the death of the urban office building

[lnofeisone]

I’m in DC and I did a quick search to see how the high end apartment market is doing in my area. Vacancies seem elevated ... to say the least. Nice buildings that I think used to have around 5 vacancies this time of the year now have like 20. Hard to say if this is permanent but if it is the economic impact will be huge.

 

I saw the same trend here in DC. Lots of availability in the high-end market. Few of our friends are now playing hardball with management companies because they are not getting amenities that were originally promised. Mid-market seems to be doing a bit better. Had friends rent a basement in about a week with plenty of qualified applicants.

[Spekulatius]

Am I going to go to the virtual theater?  the virtual music arena?  the virtual ballpark?  the virtual museum?  the virtual skateboard park? the virtual hospital to have virtual surgery from a top-rated cardiothoracic surgeon?  Pardon the hyperbole, but you get my point. 

 

Sure I like to live within an hour drive of a city (I'm about an hour drive from Boston), but do you go to the theater or the hospital everyday?  Cities are nice places to visit, but I wouldn't want to live (or work) there.

 

MF had a pretty good podcast about 18 hour cities and suburbs as an investment thesis for real estate. This was pre COVID. Makes a lot of sense to me, you live in an area where you get most stuff and drive to a city when you want to do something special. This makes even more sense if you can get equivalent pay without a commute or paying an arm and a leg for a shoebox Appartement.

 

But then there are folks who just can’t live without the hustle of a large city. So each it’s own.

[SharperDingaan]

A high-tech/new age company locates in a city, because that's where the labour is. If you're targeting the talented 'hip labour pool', you have to be where they want to live, and pay up - as the cost of doing business. California, Boston or Toronto for tech; NYC, Chicago, SF, or Toronto for finance; LA, Toronto, or Vancouver for entertainment production. Houston, or Calgary for o/g.

 

But ... everyone gets old  and your time as the 'hip' ... is a limited term engagement.

You lived in the city to find a mate, once you find one ... you live in the 'burbs if you want to raise a family. You split, the kids grow up, and you move back to the city for the amenities. Grade-B space in the 'burbs of a major city targets this pool, and the value-add to both employer/employee is low-hanging fruit. The functional comparative is Grade-A space in a 2nd Tier city (Detroit).

 

For most companies, 1/2 to 2/3 of the white-collar workforce really doesn't 'need' to be in downtown Grade-A space -  it's primarily operating leverage on the fixed cost of the space, prestige as part of the comp, and inertia. It worked, because like an airline ... the more people you could jam in the space (or aircraft), the lower the cost/seat - which social distancing no longer allows. Move that workforce to Grade-B space and you both save material $ and RAISE the comp value of Grade-A seat prestige. 

 

The truly evil will also change industry comp incentives within the Grade-A space - by paying most of the bonus in 'prestige', via society page advertising (eg: Harrod's high-end christmas gift basket) - and NOT in money. 'Cause .... if you live/work in Manhattan, you must already be independently wealthy - so why are we just giving more money to millionaires? when the prestige of 'social rank' is more valuable? And as the shareholders who gave you the opportunity, it elevates our 'social rank' as well. 'White-wall' investment banking firms did very well for a reason - and their approach can be copied  ;)

 

In the words of Gordon Gekko, Greed is good!, Greed works!

https://www.americanrhetoric.com/MovieSpeeches/moviespeechwallstreet.html

 

And it is coming to the office space near you.

 

SD

 

 

 

[Guest cherzeca]

@sd

 

not sure I caught all of that, but it reminds me what women say when they buy new expensive handbags...it is not to attract guys but to impress other women.  nice offices are like that, you come into work and execs feel good about themselves when they look around at the art and polished wood.  all of this comes at a cost, and if this is no longer really needed for some 50% of your office staff's labor hours, then that is an easy cost to cut

[thepupil]

I think the answer is a big giant “it depends”. And I think a big factor is tenant quality/profitability which will determine price sensitivity. As one extreme, New Mountain Capital leases the top 2 floors of 1633 Broadway as their headquarters, 108K square feet @ $85/foot = $9mm / year, the lease goes to 2035. New Mountain Capital manages $20B and is about to raise a new $8B PE fund on which they’ll charge 1.5-2% on committed capital. Assuming 2% on the $8B ($160mm management fee and 1% on the another Guesstimated  $15B or capital, $150mm of management fee), NMC probably has about $300mm of management fees coming in. Not sure how many people work there, but they have 187 employees on LinkedIn, so I think they’re doing okay with that level of management fee which is not the only source of revenue (the deal by deal carry will certainly being in more revenue) Now is NMC going to try and save a lousy $9mm trying to weasel out of its lease or trying to move associates to the hinterland? No, of course not.

 

If people that work there want to be in NYC on the top 2 floors of a big building, they’ll be there. If they lose one big LP for having a shitty office (do not put this past LP’s) or lose talent because some dude likes another PE firm’s office better and that guy’s very good, they haven’t saved any money at all. I’ve never met a 28 year old I banker who said “man I can’t wait to move to Westchester (or even Hawaii/Asheville/boulder, Jackson Hole”

 

I have zero concerns about NMC not paying their rent for the next 15 years and I think the 25-35 yr olds who do all the work, want to live and work in the city

 

On the other end of the spectrum, PGRE has a big tenant in McGraw Hill Education, an Apollo owned overlevered company in secular decline. They’ll file, reject the lease, and if the company continues to exist, they probably won’t lease 100K feet in midtown because some distressed debt fund or PE form that owns the post reorg will say “hmmm we can lease 50K feet in noweheresville for $30 instead of 100K feet in NYC for $60” and they’ll save $5mm or whatever and think that that’s important.

 

I think supply/demand imbalance is inevitable (at least in NYC) and spot lease rates will endure significant declines for an extended period of time. I do think working in an office has appeal and that a decline in rents will increase demand and also decrease new supply formation, such that the fundamentals of the far out years are more likely to look like today (the peak) than the trough. If you think rents go down 30-40% and stay there, you don’t really want to own any offices (They are priced such that you probably won’t lose a ton of money, but you may not make any). If you think the potential for long term mean reversion (after the fall) and the NYC premium continuing  exist to any degree, you want to own these.

 

To mitigate risks and have staying power, focusing  on tenant quality and lease duration is important, even better if there is non recourse interest only financing in place, or unlevered buildings, giving the equity full access to contracted NOI / cash flow, which again de-risks you. To use PGRE again, they do about $700mm or rent /$400mm NOI/$50mm g&A/$120mm interest/ $200mm ish free cash flow. 40% of leases expire in more than 10 years and the WAL is 7-8. Let’s say FCF glides to $100mm over 8 years and averages $150mm/year as tenants go bankrupt or space is renewed at lower rates. Over 8 years the equity would get $1.2B of FCF; the stock trades for $1.4B equity (market cap less net cash). There are some holes in this argument (not all their maturities are that long) but my point is that contracted cash flow de-risks you over time. They also own 2mm sf w/o a mortgage.

 

I don’t think I’m going out on a limb and saying the share price implies almost no residual value for the buildings; I can’t tell you the future of remote work, only the present of low valuations a a collapse in implied value/foot / rapid rise in cap rates.

 

https://www.google.com/amp/s/www.globest.com/2018/05/03/mcgraw-hill-moves-from-midtown-south-to-midtown/%3famp=1

 

https://www.google.com/amp/s/therealdeal.com/2019/02/05/asset-manager-new-mountain-capital-inks-100k-sf-lease-in-midtown/amp/

 

[Guest cherzeca]

new mountain's assets go out the elevator every evening.  if they dont come back in the morning they are done. plenty of hedge funds have stars leave to do their own thing.  and all of that capital has a string on it.  I think HFs need the constant face to facer time back and forth discussion more than most other businesses and need nice offices as a signal to investors, so I get the impetus...but HFs are a somewhat isolated case

[thepupil]

Not sure what you are saying. New Mountain is a private equity firm; they are in the market for their flagship PE fund; it is going to be $8billion+. PE firms charge 2% on committed capital, then the management fee steps down after 5-6 years (Or sometimes when they raise the next fund)  to 1%-1.5% on invested capital. So New Mountain has the old fund assets (and debt funds) paying management fees; that goes down as its liquidated. Then they have the new fund management fees which will last for 10+ years. I would consider them a very good tenant of high credit quality as their committed capital is a liability of large institutional investors (pensions, endowments, etc)

 

Are you saying that NMC is of poor credit quality and you wouldn’t consider their lease to be money good? That seems a stretch. They have 10+ years manamgent fees and assuming half decent performance, will be raising another fund in 5 years. In the article below about their recent fund raise it talks about a 4% GP commitment, so the GP is putting in $320mm of their money into the new fund. I like obligations of firms run by super wealthy people that have multi-year obligations from big institutions. Seems safe enough to me.

 

You can’t fill 400mm square feet of NYC office with PE firms, but you can pre-lease 65% of One Vandy to them (plus some law firms and banks), for example.

https://en.m.wikipedia.org/wiki/One_Vanderbilt

 

https://www.buyoutsinsider.com/new-mountain-targets-8bn-on-new-flagship-750m-on-non-control-fund/

 

Real estate is a combination of a bond and a stock. The bond is the lease term and the stock is the residual; I think a lot of buildings are trading almost close to the value of the bond; there’s massive uncertainty on the residual/stock of course because of all this stuff. But in some cases the bond portion goes out 10 or even 15 years

 

Like ALX’s Bloomberg lease where you get average of $75mm/year for 9 years; that’s a good bond to own. Now 2029 is difficult to underwrite of course

[SharperDingaan]

Execs will always get the Grade-A space as it's non-taxable comp. but the cost of the 'extras' comes out of the C-Suite bonus pool.

Hence there's incentive to keep the total cost low, relative to the size of the bonus pool - which can only happen if the pool is stupid big (I-Banks, etc). Hence in a good years (most of the time), it's not an issue; in bad times the exec + the space are fat. 

 

Long ago I was reminded by a former french madam/financial advisor, that a great many of the young and beautiful/handsome in this population - are playing a different game. Todays mistress, tomorrows trophy wife, along with a prenup. Todays boytoy, under a 'lease' arrangement with generous termination. The buff bods, expensive handbags/heels, and Armani suits - are business tools.

 

Sadly she has passed away now,

but it put a whole new spin on the Les Miserables, 'Master of the House'

 

SD

 

 

 

[Guest cherzeca]

Not sure what you are saying. New Mountain is a private equity firm; they are in the market for their flagship PE fund; it is going to be $8billion+. PE firms charge 2% on committed capital, then the management fee steps down after 5-6 years (Or sometimes when they raise the next fund)  to 1%-1.5% on invested capital. So New Mountain has the old fund assets (and debt funds) paying management fees; that goes down as its liquidated. Then they have the new fund management fees which will last for 10+ years. I would consider them a very good tenant of high credit quality as their committed capital is a liability of large institutional investors (pensions, endowments, etc)

 

Are you saying that NMC is of poor credit quality and you wouldn’t consider their lease to be money good? That seems a stretch. They have 10+ years manamgent fees and assuming half decent performance, will be raising another fund in 5 years. In the article below about their recent fund raise it talks about a 4% GP commitment, so the GP is putting in $320mm of their money into the new fund. I like obligations of firms run by super wealthy people that have multi-year obligations from big institutions. Seems safe enough to me.

 

You can’t fill 400mm square feet of NYC office with PE firms, but you can pre-lease 65% of One Vandy to them (plus some law firms and banks), for example.

https://en.m.wikipedia.org/wiki/One_Vanderbilt

 

https://www.buyoutsinsider.com/new-mountain-targets-8bn-on-new-flagship-750m-on-non-control-fund/

 

Real estate is a combination of a bond and a stock. The bond is the lease term and the stock is the residual; I think a lot of buildings are trading almost close to the value of the bond; there’s massive uncertainty on the residual/stock of course because of all this stuff. But in some cases the bond portion goes out 10 or even 15 years

 

Like ALX’s Bloomberg lease where you get average of $75mm/year for 9 years; that’s a good bond to own. Now 2029 is difficult to underwrite of course

 

I am saying that plenty of HF/PE funds have boomed and burst. their longevity usually doesn't outlast the long term lease.  but NYC is very beholden to financial markets for its economic survival and the good news is many of these firms will continue to lease and discourage working from home.  but also NYC was beginning to become a burgeoning tech center, and these are exactly the firms that will downsize their lease obligations

[thepupil]

We’ll have to agree to disagree on the usual longevity of PE firms. I’m actually not aware of a any large buyout firm “going bust”. I googled to try to find one but couldn’t. Using some arbitrary cut off like $2 billion of committed capital for last fund, can you name a PE firm that reached that and then folded/shut down? I’m not exactly a PE expert, but can’t think of one. HF’s have far shorter duration of capital, so I’ll agree with you there.

 

There’s lots of talk of a PE bubble, but at the same time PE has $1.5 trillion of dry powder to invest to rescue their own overlevered companies or find new deals.

 

Anyways, was just using New Mountain as an example of what i would consider to be a price insensitive tenant. Generally I think we are going into an office downturn and you want to own buildings with long term leases with price insensitive tenants.

 

I agree that tech is a super important component of NYC office now; We’ll have to see how things shake out; as tech gets less aggressive in leasing space that will contribute to the supply demand imbalance.

 

Just ten floors down from New Mountain for example is MongoDB. They are on the hook for their lease for another 10 years. Guess we’ll have to see in 2030 if they still want their NYC HQ or to go totally remote.

 

[Guest cherzeca]

"sing some arbitrary cut off like $2 billion of committed capital for last fund, can you name a PE firm that reached that and then folded/shut down? "

 

a bunch.  Forstmann Little, Wesray probably most prominent.  not bust, just rich enough to stop

[thepupil]

Forstmann Little appears to have lasted 37 years and about 10-15 years after it made poor investments in the late 90s (just did some googling). Doesn’t that illustrate the longevity of these firms?

 

Anyways need to go make some calls on my DynaTAC, the Quotron doesn’t seem to be working right today...

 

EDIT: By the way, clicked on a lot of American PE firms on this list and only found 3 that no longer exist (2 of which you mentioned). Wikipedia is not all encompassing, but again, it would seem to me the evidence suggests that PE firms last a long time and very rarely suddenly go out of business.

https://en.m.wikipedia.org/wiki/List_of_private_equity_firms

 

[Guest cherzeca]

when bergdrof's on 5th ave gets ransacked, what again is the reason a ceo wants office space in NYC?  "fire next time" has become this time.

[Broeb22]

when bergdrof's on 5th ave gets ransacked, what again is the reason a ceo wants office space in NYC?  "fire next time" has become this time.

 

I would have bet that this same argument would have been had in October 2001 after 9/11, and many people would have thought NYC office space is a dying breed because what executive wants to risk his or her life to just have a nice view of the Hudson River?. Turns out they were really wrong, and those who doubt urban office real estate will again be really wrong. But as Liberty likes to say, that's what makes a market.

 

 

[thepupil]

when bergdrof's on 5th ave gets ransacked, what again is the reason a ceo wants office space in NYC?  "fire next time" has become this time.

 

Given your conviction, which stocks should we sell/short? At what price would they be longs?

[Guest cherzeca]

when bergdrof's on 5th ave gets ransacked, what again is the reason a ceo wants office space in NYC?  "fire next time" has become this time.

 

Given your conviction, which stocks should we sell/short? At what price would they be longs?

 

I think you could do a pairs trade, vno short and amt long for example (no position).  as for your PE arg, they are a pimple on the office leasing scene.  HFs/PE firms beginning to move to Florida

[ratiman]

I've read that retail can be as much as 50% of the revenue and 75% of the value of an urban office building. That's hard to believe but if that's true then all these boarded up shops are really bad news for urban office buildings.

[thepupil]

I've read that retail can be as much as 50% of the revenue and 75% of the value of an urban office building. That's hard to believe but if that's true then all these boarded up shops are really bad news for urban office buildings.

 

I would encourage you to have a look at the numerous threads on office REITs and assess whether that is the case.

 

PGRE derives <5% from retail, parking, theatre

 

ALX has about half its NOI from retail, but that's because they own a lot of retail in Queens. For their main office asset (731 Lexington), the office is far more valuable.

 

CUZ doesn't have much.

 

Vornado is the most prominently "retail-y" pure office REIT (ALX has more, but its not an office REIT, it's a cash + bloomberg bond + Queens Retail + Queens multifamily + office residual REIT). Note that some of ALX's retail is rock solid, like Costco/Ikea etc. Some is not so good (Container Store).

 

https://therealdeal.com/2019/04/18/vornado-sells-45-stake-in-prime-manhattan-retail-portfolio-valued-at-5-6b/

 

Vornado has about $1 billion of office NOI and $200mm of retail NOI at share, the bulk of which is derived from Upper 5th Avenue and Times Square (the stores that are being looted). As of the great 2019 retail de-risking event, Vornado's exposure is primarily through a joint venture with a wealthy family (Crown Acquisition's) whose patriarch died of coronavirus recently (RIP) and whose son is head of retail at Vornado (Haim Chera). The other JV partner in the common equity is the Qatari sovereign wealth fund.

 

Vornado sold half its equity in the bulk of its retail last year at a sub 5 cap. In order to avoid transfer taxes / a big cap gains hit (or maybe to help get the sale done), Vornado provided seller financing in the form of a $1.8 billion preferred interest in the joint venture. This preferred is money good as long as the value of these properties doesn't fall to a very big degree (assuming the Qatari's wouldn't throw good money after bad to save their common equity investment). 

 

As far as what percent of value is in the retail, I'd direct you to VNO's 4Q2019 supplemental which gives a breakdown of how the company sees value. They think their NYC office portfolio is worth $18.8 billion (hilarious in the context of what's happened to the stock) and their retail portfolio is worth $4.8 billion. They have additional exposure throughout the $1.8 billion pref. So by the company's measure, about $6.6 billion of the $31 billion of assets are directly retail related.

 

All of those values are decidedly "pre-covid" but unless you think high street retail and office have declined in a very different way, the relative percentages are the same.

 

Page 22

https://s23.q4cdn.com/623119702/files/doc_financials/2019/q4/vno_4q_2019_supplemental.pdf

 

Hope that helps.

 

I am happy to be accused of focusing too much on the micro trees rather than the macro/big picture forest here, but I would encourage you all to look at the specific securities; there's lots of stuff out there put forth by me and a few others.

 

Plenty of bull cases to attack!

[Guest cherzeca]

"I am happy to be accused of focusing too much on the micro trees rather than the macro/big picture forest here, but I would encourage you all to look at the specific securities; there's lots of stuff out there put forth by me and a few others.

 

Plenty of bull cases to attack!"

 

which is why I did not pout first post of this new threat on a specific issuer like VNO.  I am making a very macro, not micro, case. one can make an argument that at some point the stronger can buy up the weaker at very cheap prices, but until then, you are going to see CMO defaults increasing and investors shying away from urban office.

[thepupil]

I would suggest BXMT as a good short to express your view.

 

It’s a diversified pool of commercial mortgages approaching 1x book; 54% office , 17% hospitality

 

The book is 100% performing and the loans attach around 65% LTV, but there’s back leverage and office buildings are dead so you should see some defaults. $18B loan book and like $4B of equity; the losses will get nice and big quickly if office is dead.

 

Note, I am short in small size, but not really material in comparison to the longs.

 

There’s a thread on it, but I didn’t do much work beyond what I wrote.

 

As far as focusing on the macro vs the micro, I’ll repeat that the micro (the leases/tenants/debt) are very important in determining one’s view.

 

The macro could be “NYC office rents are going to plunge by 40% in 2 years!” The micro could be “Alexander’s office NOI is contractually going to go from $68 million to $84 million over the next 9 years”. Both could be correct, but lead to different positioning. A highly negative 0-5 year outlook could have literally no effect on the fundamentals / cash flow of a company (in that unique case which is a big part of my office exposure)

 

Given the unemployment rate and supply demand dynamics, I think everyone should be bearish of NYC office fundamentals. Given the valuations of the securities (particularly a few weeks back and at the March lows) it’s hard not to be Uber bulled up. Call it cognitive dissonance but I think that is warranted when the fundamentals of these buildings in many cases are locked in for a long time or change gradually.

 

Investors can shy away from office and have been; that has little effect on the cash flows.

 

I will say that with VNO’s big move up lately, it’s getting a little scary in that we haven’t heard about Farley Facebook in a while, since it was leaked they were trying to sign by Memorial Day weekend. If Facebook walks, I think VNO will go down a lot irrespective of valuation, feel free to place your bets!

 

 

[Guest cherzeca]

https://www.wsj.com/articles/who-needs-cities-when-we-all-work-from-home-11591394516?mod=markets_lead_pos10

 

[thepupil]

I promised myself I'd bump this thread when Facebook leased at Farley.

 

of course my office stock picks are still underperforming stinkers. this is not a gloat. but I would say that leasing in general has been "wait and see, if up for renewal, renew" with a few big new leases like TikTok in NYC at 4 times square, Facebook at Farley Post office, etc.

 

Facebook is officially coming to the Farley Post Office redevelopment, in what is certain to be a major boost for New York’s struggling office market.

 

The social media giant has signed a lease for 730,000 square feet of space at the property, landlord Vornado Realty Trust announced Monday.

 

 

 

 

News of Facebook’s interest in the massive complex broke late last year. But as the coronavirus pandemic raised questions about companies’ need for large offices, there was much hand-wringing over whether or not the deal would go through.

 

Related: Revenge of the hoodies: Big Tech may be breaking up with Big Office for good

 

Facebook in May announced its shift to a distributed workforce, a move that could see up to half of the company’s 45,000 employees go remote in the next few years. Many major tech companies have made similar announcements since, putting a big question mark on the tech industry’s appetite for new office space in prime markets. Vornado CEO Steve Roth on Monday said in a prepared statement that Facebook’s decision “reinforces New York’s position as the nation’s second tech hub.” Robert Cookson, who oversees real estate for the social networking giant, said that the company looked forward to being a part of this iconic New York City landmark’s future for years to come.”

 

Facebook’s New York city office is currently located at Vornado’s 770 Broadway. The company also signed on last year for more than 1.5 million square feet nearby at Hudson Yards.

[Guest cherzeca]

as a New Yorker, I am most pleased to see this! I still think there are a lot of service firms who have done quite well WFH during covid, and going forward they will look at their lease expense obligations with a jaundiced eye

[thepupil]

Agreed that there will be blood in office; we also don’t know if this is to replace their existing footage at 770 Broadway or in addition and the terms/ price.

 

I do think it really helps the overall tone in terms of keeping office space (and high paying jobs in the glorious yuppie playgrounds that are NYC/SF/LA/DC etc) as a weapon in the war for young talent at tech/finance etc.

[Castanza]

My company which has a 45B market cap just decided to not renew office leases in California locations Chicago and possibly Miami and Phoenix. They also canceled the building of a new office building where I live which wasn’t even going to be started until 2025.

 

My company is not in any type of fundamental trouble. They simply said they want to adapt to the changing work environment and will pursue permanent work from home accommodations. If they need office space for “employee get togethers” they said they will rent out work spaces for weeks at a time. They said employees have proven to be productive while working from home and that this frees up capital to improve the business in other areas.

 

Edit: should have clarified. This is not across the board but for one business segment (tech/infrastructure)