Office landlords have been under tremendous pressure in recent years. A rise in remote and hybrid work following the pandemic has affected the demand for office space. Meanwhile, surging interest rates are increasing borrowing expenses. These and other issues are putting pressure on the income produced by office buildings.
These headwinds have put the office sales market in a deep freeze because buyers and sellers couldn't agree on a firm value. That uncertainty of value has added more weight to drive down office REIT stock prices.
However, this week, the sector got a big boost when SL Green Realty(NYSE: SLG) agreed to sell a stake in one of its Manhattan office buildings in a deal valuing the property at $2 billion. The sale suggests that high-quality office buildings have held their values reasonably well, despite all the sector's issues. That's driving a relief rally in other office REITs.
Details on the deal
SL Green Realty, the largest office landlord in New York City, agreed to sell a 49.9% interest in 245 Park Avenue to a Japanese real estate investor. The deal values the 1.8 million-square-foot office building at $2 billion. According to The Real Deal, the purchase price implies a real estate cap rate in the high 3% range. That's a surprisingly strong valuation, given all the headwinds facing the office sector. It suggests that high-quality office properties are holding their values quite well.
The office REIT was able to lock in a strong valuation for a property that's still a work in progress. SL Green took control of the property out of bankruptcy last year following a large tenant vacancy. The previous owner initially purchased the 1960's era building in 2017 for $2.2 billion. SL Green has been working to reposition the property to attract new tenants by adding new amenities. This strategy is already starting to pay dividends. SL Green has signed 87,000 square feet of new leases.
The sale is a huge boon for SL Green Realty. It will offload half the property's $1.76 billion debt burden from its balance sheet, which the buyer will assume. Meanwhile, the cash received in the sale is a large component of its 2023 capital plan.
The deal will help take some of the pressure off SL Green. Shares of the REIT had fallen more than 40% over the past year, weighed down by increased financing costs and vacancies. These headwinds forced SL Green to cut its dividend by 12.9% last December, ending more than a decade of increases. Even with that cut, the office REIT's monthly dividend currently yields 11.6%. That high rate suggests investors expect another reduction in the future.
Setting a floor on values
The deal news provided a lift to the entire office REIT sector, especially those with properties in New York City:
That's because it puts a firm value on a major urban office building. Sellers can use it as a comp for future sales. It also gives the market a valuation floor for existing properties. That provides investors more clarity on what office buildings are worth, at least in Manhattan's urban core.
The uncertainty of office property values has weighed on office REIT share prices, pushing up their dividend yields. For example, Alexandria Real Estate Equities now yields 4.4%, Boston Properties yields 7%, and Brandywine Realty Trust's payout is up to an eye-popping 17.3%. A big driver of those higher yields is the concern that more office REITs will follow SL Green (and others) in slashing their dividends. We've already seen big dividend cuts from Vornado, which suspended its dividend until the end of the year, and Douglas Emmett, which slashed its payout by 32% last December. These office REITs cut their dividends to increase their liquidity to fund development projects and repay debt amid the continued downturn in the office market.
However, if other office REITs can follow SL Green's footsteps and sell office properties at strong values, they could use those proceeds to repay debt and fund development projects. That could allow them to maintain their dividends instead of cutting them.
Breathing easier, at least for now
SL Green was able to sell a stake in a Manhattan skyscraper for a surprisingly strong value. That sparked a relief rally in the office sector. Investors hope the deal puts a floor under office values, freeing up more REITs to sell properties to help enhance their liquidity.
However, the sector isn't out of the woods yet. The headwinds of higher interest and vacancy rates remain fierce. Meanwhile, several office REITs still need to deleverage their balance sheets through asset sales or dividend cuts. It could be a long time before the sector recovers.
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Matthew DiLallo has positions in SL Green Realty. The Motley Fool has positions in and recommends Alexandria Real Estate Equities. The Motley Fool has a disclosure policy.
