Description

Do you wish you could go back to March and buy stocks that were being indiscriminately sold?  Well, some of the office REITs (below) are trading at lower prices than March, implying that the future is worse than expected during March.  That alone caught my eye and what I found when digging in was a bit surprising. 

Boston Properties (BXP) is the crème de la crème of Class A office REITs in the US.  BXP owns over 50M square feet of almost entirely class A office space in the dominant gateway cities across the US.  The chart below shows their geographic exposure, which is ~3/4 in the dominant East Coast cities and 1/4 on the West Coast, primarily in San Francisco. 

Occupancy and collections

Looking across the REIT sector, several questions come to mind.  What is the current actual occupancy?  What is the current economic occupancy?  Where will occupancies go over time?  A distant question is where rents will go.  Let’s start from the top: current occupancy for BXP is at 92%.  Economic occupancy is at 97%, and 99% for their office portfolio. This is in large part because of BXP’s focus on the largest and most important firms across industries.  To see these in practice, their top 20 tenants are below and the pie chart shows the tenant mix by sector.

Tenant Mix

Leasing Activity

One hint that the largest companies are not going to shrink their footprints to the point where Class A is irrelevant is the leasing activity from Q3 of this year, well after the initial shock of COVID in March.  As you’ll see below, leasing activity from the Fortune 100 and similar companies continued despite COVID. 

Lease Rates

Won’t the shadow vacancy from WFH lead to precipitous rental declines?  Maybe.  President Doug Linde provided a hint this might not be the case, when he said the following in yesterday’s conference call:

BXP’s weighted average lease term is just over eight years, which means the leases that are rolling this year and next were struck when rates were substantially below the market.  For example, BXP signed a 40,000 SF lease at the GM building this quarter and rents over $100/SF and a 170,000 SF lease at 399 Park around $100/SF.  Given the valuation, the question an investor in BXP faces is how low occupancies will go and to a much lesser degree, what will rental rates be.  As you’ll see from the aggregate rent rolls below, leases that are expiring this year are in the low $50s/SF vs. leases that expire 10 years from now are in the mid $90s/SF.  This translates to a margin of safety for BXP in terms of releasing these spaces over the next 18 months, despite spot rental rate declines compared to 2019.

Private vs. Public cap rates

Public office REITs are trading at ~7% implied cap rates vs. private transactions in the mid 4s for similar assets.  For those in class B/C office, it’s entirely possible that those buildings will face structural vacancies depending on how pervasive WFH ends up being after the pandemic.  But for the top of class A, 7% implied cap rates implies meaningful distress is coming.

Below is CBRE’s latest Cap Rate Survey, which shows cap rates for stabilized US office properties.  As you’ll see, the disparity between the implied cap rates for BXP and their respective markets is ~250 bps wide, so clearly one of the two is wrong.  What I find interesting is that BXP confirmed these private market cap rates on their call yesterday. 

https://www.cbre.us/research-and-reports/US-Cap-Rate-Survey-Special-Report-2020

The biggest private market transaction was Genesis Towers in South SF, which recently sold for $1B or a 4.5% cap rate.  Other smaller transactions included a $166m deal in Santa Monica at a 4.3 cap, a $325m deal in Reston for a 5.6 cap, and a $565m deal in Bellevue Washington for a 4.5% cap.  I don’t have a strong view of precisely the right cap rate for trophy class A office but if these recent private market transactions are indicative of where the market is going, a 7% cap rate for BXP is the wrong price.

Balance Sheet

BXP’s debt/assets is ~47% and their debt service coverage (EBITDA/interest) is 3.65 and over $3.5B of liquidity so I don’t think you’re wrong from the debt.  My bigger question is related to maturities, which as you’ll see below is manageable relative to the size of the asset base.

Expected Returns

What do you have to believe?  The current dividend is 5.5% and based on their Q3 looks sustainable.

On the upside, if the progress from Q3 is indicative of the future, BXP should be able to generate low single digit NOI growth, which gets you to say 7.5% returns.

BXP then has a development pipeline of ~15M SF that is currently 74% pre-leased.  As shown below, BXP’s expectation is that this will result in 3% annualized growth. 

The combination of dividends, NOI growth, and growth from the development pipeline would lead to overall annualized returns in the 10ish range.

Where this gets interesting is in the spreads between public and private cap rates.  If the indications from BXP’s quarter are indicative of the future, then a cap rate reversion would lead to the stock doubling.  Depending on the timing, that’d put you in the 20s for IRRs, which would be competitive with some of the CRE deals from the RTC days of the early ‘90s.  What’s especially compelling here is you can create this risk/reward without locking up capital in a long term, private asset. 

Risks

Given the operating leverage inherent in owning a building (from the landlord paying taxes, insurance, and maintenance charges for unleased space), I’m most concerned about where overall occupancy levels go over time.  This concern led me to focus on BXP rather than a lower tier (think class B/C) office REIT.  There’s some chance that marginal spaces ends up being structurally under leased given the potential societal changes from WFH.  However, class A office should be able to absorb tenants in this environment, given they would likely trade up.  I don’t expect this to happen but even if it does, BXP would still generate an ok return.

Catalyst

·       Return to work at scale

·       Continued lease up over the next couple of quarters

·       Increasing private market transactions for similar assets at lower cap rates than 7%

·       Dividends