Value Line has initiated coverage of New York City focused SL Green Realty (SLG), a real estate investment trust (REIT) that owns, manages, and develops properties in and around the Big Apple. The company was formed in mid-1980 by Stephen L. Green, with the current entity taking shape in 1997. Reckson Associates Realty Corp. and Reckson Operating Partnership, L.P. are subsidiaries of SL Green Operating Partnership, L.P., one of the entities contained within SL Green.
At the end of 2011, the company owned 65 office properties in and around New York City, many of which contain retail space. In addition to these core properties, it also owned nine stand-alone retail properties, seven properties under development, and three land interests. SL Green also manages four office properties owned by third parties and affiliated companies. The REIT’s focus is on owning "high-quality office properties strategically located in close proximity to midtown Manhattan's primary commuter stations.”
REITs were created by the United States Congress in the 1960s, giving individuals the opportunity to invest in large property businesses. Some regulations, as outlined by the Internal Revenue Service, apply to these investments. Prominently, REITs must invest at least 75% of their assets in real estate and distribute 90%, or more, of their annual taxable profits, as dividends, to shareholders. These distributions are generally taxable as regular income for shareholders. Note, too, that REITs report “Revenues” or “Rental Income”, largely consisting of rental proceeds from wholly owned properties.
Rental income is affected by many factors, but two important ones are occupancy rates (the percentage of a REIT’s stabilized, in-service square footage that’s occupied) and a company’s ability to raise rents. These are all factors that investors should monitor. Additionally, REITs also publish a non-standard metric called funds from operations (FFO). This is analogous to earnings in a standard corporation, but adds back non-cash items, most notably depreciation (owning and managing properties makes this a material non-cash expense for most REITs). As such, FFO per share is similar in nature to earnings per share.
As an office focused REIT, SL Green tends to divide its space among fewer tenants than many other REITs and its leases will ordinarily span multiple years. This provides a benefit in that revenues from a big lease can normally be counted on for the entire length of a contract—making new tenant wins very important. However, the loss of a single tenant can have a negative impact. Also, concessions, such as property improvements, are a normal part of the leasing processes, so new tenants and extended leases can be costly to procure.
Lease terms often include some level of annual rental increases. By the same token, when a lease ends, contract terms are typically altered to better conform to the rents prevalent at the time of negotiations. As such, SL Green has some power to raise rents over time. That said, the market in which the company operates provides a great deal of support to SL Green’s operations. Indeed, the New York City market is one of the premier property markets in the world, and SL Green owns and operates many prime buildings. Not only does this support the REIT’s efforts at increasing rents, but it also creates a very large barrier to entry for competitors since the properties in this market are generally afforded premium prices. There are negatives to the New York office market, like a substantial portion of tenants in the financial sector and high asking prices for properties (which make acquisitions costly for SL Green, too). But overall, the Big Apple has proven a prosperous market for landlords.
That said, the company’s portfolio is relatively small when compared to REITs that diversify across more, and often smaller, markets. In fact, seven of the company’s properties accounted for approximately 41% of its annualized rent in 2010. Clearly problems at any of those properties would have an outsized effect on the company’s operations. However, SL Green’s tight focus on just one market can afford benefits for its operations. This includes an ability to see potential where others might not, allowing management to buy properties and “reposition” them to generate higher rents. Another often overlooked benefit is the tightness of the property community in a given market—with its focus, SL Green is a major player in New York and needs no introductions to get involved in a deal.
As a REIT, SL Green makes use of leverage at multiple levels of its corporate structure. Specifically, it can mortgage properties it owns and take out debt at the corporate level. Thus, leverage is an important issue for shareholders to monitor over time. This is particularly true if SL Green makes any material acquisitions, which may demand additional debt to consummate and could require the company to take on the debt burdens of its target. Both debt and equity are important to watch, because REITs must pay out the vast majority of their earnings. This leaves little money for growth initiatives, so either debt or the issuance of new shares must be used to expand. Both types of financing can have a material impact on performance.
It is also worth noting that SL Green is not particularly generous with respect to returning cash to shareholders via dividend distributions. Although REITs legally must payout a certain amount of their earnings as distributions, the percentage is based on earnings and not cash flow. Since dividends are paid out of cash flow (which adds depreciation back to earnings), many REITs actually pay more in dividends than they earn. By contrast, SL Green has historically opted to pay much less than it could based on cash flow (a figure similar to FFO) and, instead, maintains a focus on business growth. This is a legitimate business decision, but one about which investors should be aware.
SL Green is a large player in an important office market. It has a long history of solid results. Although dividends aren’t the main story here, investors interested in gaining exposure to the New York City market would do well to consider this REIT. Subscribers can monitor Value Line’s quarterly reports in The Value Line Investment Survey, while keeping an eye out for Supplemental reports covering late-breaking news.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.