New York office REITs provide a good bet for convertibles investors, Lehman Brothers says

By Evan Weinberger

New York, Aug. 23 - Real estate investment trusts focused on the New York office space sector are a good bet for convertibles investors, a new report by Lehman Brothers convertibles analysts released Thursday says.

"The New York office property market has demonstrated remarkable strength over the past few years," the report says.

According to the report, while many REITs have been hurt by the subprime mortgage mess, New York office space REITs offer some cushion to investors because of recent rapid rent growth, low vacancy rates in class A office space and historically low new development. Financial services, legal and accounting firms make up the bulk of office renters in Lower and Midtown Manhattan.

Implied volatility in seven convertibles issued by three REITs - SL Green Realty Corp., Boston Properties Inc. and Vornado Realty Trust - is at the low end, with the highest being 23.1%, according to the report. Realized volatility in the convertibles is at the high end and all seven have very high bond floors - the highest risk premium over the floor is 37.84% and the lowest is 2.89% - and high gammas, the analysts say.

The report cites an Aug. 23 Wall Street Journal report that says financial service firms take up 42% of class A office space in Lower Manhattan and 28% in Midtown. Vacancy rates for class A office space stand at 5.3% in Lower Manhattan and 5.6% in Midtown.

The reliance on financial services firms does provide the largest downside risk to convertibles issued by REITs with significant exposure to the New York office sector.

"Should the broader market weakness persist and negatively impact the financial services industry, this would likely translate to a weakening New York office property market driven by softer rents, higher vacancy rates, higher cap rates and lower NAVs on the back of a fading privatization bid for New York office property," the report issued by the Lehman Brothers convertibles analysis and research team says.

If markets recover, the analysts expect the underlying strength in Manhattan office space to continue. The weak dollar is also helping to increase demand for New York office space from abroad, and even if rents remain flat or decline slightly, "most Manhattan landlords should continue to experience positive roll on expiring rents," the analysts write.

Although they find all seven convertibles issued by the three REITs attractive, the analysts recommend the SL Green convertibles in particular.

SL Green currently has two outstanding convertibles: 3% exchangeable senior notes due March 30, 2027 and 4% senior unsecured convertible notes due June 15, 2025, which were acquired when SL Green merged with Reckson Associates Realty Corp. earlier this year.

The analysts point to the convertibles' low implied volatility - the 3% exchangeables have an implied volatility of 14.5% and the 4% convertibles have an implied volatility of 15.6%, the two lowest in the sample - and SL Green's concentrated exposure to office real estate in Manhattan as their reasons for recommending the firm's convertibles over the others.

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