Bearish on office REITs, Goldman downgrades Vornado, SL Green

In the face of a “maturing” commercial real estate cycle that’s bracing for an interest rate hike, Goldman Sachs this week downgraded SL Green Realty and Vornado Realty Trust, citing a debt-heavy strategy for SL Green and Vornado’s high exposure to a risky high-end Manhattan retail market. In contrast, Boston Properties’ low-cost-capital, high-cash-flow strategy bodes well in the near future, the investment bank said.

Goldman delivered diverging outlooks for the three real estate investment trusts, which rank among the major players in the city’s commercial office market. Goldman downgraded SL Green to a “Sell” rating and dropped Vornado to a “Neutral.” Boston Properties maintained its “Buy” rating in the same report.

Goldman claimed the bullish market for office REITs has been driven by “price appreciation of underlying assets,” but it predicted slower future price growth for these assets. Its outlook on office REITs fell from “Attractive to “Neutral.”

Investors are not prepared for a “coming increase” in interest rates and its upcoming impact on the REIT market, the bank said in the report.

“The market has rewarded acquisition-driven growth, funded with low-cost short-duration debt,” the report stated. “REITs that have built cash, sold mature assets and reduced debt have under-performed,” it added, while those “that increased debt, made acquisition in excess of dispositions, and maintained modest cash balances outperformed.”

The bank predicts a change to that dynamic and cited a “superior outlook across all metrics“ for Boston Properties, which is led by CEO Owen Thomas. It pointed to the REIT’s “excess balance sheet cash” and “low-cost capital” that it deploys into “high-return” development projects. SL Green, on the other hand, “screens poorly within this framework,” and has a concerning level of high capital costs, Goldman said.

“SLG’s FFO (funds from operations) growth over the past four year appears driven in large part by increasing debt, the ample use of floating rate debt, increased debt and preferred investments and relatively attractive returns on new acquisitions,” Goldman said. “We view these drivers as being less sustainable in the current environment.”

SL Green recently said it intends to divest at least $1.1 billion in properties to finance its acquisition of 11 Madison Avenue from the Sapir Organization and CIM Group. The REIT sold stakes this week in two Manhattan office properties, including Tower 45 at 120 West 45th Street, for a combined $587 million, The Real Deal reported.

Goldman added that it does not believe “investors appreciate the magnitude for the headwinds to SLG’s cash flow growth,” though the possible sale of a “significant equity stake” in the REIT’s One Vanderbilt office tower development “would likely be received positively” and prompt shares to overperform.

Vornado, meanwhile, has several potential high-growth properties within its portfolio but the bank doubts it will execute on them in the short term. Vornado’s growth largely depends on ultra-luxury condos, the bank said — noting that while low-cost capital from sales of condos at 220 Central Park Avenue are a positive, Vornado is also “highly exposed” to any softening in the high-end retail market.