. While REITs might have a bad quarter and pay out more than FAD, this is usually a warning sign that the dividend isn't on solid ground.
SL Green has projected 2023 FFO per share of between $5.30 and $5.60. At the midpoint of the forecast, this puts the stock on a price-to-FFO ratio of 6.2 times, which certainly seems cheap. The dividend yield is more than 9%, but given what we know this should be taken as a red flag for the stock. The problem for SL Green is that occupancy continues to fall, which reduces the value of its assets. As SL Green sells properties, the amount it receives from asset sales falls is a cooling market. While SL Green will probably be able to roll over maturing debt, the amount it will have to pay in interest will undoubtedly go up to compensate investors for the added risk. SL Green looks more like a value trap than value at the moment.
