Image Source: Unsplash

SL Green Realty (SLG) has an interesting business model, focusing solely on commercial buildings in Manhattan. The model worked for many years, but the COVID-19 pandemic changed how New Yorkers work and live. As a result, more companies are attempting a hybrid model when employees are at the office three or four days per week. But low office occupancy, high building vacancy rates, higher interest rates, and too much leverage caused SLG Realty to cut the dividend and lower its outlook. Many investors sold the stock before the cut because of the weak balance sheet and declining growth momentum.

Overview of SL Green Realty (SLG)

SL Green Realty (SLG) was founded in 1997 and has grown into the largest office landlord in Manhattan. The firm operates as a real estate investment trust (REIT), buying, managing, and selling commercial buildings. The firm either owns properties or provides financing through debt or preferred equity.

At the end of December 31, 2022, SLG Realty had an interest in 62 buildings with 33.6 million square feet of rental space. Of this total, 29.3 million square feet was ownership interest, and 3.5 million was debt interest. In addition, the REIT has an interest in many trophy properties, including 450 and 245 Park Avenue, One Madison Avenue, One Vanderbilt Avenue, and the Giorgio Armani Residences.

Total revenue was $766 million in 2021 and $719 million in the past twelve months.

Source: SL Green Realty Investor Relations

Dividend Cut Announcement

SLG Realty announced a dividend cut on December 5, 2022. The company reduced the quarterly dividend by 12.9% to $0.2708 from $0.3108 per share. Specifically, the REIT’s Chief Financial Officer stated,

“We endeavor to provide our shareholders with a meaningful, sustainable ordinary dividend that has a correlation to operating cash flow while furthering our initiative to maintain substantial liquidity and repay debt amid the backdrop of a rising rate environment. We have reduced the dividend to match our current projection of Funds Available for Distribution (“FAD”) for 2023, which allows us to strike this balance as we continue to provide a yield on our common stock of approximately 8.0%, based on the current share price, while projecting an increase in liquidity to nearly $1.6 billion and a reduction of combined debt by almost $2.4 billion during 2023,”

The announcement indicates the REIT is focusing on debt repaying and increasing liquidity, probably to improve its financial position. Although REITs performed well for many years, the leasing and funding environment has changed dramatically in 2022. The REIT is likely positioning itself for a difficult 2023.

Challenges

SLG Realty is experiencing declining growth because of the challenging New York City, especially Manhattan commercial office market, higher interest rates, and high leverage.

Commercial Office Market

The commercial office market is facing unprecedented challenges because of the work-from-home trend. Despite an uptick in the second half of 2022, office occupancies remain below pre-pandemic levels. Office occupancies were below 20% in April 2020 and have slowly risen since then. The NYC office occupancy was almost 50% at the end of 2022, better than in many cities. Hybrid work and low occupancy is causing higher than typical vacancy rates, approaching 20% in some cities. A normal vacancy rate is roughly 12%. Also, listed lease rates per square foot have fallen, although Manhattan still commands the most expensive office rates in the country. 

In addition, recession fears combined with layoffs are further reducing the need for office space. The bottom line is that commercial tenants are reducing their office space because they have fewer requirements.

Higher Interest Rates

Rising interest rates result in problems for REITs because of their business model. REITs acquire new properties by issuing debt and equity. Higher interest rates impact both. The cost of debt is higher because the rising rates increase the interest payment. Issuing more equity is also more difficult. If safe United States Treasuries are paying a higher coupon, shareholders may sell REITs, causing their stock prices to drop. Hence, a firm must issue more shares to raise the same amount of cash for growth, significantly diluting shareholders. Moreover, dilution makes it difficult to grow adjusted funds from operations (AFFO).

Higher interest rates make it harder for a REIT to grow profitably. That said, higher interest rates may depress real estate prices, allowing good management to acquire properties cheaply.

Leverage

Although SLG Realty’s total debt from its peak has come down, leverage is still high. The chart below from Portfolio Insight* illustrates that total debt is about $6.63 billion at the end of Q3 2022. This amount translates to an extremely high-value leverage ratio of over 18.6X. On the other hand, interest coverage is low at about 1.8X, another weak ratio. 

Analysts agree that SLG Realty has too much debt and too little interest coverage. Scotiabank analyst Nicholas Yulico wrote,

“Given still high leverage and downside earnings risk, we expect the stock will continue to trade at a discounted valuation that incorporates some level of future dividend cut,”

Consequently, the dividend cut was not surprising because the company wants to use cash flow to lower debt. 

(Click on image to enlarge)

Source: Portfolio Insight*

Dividend Safety

SLG Realty must meet the requirements for paying its dividend to remain a REIT. Specifically, it must distribute a minimum of 90% of taxable income as shareholder dividends each year.

Note that SLG Realty cut its dividend during the COVID-19 pandemic in 2020 before increasing it again in 2021.

(Click on image to enlarge)

Source: Portfolio Insight*

The dividend yield before the cut was over 11%. After the reduction, the forward dividend yield dropped to about 8% and is now ~9.2%, a still high value. Percentages this high can indicate distress and potentially signal another dividend cut.

But after the reduction, the dividend safety has increased slightly. The annual dividend payout now requires approximately $208 million ($3.25 yearly dividend x 65 million shares) compared to $271 million in 2021 and $263 million in the trailing twelve months.

Additionally, the REIT has made progress in deleveraging. The CEO said,

“I’m just as happy that we were able to retire $800 million of maturing public bonds through a series of paydowns and financings that were done on attractive terms. Furthermore, we’re highly focused on implementing strategies to mitigate our exposure to rising interest rates by executing on a series of swaps, caps and debt repayment.”

Although the dividend safety has improved, SLG Realty is still facing a challenging rental market in Manhattan. In addition, the U.S. Federal Reserve is still signaling further rate increases, and the possibility exists for a future dividend cut.

Final Thoughts on SL Green Realty (SLG) Dividend Cut

SL Green Realty cut the dividend and improved safety. It has a plan to deleverage. Office vacancies will drop in Manhattan. Landlords are upgrading properties, converting some to residential use, and bringing in casinos. This will take time, but rising office occupancy combined with these actions will lower vacancy rates.

However, the balance sheet is still leveraged, and the recession risk is not minimal. A recession will accelerate layoffs and pressure the REIT’s finances. Consequently, people following a dividend growth investing strategy or desiring REITs should consider other options.

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