New York Office Market's Recovery Clashes With Shrinking Profit Margins, Yet Promises Diversification And Strategic Gains

Key Takeaways

• Increased demand in New York's office market, particularly in Midtown and the Penn District, could lead to higher revenue and lower vacancy rates.
  
• The diversification of revenue sources and potential increase in earnings from financial services, technology, and legal sectors indicate a broadening financial base.
  
• Vornado's strategic leasing, asset sales, and favorable market conditions suggest improved occupancy, revenue, and financial position, particularly in prime New York City submarkets.

Catalysts

Vornado is a fully integrated real estate investment trust (“REIT”) with a portfolio of premier New York City office and retail assets and the developer of the new PENN DISTRICT.

• New York's office market is showing signs of recovery which might lead to increased demand and leasing rates, particularly in Midtown and the Penn District, thereby potentially increasing revenue and decreasing vacancy rates.
  
• The significant leasing activity, especially in prime locations such as the Penn District and 731 Lexington Avenue, could enhance net operating income (NOI) due to higher starting rents and strong tenant demand.
  
• The nearing completion of major projects and successful leasing cater to financial services, technology, and legal sectors suggests diversification of revenue sources and a potential increase in earnings from these properties.
  
• The capability and plan to monetize assets and repatriate a portion of preferred equity could improve liquidity and contribute positively to the balance sheet, reducing leverage.
  
• The announcement and expectation of interest rate stabilization or reduction may lead to decreased borrowing costs and improved financing conditions, likely having a positive impact on net margins through reduced interest expenses.

Assumptions

• Analysts are assuming Vornado Realty Trust's revenue will grow by 1.5% annually over the next 3 years.
• Analysts assume that profit margins will increase from 1.0% today to 1.5% in 3 years time.
• Analysts expect earnings to reach $29.0 million (and earnings per share of $0.12) by about October 2027, up from $18.1 million today. However, there is a considerable amount of disagreement amongst the analysts with the most bullish expecting $35.7 million in earnings, and the most bearish expecting $17 million.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 309.6x on those 2027 earnings, down from 456.2x today. This future PE is greater than the current PE for the US Office REITs industry at 77.5x.
• Analysts expect the number of shares outstanding to grow by 4.38% per year for the next 3 years.
• To value all of this in today's dollars, we will use a discount rate of 7.32%, as per the Simply Wall St company report.

Risks

• Vornado's active leasing efforts indicate recovering and strong demand for office space, especially in prime submarkets like New York City's Midtown, which is likely to boost occupancy rates and therefore revenue.
  
• The inability to economically build new office spaces in New York City likely means restricted new supply, potentially leading to a landlord's market, which could result in rising rents and improved net margins.
  
• The sale of assets like the UNIQLO Fifth Avenue flagship at a favorable cap rate reflects a strong capital recycling strategy, improving liquidity and potentially leading to more strategic investments or debt reduction, enhancing earnings.
  
• The handshake deal for a master lease of the entire 1.1 million square foot office component of 770 Broadway indicates significant leasing momentum and confidence in demand, predicting a stable or increasing revenue stream.
  
• Market dynamics and the anticipated reversal of interest rates, as hinted by recent government bond and stock market activities, suggest a favorable financial environment for Vornado, potentially leading to lower borrowing costs and improved profitability.

Valuation

• The analysts have a consensus price target of $31.3 for Vornado Realty Trust based on their expectations of its future earnings growth, profit margins and other risk factors. However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $42.0, and the most bearish reporting a price target of just $23.75.
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2027, revenues will be $2.0 billion, earnings will come to $29.0 million, and it would be trading on a PE ratio of 309.6x, assuming you use a discount rate of 7.3%.
• Given the current share price of $43.24, the analyst's price target of $31.3 is 38.1% lower. Despite analysts expecting the underlying buisness to improve, they seem to believe the market's expectations are too high.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.