As third-quarter earnings continued to trickle in this week, familiar patterns kept repeating themselves. Results were generally better than analysts expected, and companies are beginning to see the light at the end of the tunnel. Cost-cutting remains a central driver of improved earnings, but a rebound of demand is being seen in many sectors as well.
REITs Report
Commercial real estate has been a focus of many investors for months amid concerns that a wave of commercial defaults could create a renewed banking crisis. Non-residential real estate fundamentals typically lag residential as long lease terms make prices and occupancy stickier than they would be otherwise.
One way to gauge the health of the commercial real estate industry is to examine the earnings of real estate investment trusts (REITs). REITs are not a perfect proxy; they tend to be higher-quality properties with more conservative financing, but they do give a general sense of broad trends. This quarter, there was broad weakness across property types (office, apartments, retail, etc.), but rents and occupancies have not dropped off a cliff. Cost controls are also providing a positive catalyst for earnings.
One unexpected bright spot this quarter was at SL Green (SLG), which saw operating revenue fall about 1%, but earnings before interest, taxes, depreciation, and amortization rose slightly to $116.6 million, thanks mainly to general and administrative expense savings. Other operating metrics held up well, with SL Green's Manhattan occupancy rate at 95.7%, about 500 basis points higher than the average in its core midtown Manhattan submarket. The firm also achieved positive leasing spreads (the difference between the rental rates on new versus expiring leases) of 5% for its Manhattan leases. This is down meaningfully from recent historical spreads, however, and concessions for tenants were significant, including nearly seven months of free rent and tenant improvement allowances of $56 per square foot on average (with an average lease term of 9.6 years). Equity analyst Todd Lukasik sees this as a sign that the weak Manhattan leasing market is beginning to negatively affect SL Green's business, and we expect weakness in its financial results to follow.
Other office landlords saw slightly improved results but also showed signs that there is significant weakness to come. Boston Properties (BXP), which owns buildings in the Northeast, saw total revenue increase 5% and earnings before interest, taxes, depreciation, and amortization increased 8.5%. But these results were aided by an increase in revenue-generating property assets and somewhat masked the weakness in the firm's same-store (internal) results. On a cash basis, same-store net operating income fell 5%. Lukasik thinks these results mainly reflect the recent loss of major tenants Lehman Brothers and General Motors, which together represented about 4% of revenue. Given the difficult leasing market in midtown Manhattan where these vacancies arose, he believes it will be difficult for Boston Properties to re-lease the space, causing a drag on internal results for some time.
Apartment owners, which have much shorter lease terms than office owners, had a tougher time in the quarter.
