A particularly unpopular class of REITs since the onset of the COVID-19 pandemic has been office REITs. Due to social distancing, temporary remote work, and the prospect of remote work becoming permanent for many people companies, players in this niche have been particularly affected. As a result, some of them are now trading at fundamentally attractive prices, even though they generate large cash flows. One of the cheapest players in this space is Paramount Group (NYSE: PGRE). But when evaluating the company, you have to take into consideration that the company’s pre-pandemic growth track record wasn’t even that fantastic. When you factor in this inability to grow, a discount to its peers is probably warranted. So as a result of that, I’ve decided to classify the business as ‘on hold’ for the time being, with the idea that it might become an attractive prospect if growth develops.
A major player in key markets
Today, Paramount Group operates as the owner of high quality Class A office properties located in key markets. Management identified the central business district submarkets of New York and San Francisco as the company’s playground. At the end of the company’s last quarter, it had a portfolio of 13.9 million square feet. The company currently owns 8 properties (wholly and partially owned) in New York City, totaling 8.6 million square feet. 8.2 million square feet of this space is designated as office space, while the remaining 0.4 million is split between retail, theater and amenity space. The Company owns 6 other wholly or partially owned properties totaling 4.3 million square feet in San Francisco. 4.1 million square feet of this area is office space, with the remainder commercial in nature. And finally, the company also has six managed properties totaling 1 million square feet spread between New York and Washington, DC.
The company is not too exposed to a single tenant. Currently, its main tenant, First Republic, accounts for just 4.7% of the company’s annualized rent. Its top five tenants represent 22.2% of annualized rent, while its top 10 represent 35.2%. In terms of industry exposure, the company’s greatest concentration is in the area of legal services. 22.7% of the company’s annualized rent comes from operators in this market. 21.3% comes from technology and media companies, while financial services dedicated to the commercial and investment banking categories account for 17.8%. All other financial services account for 16.1% of annualized business rent. Other major categories include insurance, travel and leisure, retail, consumer products and other miscellaneous professional services.
Another interesting thing about the company is the breakdown of its leases by expiration date. This year, leases representing barely 2.6% of annualized rents are coming to an end. From 2022 to 2026, this number increases to 43.3%. After that, however, the picture is much better. Indeed, the leases representing 32.8% of the annualized rents do not expire until after the year 2031. This should provide some stability to the company if the management is able to renew the leases which expire at favorable rates over the next few years.
Although the company claims to have great strengths, the management has not done a great job of developing the company over the past few years. Like almost all office REITs, Paramount Group is getting a pandemic years pass. However, even then the business did very well. But before that, the company had shown no real growth. Revenues of $759 million in 2017 increased only modestly to $769.2 million in 2018. In 2019, they fell to $743.8 million. Fiscal 2020 was a little tougher, with sales dropping to $714.2 million before increasing slightly to $726.8 million in 2021. It looks like the business suffered somewhat from a decline in its occupancy rate. After falling from 94.2% in 2017 to 97% in 2018, it began a steady year-on-year decline. 2021 was the most difficult year for the company, with an occupancy rate of only 90.7%. Management was able to offset some of this pain by increasing the square footage of the company’s portfolio. After growing from 12.5 million in 2017 to 11.9 million in 2018, square footage began a general increase, eventually reaching 13.9 million by the end of 2021.
Ultimately, the results were inconsistent but nonetheless positive. Operating cash flow was all over the place, ranging from a low of $156.5 million to a high of $285.4 million. Core FFO, or funds from operations, was more stable, with a range between $201.1 million and $229.9 million. But for four of the past five years, this measure has deteriorated year on year. The lack of a clear trend in profitability can also be seen when looking at EBITDA. This number has varied from a low of $358.7 million to a high of $394.5 million over the past five years.
For the company’s first quarter of fiscal 2022, results were generally positive, but nothing special. Revenue of $183.7 million was slightly higher than the $181.2 million reported for the first quarter of its fiscal 2021. This was due to an increase in square footage from 12.9 million to 13, 9 million, as well as an increase in the company’s occupancy rate from 88.9% to 90.6%. Profitability followed a similar trajectory, with cash flow from operations falling from $58.3 million last year to $58.7 million this year. Core FFO also improved from $50.6 million to $54.6 million, while EBITDA increased from $94.2 million to $96.1 million.
With regard to the 2022 financial year, the only guidance given by management concerned the basic FFOs. The current expectation is for this to be between $0.93 and $0.97 per share. At the midpoint, that implies a base FFO of $208.1 million. Since this number falls within this very narrow range demonstrated over the past five years, I have decided to price the company solely based on the 2021 results. In doing so, we see that the company trades at a price to operating cash flow multiple of 9.7. The base price/FFO multiple is only slightly above 10.3, while the company’s EV/EBITDA multiple is 16.8. To put the price of the company into perspective, I decided to compare it to five similar companies. On a price/operating cash flow basis, these companies ranged from a low of 7.7 to a high of 12.9. In this case, Paramount Group was cheaper than all but one of the companies. Due to the company’s higher leverage, with a net debt ratio of 9 right now, we can see that three of the five companies were cheaper than it on an EV/EBITDA basis, those companies ranging from a low of 2.4 to a high of 17.5.
|Company||Price / Operating Cash||EV / EBITDA|
|Highwoods Properties (HIW)||9.8||10.5|
|Kilroy Realty Corp. (KRC)||11.6||17.5|
|Head Office Properties Trust (OFC)||11.6||16.5|
|Municipal Office REIT (CIO)||7.7||2.4|
|Boston Properties (BXP)||12.9||17.0|
At first glance, Paramount Group strikes me as a company that trades cheaply and has quality assets in quality markets. However, I am disappointed with the company’s inability to grow revenue and earnings over the past few years, especially before the COVID-19 pandemic. The company has stable cash flow at present, and it could very well become an attractive investment. However, between the inability to grow and its high leverage, I think the company is closer to being valued at its fair value right now.