While I have never been a big fan of investing in office REITs, Boston Properties (BXP) does look like a compelling buy at current prices. With quality, diversification, and a strong balance sheet, it is arguably the best-positioned office REIT to weather the disruption and challenges facing the space right now. Investors should avoid taking on outsized exposure to office real estate given the risks, but BXP is a Buy given its significant margin of safety relative to its historical valuations and net asset value.
BXP boasts one of the strongest office portfolios in the world due to having significant geographic and tenant diversification and well-located properties. Its assets are primarily located in Boston (34%), New York (26%), and San Francisco (22%), along with a presence in Washington, D.C. and Northern Virginia (15%) and Los Angeles (3%). Each of these markets is considered a “Gateway Region” with strong durable demand drivers and solid long-term growth drivers.
The REIT’s top tenant is Salesforce.com (CRM) – a growing ecommerce business – and it accounts for less than 3.5% of its annualized rental income. Its largest industry exposures are to financial services (29%), media, technology, and life sciences (26%), and legal services (20%). With only 7% exposure to retail tenants, it is fairly well-insulated from the retail apocalypse.
Furthermore, 86% of BXP’s total revenue comes from office rents that are tied to lengthy average lease terms with maturities that are well-laddered (8.1-year average remaining lease term). For example, only 5% of its leases expire this year and only 7% expire in 2021. Given these factors, BXP enjoys a healthy occupancy rate of 92.9%.
Given their portfolio strengths, BXP has held up relatively well during the pandemic, as June collections came in at 98% on the office portfolio. That said, the remaining 14% of rental income (consisting of retail, parking, hotel, residential, management services, and other) saw lower collections due to retailer challenges, hotel closures, and a steep decline in demand for parking at office properties. As a result, in Q2, revenue was down 10.8% year over year, and FFO per share fell to $1.52 (down 14.6%) as management took a $0.24 per share charge to revenue from write-offs of accrued rent and accounts receivable of retail tenants.
Two silver linings that have come with the pandemic are that new speculative construction in BXP’s markets is declining due to the economic uncertainty. Furthermore, the cessation of a lot of construction has resulted in higher lease renewal rates, since tenants are unable to complete alternative space build-outs. Both factors have led to reduced competition for BXP.
While cash flows will likely remain subdued for the foreseeable future, the good news is that the vast majority of its office tenants should be able to continue paying rent, giving the company a health amount of cash flow to support its dividend and other obligations, while also continuing to invest in opportunistic and long-term growth opportunities.
Further strengthening BXP’s position in the current period of uncertainty is the fact that it boasts an A-rated balance sheet. While the company’s debt has a fairly low term to maturity of just 3.9 years, the good news is that the weighted average interest rate is only 3.38% and will likely go even lower as long-term treasury interest rates continue to hover around record lows. The company also has more than enough liquidity to handle near-term debt maturities in the event that banks begin to balk at refinancing office real estate, thanks to $3.3 billion in liquidity and just ~$2.5 billion in debt maturing over the next two years. When accounting for retained cash flow, it will likely have enough combined liquidity to pay off all debt maturing through 2024 assuming no refinancing. That said, we do not expect this scenario to play out barring a major international economic meltdown, given the fact that BXP has an A-rated balance sheet and, therefore, easy access to cheap capital.
While the asset portfolio remains top-tier, recent performance indicates resilience in the core portfolio, and the balance sheet is one of the strongest in the entire REIT space, BXP still faces several meaningful challenges.
First and foremost is the traditional risk facing any office REIT during a recession: job losses and increases in business failures will lead to lower demand for office space, resulting in lower lease renewal spreads, poorer performance for new developments coming on-line, and potential increases in vacancies. That said, BXP’s high-quality, well-located assets in top markets combine with its modest near-term lease expirations to temper these concerns.
The second big risk is that the combination of COVID-19 and the violent riots that tormented large cities earlier this summer are increasingly scaring people away from dense city centers and are increasing the work-from-home trend. While many do not expect this to be an overnight transformation and doubt that the pace of change will come anything close to what has taken place in the retail sector, there is still a very strong likelihood that the long-term trend favors more remote work over the traditional corporate office. As a result, the value appreciation outlook of urban office real estate is much weaker now than it was in February.
In light of these near-term challenges and risks, BXP’s management is focusing on courting quality tenants from industries that will be least likely to be impacted by the work-from-home trend and retail apocalypse. They are focusing largely on attracting tech, life sciences, and related growth sectors that require skilled young workers seeking collaborative environments (that require the value-add of an office space work environment as opposed to remote work). The company also expects the need for less dense office space (due to health concerns) to drive increased demand for square footage per person in the office, thereby offsetting some lost demand to increased work-from-home practices.
BXP also plans to continue its capital allocation practices, including strategic property developments, dividend payments, and maintaining a strong balance sheet in order to maximize shareholder value. Given their strong financial position and solid underlying portfolio performance, management does not see any pressing need to make drastic changes to capital allocation strategy at this point.
As the chart below indicates, BXP’s share price has fallen sharply in the wake of COVID-19 and is now trading near 10-year lows, and its dividend is trading at twice its average level over the past decade.
Furthermore, the current share price implies a portfolio average cap rate of nearly 7%, which would represent a historically wide gap to interest rates and a significant discount to recent cap rate data from CBRE, which indicates BXP’s cap rates prior to COVID-19 likely stood in the 4.5-5% range. That said, we do expect some expansion given the aforementioned heightened risks in the sector (though this should be partly offset by the further declines in interest rates). This is also reflected in recent consensus NAV estimates, which at the beginning of 2020 stood at $152 per share (~4.75% cap rate) and today stand at $135 per share (5.25% cap rate), which we view as reasonable given the risks and the offsets (lower interest rates and the company’s unique competitive advantages).
As a result, we assign a fair value estimate of $135 per share and feel quite confident that fair value lies between $120 per share and $150 per share, as we expect cap rates on BXP’s properties to settle in the range of 4.75-5.75% in the post-COVID-19 world given the need for a slight discount to offset heightened risks.
BXP boasts one of the top portfolios and balance sheets in the REIT sector. It also looks very cheap relative to its history based on share price, dividend yield, and discount to NAV. That said, the company does face significant long term uncertainty given the potential shift away from urban densification, as well as the move towards more work-from-home instead of using the traditional office space. As a result, we do believe that a higher cap rate than was previously typical for BXP’s assets is appropriate.
However, lower interest rates, BXP’s balance sheet and portfolio strengths, and management’s renewed focus on attracting tenants that require younger employees in industries that rely on collaboration offset a significant amount of this risk. As a result, we believe with a high degree of certainty that shares are significantly undervalued given current interest rates. We rate shares as a Buy, but do urge investors to keep the position size relatively small in their overall portfolio given both the short-term economic and the long-term office sector uncertainties.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.