Vornado Realty Trust - Buying World-Class NYC Real Estate for 30 Cents on the Dollar
A generational opportunity to invest in distressed NYC commercial real estate at a significant discount to underlying asset value.
“The one thing I’m sure of is that by the time the knife has stopped falling, the dust has settled and the uncertainty has been resolved, there’ll be no great bargains left. When buying something has become comfortable again, its price will no longer be so low that it’s a great bargain.” – Howard Marks, The Most Important Thing
The topic du jour is Vornado Realty Trust (NYSE: VNO). VNO is a prime example of a “falling knife” opportunity that, despite the uncertainty, in my view, is trading at bargain-basement levels. As one of the largest owners of office and retail properties in Manhattan, VNO has been unsurprisingly decimated since the onset of the pandemic. At the time of this writing, the common shares have recovered from the 2023 lows but are still down close to 70% relative to pre-COVID levels.
The current narrative is understandable. When you combine remote work, COVID lockdowns, higher interest rates, and the recent banking crisis, it’s obvious to almost everyone that commercial real estate (“CRE”) is in deep trouble. The overwhelming consensus seems to be that the next recession will be triggered by a massive wave of defaults in CRE, particularly in office loans. With loan maturities fast approaching, and asset values significantly impaired due to higher interest rates and lower demand, many operators are going to be forced to turn over the keys to the lender and walk away from their properties. To compound the problem even further, once you consider that ~70-80% of CRE loans are held by smaller regional banks, and the condition of such banks following the recent crisis, it becomes very hard to imagine how the CRE industry will escape from this mess unscathed.
As a result, the whole sector has sold off massively. The selling has been relentless and almost indiscriminate over the past 12 -18 months. When markets sell off in such a broad-based fashion, there are bound to be a few babies thrown out with the bathwater. I believe VNO to be one of those babies.
In this post, I’m going to lay out an overview of my thesis on VNO, what I think the market may be missing, and why I believe the company represents one of the most asymmetric opportunities available in the market today.
Before I dig in, as full disclosure, I am long VNO – I own the common stock, majority of which I’ve acquired at an average cost of ~$14 per share, as well as various classes of the preferred stock. I have been building up a stake over the past several months and may opportunistically buy more (or sell!) over the next 12-18 months depending on how the market environment evolves.
The usual disclaimer applies as always — this is not investment advice; please do your own DD before you make an investment decision.
Company Overview and History
Put simply, VNO is a fully-integrated publicly-traded REIT and one of the largest commercial landlords in New York. The company owns some of the highest quality Class A office skyscrapers as well as prime street retail properties on Fifth Avenue and Times Square. Here is a high-level breakdown of the portfolio (wholly and partially owned):
62 Manhattan properties, consisting of:
19.9 million SF of office space in 30 of the properties
2.6 million SF of street retail space in 56 of the properties
1,664 residential units in six Manhattan properties
Multiple future development sites, including 350 Park Avenue and the Hotel Pennsylvania
A 32.4% interest in Alexander’s, Inc. (“Alexander’s”) (NYSE: ALX), which owns six properties in the greater New York metropolitan area, including 731 Lexington Avenue, the 1.1 million square foot Bloomberg, L.P. headquarters building, and The Alexander, a 312-unit apartment tower in Queens
Signage throughout the Penn District and Times Square
Building Maintenance Services LLC ("BMS"), a wholly owned subsidiary, which provides cleaning and security services for its buildings and third parties, currently employing 2,622 associates
theMART in Chicago, the largest privately held commercial building in the US encompassing 3.7 million SF
And a 70% controlling interest in 555 California Street, a three-building office complex in San Francisco’s financial district aggregating 1.8 million square feet
VNO is a big real estate operation. Very big. To help you visualize the sheer size and scale of the portfolio, here are 6 key properties:
These 6 properties combined add up to roughly 12.3 million square feet, or 35% of total square footage in the portfolio.
Financial and Valuation Summary
There are a few things to note at the outset. At the current share price of $22, VNO is worth roughly $13.6 billion on an adjusted enterprise basis, including $4.6 billion of equity, $10.4 billion of debt, and $1.2 billion of preferred stock valued at liquidation preference.
This implies an 8.3% cap rate using trailing 12-month net operating income (NOI), which, notwithstanding the uncertainty and macro headwinds, is high by any historical standards. At its trough earlier this year, the implied cap rate was closer to 10%. Imagine that – receiving a 10% yield on some of the highest quality real estate in the world. As a point of reference, pre-COVID, VNO and similar assets were trading at 5% cap rate levels, and in some cases even sub 5%. An additional reference check – during the last real estate boom of the 2000s, Class A NYC commercial real estate traded at 5% cap rate levels in a 5%+ interest rate environment. Of course, history is not necessarily an indication of future trends but it’s helpful in contextualizing how investors have valued such assets in the past.
Given this view of the current state, here’s my back-of-the-envelope estimate of the intrinsic value range for VNO:
I recognize that this is a crude approach to estimating value but I find that in investing, it’s often more helpful to think in broad terms and be approximately right than precisely wrong. For a more granular analysis, I would highly recommend Warden Capital’s post on VNO — his conservative estimate also came close to ~$50 per share.
My central assumption here is that overall office and retail demand returns to normal and the market recovers back to the 5% cap rate ranges. Using an NOI approach, I estimate the value range to be somewhere between $55 and $85 per share. Even if we use the lower end of this range, this would still result in an attractive 2.6x multiple return from current prices – effectively buying Class A Manhattan real estate for 30-40 cents on the dollar.
Another approach would be to look at this from a replacement cost perspective – i.e. the cost it would take to build or replace these properties from scratch, assuming you could even find the available land in Manhattan. Granted, replacement cost has been a rather irrelevant and ephemeral measure in the valuation of real estate over the past several years given the large discount, but I believe it still serves as a useful proxy into potential future changes in underlying value. As a result of inflation over the past several years, replacement cost has been rising aggressively and is likely somewhere at the higher end of this range, if not even higher. This gives us an idea of where values could end up at the top of the upcoming real estate bull cycle.
An interesting point to note is that VNO has not only been discounted since COVID. In fact, there has been a persistent gap to NAV (~30%) going back since 2015. There were a few reasons for the undervaluation from 2015 through 2019. First, retail apocalypse was a key negative factor that bogged down the share price. In 2016 and 2017, retailers were going bankrupt left and right and many were closing a significant amount of stores nationwide. Although Manhattan street retail was more insulated than rural strip malls, few retail assets were spared in the turmoil.
Since VNO’s street retail business produced a meaningful 20% of NOI (despite comprising less than 10% of total SF), the uncertainty clouded the outlook for the company. VNO’s retail business began seeing a negative impact through NOI declines starting in 2018 - which further accelerated in 2019 and beyond due to COVID.
A second negative factor was the growing trend in coworking and flexible office space movement epitomized by Wework. As you may recall, there was significant investor enthusiasm for the promising unicorn startup and its potential to disrupt the traditional office sector in the same manner as Airbnb and Uber had overturned their own respective legacy industries. In hindsight, we can now look back and see that there was more hype than actual substance but I believe the euphoria did not help traditional players such as VNO.
The third and final key diminishing factor on VNO’s share price was the company’s large development pipeline. In the REIT world, investors tend to dislike ground-up development given the increased uncertainty — higher CapEx, higher leverage, and depressed earnings until the development is complete. At the time, VNO was planning to embark on two large successive development projects — 220 Central Park South and PENN District development.
220 Central Park South was, to the market, a highly ambitious $1.3 billion bet (ultimately it would cost ~$1.5 billion in development costs) on an ultra-luxury residential condominium tower during a time when the high-end condo market was facing oversupply and a waning foreign buyer pool. On a per SF basis, VNO was spending over $5,000 per SF on construction costs — $1,500 on the land and $3,500 for hard, soft, and financial costs — an astounding amount even for the luxury market. Ultimately, the project was a tremendous success. VNO netted ~$1.6 billion in profit on the project (which it seamlessly funneled into the PENN District development), making it one of the world’s most profitable condo towers ever built. Ken Griffin ended up buying the most lavish penthouse in the building — a 23,000 SF quadplex spanning the 50th through 53rd floors — for a record-breaking sum of $238 million, making it the country’s priciest residential transaction ever.
Brief Company History
Pre-REIT Conversion Period
To best appreciate the investment opportunity, it’s helpful to first understand a little bit of the company’s history. The origins of the company can be traced back to the Two Guys discount store chain that was founded in the 1940s by two brothers - Sidney and Herbert Hubschman. Based in Harrison, New Jersey, the retail chain started off by selling major appliances such as televisions.
In 1959, the company merged with O. A. Sutton Corporation - manufacturer of the Vornado line of electric fans, air conditioners, and humidifiers - and subsequently renamed itself as Vornado Inc. (Fun fact: the name “Vornado” is a portmanteau of “vortex” and “tornado.”) The merged company would go public in 1962 on the New York Stock Exchange under the symbol VNO, and by 1965, would grow to become the nation’s fifth largest discount chain with 25 stores in 5 states. At its peak, there were more than 100 Two Guys locations nationwide across the East Coast and California.
In the late 1960s, in an attempt to diversify operations, the company merged with a similar-sized retailer based out of Southern California called Food Giant Markets, Inc. The merger would prove to be unsuccessful and by the mid-to-late 1970s, Vornado began divesting unprofitable stores and reducing its footprint.
Around the same time of Vornado’s decline, Steve Roth noticed that the value of the company’s underlying real estate was worth much more than the retail operation and thus realized that the company’s stock was grossly undervalued. As a result, by mid-1980, Roth, through his company Interstate Properties, would acquire an 18% ownership stake in Vornado and, through a contentious proxy battle, would later gain full control of the company.
Shortly after, in 1981, the company discontinued its Two Guys discount store operation and focused its full attention on realizing the value of its real estate assets. Throughout the ‘80s, Vornado would transform the real estate properties into strip shopping centers, leasing out space to major tenants such as Montgomery Ward & Co., Bradlees (a discount store chain owned by Stop & Shop), TJ Maxx, and Home Depot. By 1992, the company owned 52 shopping centers in 7 states and 8 warehouses in New Jersey, for an aggregate total of 10.3 million square feet.
The transformation was highly successful — profitability went from a net loss in 1981 of $56 million to a net profit (FFO) of $26 million by 1992. As a result, the market responded accordingly: Vornado stock would increase from a low of $3 per share in 1982 to over $32 per share by 1992, an attractive 10x multiple on invested capital.
One crucial point I want to call out for this period in VNO’s history is that in addition to successfully transforming the company, Steve Roth was also extremely opportunistic in buying back the company’s shares, further accelerating the growth in earnings per share. Capitalizing on the extreme undervaluation in the company’s stock, Vornado bought back ~60% of its outstanding shares over a 4-year period beginning in 1982 — one of the most consequential stock buyback programs in the history of the NYSE. In hindsight, it was an incredibly brilliant maneuver that unlocked tremendous value for Vornado shareholders.
Post-REIT Conversion
In 1993, Vornado Inc. converted into a publicly-traded REIT and was renamed Vornado Realty Trust. For the ensuing decade-plus period leading up to the GFC in ‘08/’09, VNO experienced a rapid growth campaign through a series of major acquisitions:
1990s through early 2000s: Roth successfully applies the same playbook that he used for Vornado — mining real estate in public companies — on another retail chain, Alexander’s Inc., and also turns it into a successful public REIT.
1997: VNO enters Manhattan office and retail scene by acquiring Mendik Co. in a deal valued at $654 million for 7 buildings in Midtown Manhattan. Mendik’s portfolio included PENN 2 and PENN 11 - two crucial assets in VNO’s PENN District portfolio today.
1998: VNO acquires Kennedy Family real estate portfolio, ~5.3 million SF of real estate including the MART in Chicago, for $625 million.
2002: VNO acquires 100% interest in Charles E. Smith Commercial Realty (“CESCR”), at the time the largest and most important office landlord in Washington DC. CESCR owned ~14 million SF of prime office space, half of which was located in Crystal City, Arlington, VA.
Vornado acquired CESCR in multiple stages: $60M in 1997, $242M in 1999 to bring interest to 34%, and the remaining 66% in 2002 through $1.58 billion in stock and assumed debt.
2004: Bought 1/3 interest in Toys “R” Us for ~$450 million of equity, partnering with Bain Capital and KKR.
Coming out of the GFC, Vornado traded at a modest discount to underlying private market value as the real estate industry recovered from the depths of the crisis. In an attempt to unlock hidden value, Roth began a campaign of simplifying operations by selling off non-core assets and refocusing the portfolio on the best-in-class assets in New York and Washington. As the discount continued to persist, VNO ended up spinning off its legacy strip shopping center business and large Washington office portfolio into two separate publicly-traded REITs — Urban Edge Properties (NYSE: UE) in January 2015 and JBG Smith Properties (NYSE: JBGS) in July 2017 — effectively distributing $9.7 billion to shareholders in a tax-free manner. By 2019, the company was left with a smaller, leaner, and higher quality portfolio primarily focused on the most prime NYC office and retail properties.
As you can see in the table above, for the 10-year period ending in 2019, dispositions totaled $19.1 billion with a cumulative realized gain of $4.4 billion. VNO has been a net seller to the tune of $12.3 billion as it simplified operations and refocused on its core assets. 2017 includes $5.997 billion for the JBG Smith spin-off and 2015 includes $3.7 billion for the Urban Edge Properties spin-off — no gain was recognized on the spin-offs. A pretty remarkable 10-year run.
Investment Thesis
The crux of the thesis is simple. This is a classic distressed value play — buying high quality assets at a wonderful price. Buying at a 60-70% discount to replacement cost gives us a significant margin of safety and good downside protection, and since it’s a REIT, we also get paid 8-10% yield per year while we wait for the NAV gap to close. In addition to the NAV discount, there are few other prongs to the thesis worth highlighting.
First, I believe underlying earnings have largely bottomed and will be inflecting rapidly in the next few years. The PENN District development is scheduled to be complete by the end of 2023, at which point rental rates will increase in a step-function fashion from low $60 psf to $100 psf (especially for PENN 2). My rough estimate for incremental NOI from PENN 1 and PENN 2 alone is $110 million in the next 3 years as the properties stabilize. Given the superior quality of the PENN District assets in terms of condition, location, and amenity offering, it’s hard to overstate the earnings potential of this segment. The two PENN buildings have 4.3 million SF of office space and over 180,000 SF of amenity space — all sitting atop PENN station, North America’s most significant transit hub. From a future tenant’s point of view, PENN District checks all the boxes in trying to get employees back into the office — modernized high-quality product, attractive amenity base, and close proximity to public transport. This kind of scale also represents a significant competitive advantage as it provides tenants with flexibility for growth and expansion.
With regard to remote work, I believe the worst is likely behind us. Most major companies have instituted return-to-office mandates and it is only a matter of time until employees fully adhere to the company policies. Although the return of a 5-day in-the-office work week is unlikely for years to come, I think a 3-day week is here to stay and will be more strictly enforced to encourage collaboration and culture development.
Another key component to the thesis is the flight to quality trend. In a world where overall office demand is lower and tenants have higher bargaining power, most companies have been trading up their office space from lower quality Class B and C buildings to Class A buildings in an attempt to coax employees back into the office. According to Steve Roth, out of New York’s ~400 million square feet, only about half of the space really qualifies for the workplace of the future. This salient trend will only benefit VNO as the overwhelming majority of the portfolio’s assets are high-quality Class A assets.
Last but not least, it is worth re-iterating the importance of superior management as part of the investment thesis. Although the market reversion to NAV will likely drive most of the returns, VNO’s best-in-class management team will ensure the value recovers and continues to grow in the future. As you can probably tell from the discussion of VNO’s history, Steve Roth and team are no run-of-the-mill operators. With over 40 years of experience, they are undoubtedly one of the shrewdest, most experienced and well-connected management teams in the business. The extensive experience and network of relationships are especially critical in the real estate business — where long-term relationships can provide an advantage in the form of special access to the most attractive deals and capital in times of stress.
They are also incredibly long-term oriented and opportunistic. This alignment is in large part due to the fact that Roth’s investment partnership, Interstate Properties, still directly and indirectly owns ~13% of the outstanding shares. And most recently, after resisting buybacks for years in favor of development and conservative positioning, VNO is now going on offense with their $200 million buyback program. And if the 1980s serve as any indication, the next decade should bode pretty well for patient long-term shareholders.
Class A writing here Tuan. Fantastic and valuable breakdown of $VNO.
Tuan, this is a great write-up. Could you walk me through how you estimated the 8.3% cap rate?