With SL Green Realty, Focus Is Clearly Not An Issue

By Stephen D. Simpson, CFA | June 28, 2012 AAA

Analysts and investors prize diversity, and that often serves a company well as it reduces the overall risk profile of the company. On the other hand, sometimes the opposite is true - sometimes running an intensely focused and specialized operation can provide above-average returns by virtue of truly understanding that market and its risks. Investors considering SL Green Realty (NYSE:SLG) pretty much have to subscribe to that second point of view to find an attractive investment idea here.

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New York Is the Center of the World (For SL Green, at Least)
SL Green is quite focused on what it does; the company owns and operates office properties in the New York City area, with a keen focus on Manhattan and Midtown Manhattan at that. In fact, 90% of the company's revenue comes from New York City, with about three-quarters of the 31.4 million square footage located there as well. That makes SL Green dramatically more concentrated than other property managers like Vornado (NYSE:VNO) or Boston Properties (NYSE:BXP).

With such a sharp focus on the New York office market, it's likely not going to surprise investors that the health of the financial services and media industries are of central importance to the company. Financial services companies make up nearly 40% of the customer base, with Citigroup (NYSE:C) and Viacom (Nasdaq:VIA) standing out as notable clients.

This focus is certainly a good news/bad news situation. SL Green clearly knows the market well (and equally clearly has no excuse not to ... ), and does not have to worry about spreading management's focus too thin. Likewise, for all of the ups and downs of the financial markets, the large players don't change all that much and companies are loathe to leave Manhattan as there are issues of prestige, ego and image to consider (both for clients and employees). That has proven beneficial for rents and occupancy for SL Green over the years.

SEE: The Exploration and Development Of Financial Markets

Creativity can Cut Both Ways
SL Green has been willing to act a little unconventionally to expand its money-making opportunities. Not only has SL Green participated in some mezzanine debt and preferred equity investments, but it has also been willing to engage in joint ventures (JV) and structured financings to acquire new buildings. Relatively recently, for instance, the company used JVs with Jeff Sutton and the Canadian Pension Plan Investment Board to acquire properties in deals valued as high as $400 million and $250 million, respectively.

This creativity comes with a price, though. These transactions make it somewhat more difficult to evaluate the company's liquidity position, and these transactions are often much easier to get into than get out of (should business suddenly turn down).

Improving Results in a Mediocre Market
These aren't great times for the Manhattan office market. Nevertheless, SL Green is doing a little better than alright. Reported revenue and EBTIDA rose about 18% each in the last quarter, with cash "same store" operating income up better than 4%. What's more, while the suburban business continues to struggle a bit (occupancy up 10 basis points to 86.4% on a negative releasing spread of 4.6%), the Manhattan business is doing pretty well (occupancy up 30 basis points to 93.4%; releasing spreads of over 31%).

SEE: A Clear Look At EBITDA

The Bottom Line
Given the dependence of SL Green on the New York City property market, investors cannot afford to not consider the possibilities of another extended downturn in the financial markets or some sort of external event that makes operating in New York City unattractive to businesses like Citigroup and Morgan Stanley (NYSE:MS). Fortunately, the odds of that happening are relatively low.

The ever-present problem with valuing real estate companies like SL Green is that estimated net asset values can change so dramatically with just small changes in the assumed cap rate. Supporting a positive viewpoint, though, is a long history of above-average returns on equity, better-than-average performance in terms of occupancy and rents and above average book value-per-share growth.

SL Green looks about 15% undervalued today, and that might be good enough if SL Green had a more industry-normal dividend yield. This company offers a relatively modest dividend yield, though, and the total return potential today isn't quite high enough to make this a must-consider name right now.

At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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