SL Green shows 'em how it's done

Real Estate Weekly, April 30, 2008 by Daniel Geiger

The Manhattan based real estate investment trust, SL Green, got another strong rating from REIT analysts at Goldman Sachs. The investment firm advised investors to buy SL Green shares at a time when many are cooling towards office REIT stock for fear that me slowing economy will begin to curtail the demand for office space, creating higher vacancy and decreasing rental rates.

SL Green's funds from operation, a key measure of REIT performance, exceeded expectations in the first quarter of the year, coming in at $1.44 per share, which was above estimates of $1.40.

The strong performance came despite the fact that rents are beginning to slacken slightly in Manhattan, which is considered one of the strongest office markets in the country. According to an office market report released by CB Richard Ellis, average rental rates began to drop during the first quarter.

But the company still saw a 12.2% increase in net operating income as a result of the higher rents it was able to net for office space that came available in its portfolio. Those rents may have been lower than the peak pricing the company could have achieved before the credit crunch and the dip in the economy in recent months, but the Goldman report said they still were far above what previous rents had been for the space.

The growth highlights how landlords are still in for a payday when space comes available in their portfolios, even though the market has clearly begun to stall.

Goldman predicted that rents could drop by 10-15% in the coming months but the rise in the rental rates in recent years had been so precipitous that the modest dip in rents so far is often still far above rates that landlords are receiving for leases signed years ago and that are now set to expire.

In SL Green's case, the company was able to net a huge 44% gain in rental rates for new deals in the first quarter. According to the Goldman report, SL Green will continue to fill its space with higher paying tenants as more leases roll over in the coming months.

"Average in-place rents remain 30@% below market and we believe the company can continue to achieve solid re-leasing spreads throughout 2008 (25% )," the report stated.

The report also said that the prospect of having large financial firms, still reeling from subprime losses, dump large blocks of office space on the market--what has been one of the most dreaded scenarios for the city's leasing market--appears to be less of a risk than many may have previously thought.

"SLG's results bolster our view that the headline risk of financial services-related layoffs and the resulting overhang on the shares may be overdone," the report said.

Another measure the report used in its recommendation was the value of SL Green's real estate. The credit crisis has cut off capital for large real estate deals, making debt more difficult and expensive to arrange. The problems have brought the investment sales market in Manhattan to a near standstill and prices down from peak levels last year. But Goldman said that a handful of recent transactions, including a building recently sold by SL Green, show that commercial real estate values have only fallen moderately.

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The report cited the recent sale of 650 Madison Avenue to the real estate investor Ben Ashkenazy last month, a deal first reported by rew-online.com. According to Goldman Sachs, the building traded at an extremely low 3.7% cap rate. In March, SL Green sold 1250 Broadway, an office building that it owned in partnership with the institutional investment fund SITQ, to Murray Hill Properties for $310 million, a price that translates into a 4.5% cap rate.

Goldman said that the SL Green's stock is trading at a level that implies a cap rate of about 6% for the company's real estate. Given the recent sales, that cap rate could actually be lower, meaning the company's real estate and its share value is underestimated.

"We note that the stock appears grossly undervalued when viewed from an implied value per square foot or simply an implied cap rate basis," the report said.

"For instance, the stock, with an enterprise value of roughly $500 per square foot, is trading well below the recent levels of property sales in Manhattan. The same can be said on a cap rate basis as the stock trades at an implied cap rate of roughly 6.0%. In short, we rate the stock Buy and believe it is attractively priced versus REIT peers."