The 10-Q Detective: Vornado Watch

REITs have rallied off year lows as investors discount the weakness in commercial real estate. But David Phillips finds reasons for doubt about Vornado Realty Trust

By David Phillips

This is the first column for BusinessWeek by David Phillips, who examines companies' financial statements and writes the 10-Q Detective blog.

Vornado Realty Trust (VNO) is one of the biggest players in what seems to be one of the least appetizing corners of the business world right now—commercial real estate. Despite a disappointing earnings announcement and gloomy prospects for commercial real estate, Vornado's stock has jumped 60% since Mar. 1. What investors may be overlooking is that the highly levered real estate investment trust (REIT) has a ratio of total debt to enterprise value of approximately 60%, and is struggling to juggle dividend payouts owed to stockholders, honor interest-coverage and maturing debt obligations, and stabilize decreasing spreads between new tenant and expiring rentals.

Vornado announced on Aug. 4 that recurring funds from operations (FFO) in its second quarter 2009 fell 53% year-over-year to $93.5 million, or 54¢ per share, due in part to lower investment returns (including $122.7 million of loss accruals on mezzanine loans and a $7.6 million lease termination due on its partial ownership interest in Filene's Basement), a 20% decline in profit at its Merchandise Mart office and retail showroom portfolio of Chicago properties, and higher vacancy rates and lower rents in Manhattan. (Initial rents on relet Manhattan office space are down by $19.15 a square foot, from $70 in December.)

The New York-based company is one of the largest publicly traded REITs in the U.S., with a real estate portfolio that includes about 36 million square feet of office space (almost all in Manhattan and the Washington, D.C., area), and another 22.4 million square feet of retail properties across the country. The company also has a 32.7% stake in Toys "R" Us and partial equity stakes in the two REITs Alexander's (ALX) and Lexington Realty Trust (LXP).

The big concern with Vornado, as disclosed in its 10-Q regulatory filing, is a growing imbalance between aggregate earnings and dividend distributions paid. At June 30, earnings were running a deficit to distributions paid of –$1.29 billion, up from –$527.2 million in the prior year, which suggests that the current quarterly dividend payment of 95¢ a share to stockholders is unsustainable going forward. To preserve cash (about $390 million annually), shareholders are being asked to make an election to receive this dividend in a combination of 40% cash and 60% Vornado common stock. A Vornado spokesperson said the company does not comment on forward trends.

Manhattan Office Vacancies

It's no wonder that Vornado is becoming more cautious. Commercial real estate firm Cushman & Wakefield reported on July 14 that the vacancy rate for offices in Manhattan rose to 10.5% in the second quarter, a 4½-year high—and could possibly hit 15.5% within a year, as companies continue to shed jobs or hold back expansion plans. Not the best of news for Vornado, as a significant portion of its business dealings are in New York City and Washington. For the first six months of 2009, 70% of its pretax profits came from properties in these markets.

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