SL Green: I’m Long But I’m Not Entirely Sleeping Well At Night

Ask SL Green’s (NYSE:SLG) bears why they’ve built a nearly 13% short interest in the Manhattan office REIT, and they’ll likely respond with a three-letter acronym; WFH. Once thought to be a temporary feature of pandemic-era stay-at-home orders, work from home (WFH) now looks set to become a structural part of contemporary American working patterns. The benefits for workers center on flexibility, work/life balance, and cutting the commute. However, this is counterbalanced by the drawbacks; fragmentation of collaboration, culture, and some productivity headwinds. WFH is likely here to stay, with most employees preferring a hybrid working arrangement with their employers.

SL Green is Manhattan’s largest office landlord, with interests in 62 buildings totaling 33.6 million square feet. This includes the fully let and newly completed One Vanderbilt Avenue and 2 Herald Square, which counts co-working pioneer WeWork (WE) as a tenant.

REITs of course are structured to pay out 90% of their taxable earnings as dividends. This saw the last monthly cash dividend payout at $0.3108, in line with the prior and for an annual yield of around 9.20%. SL Green switched to monthly payouts at the start of fiscal 2020 and has consistently paid this out even through the pandemic. With 68.9 million shares outstanding, the company sports a $2.61 billion market cap with a healthy balance sheet that held total equity of $5.2 billion.

Why I Bought The Common Shares

Let’s be clear here, the market is discounting SL Green due to the potential impact WFH could have on occupancy and lease spreads. The situation is more acute against rising interest rates possibly set to be hiked by another 50 basis points when the Fed meets later this month. The bears are betting that FFO will come under material pressure from rising Fed fund rates and weaker leasing activity as more companies fully embrace the WFH model to save money.

I think this bearish line of thinking betrays a key consideration. There will remain a material level of demand for office space in Manhattan, and WFH is not a fit for certain industries. Indeed, the company recently signed a 15-year lease with Franklin Templeton for its One Madison Avenue. The development of the building is set for completion in November 2023 and is more than 55% fully leased. SL Green last reported earnings for its fiscal 2022 third quarter saw revenue come in at $212.46 million, up by 3.5% over the year-ago quarter and a beat by $55.23 million on consensus estimates. Third quarter FFO at $1.66 was also a beat of $0.01 on consensus but was down by 6.7% from $1.7 in the year-ago comp.

Management during their earnings call with analysts for the quarter stated that rising interest rates on their debt will continue to pose a near-term headwind but that they’re focused on executing strategies from swaps, caps and debt repayment to mitigate their exposure. SL Green entered into interest rate cap contracts on $270 million of property debt and initiated $1.25 billion of interest rate swaps, with around 80% of its debt now hedged.

The company was also able to retire $800 million of maturing public bonds through refinancings and the proceeds from asset sales. This saw the sale of 414,000 square feet in its Lipstick Building at 885 Third Avenue to Memorial Sloan Kettering for $300 million.

Interest rate hedging and debt reduction is our number one priority for the foreseeable future – SL Green CEO Marc Holliday

The New World Of Work, It’s The Old One

SL Green signed 32 office leases covering 930,232 square feet during the third quarter, which drove a 92.1% occupancy rate. With a trailing 12-month price to FFO of just 6.03x, 58% less than its sector median, bulls would be right to state that the WFH bearish trade is perhaps overdone, especially as leasing activity remains healthy. This comes against a dividend yield that is more than double its sector median.

The company has rightly pivoted to debt reduction against a total debt-to-equity that’s high at 127%. With the bulk of this debt hedged, the risk to the long side has been significantly mitigated. Whilst a recession next year could weaken leasing activity, occupancy is likely to remain steady above 90% for much of the full fiscal year, with tenants secured on long-term leases.

Bears have put forward a vision of the future where offices become relics of the past, and this has disturbed sleep. But some pragmatism is required here as not all offices will experience the same level of disruption. SL Green continues to build a quality tenant base as it molds itself around the post-pandemic zeitgeist. The story will eventually change, and I am long on a DRIP, with sentiment likely to recover once the current interest rate hiking cycle is over.