Credit analyst: Vornado risks should be priced into new issue

By Ronda Fears

Nashville, Tenn., June 18 - Vornado Realty Trust's pending debt issue is needed but there are funding risks that should be priced into the deal, said Kathy Shanley, senior bond analyst with Gimme Credit.

Historically funded primarily with mortgage debt, Vornado is now in the market with a five-year straight debt offering. The REIT has a $1.1 billion 6.5% perpetual convertible preferred outstanding, which is trading at 62.5.

"Despite the vicissitudes of the past year, Vornado Realty Trust (Baa2/BBB), which runs a diversified portfolio of mostly office and retail properties, has been a solid performer in the equity markets, Shanley said in a report Tuesday.

"Despite the resilience in earnings, we would not rush into buying Vornado debt. A corporate debt issue would mitigate this funding risk, but any new issue should be priced to reflect the risks of Vornado's aggressive expansion strategy."

Although occupancy levels remain strong in its core markets, possible buyers need to consider potential risks, such as the limited availability of terrorism insurance coverage.

In January, Vornado completed the acquisition of the 66% of Charles E. Smith Commercial Realty LP it did not already own. The price was $1.6 billion, including $607 million in newly issued partnership units and $992 million in assumed debt.

Charles E. Smith owns and/or manages about 18 million square feet of office space in the Washington D.C. and Northern Virginia market. The purchase diversifies Vornado, a major New York City developer whose office portfolio had been concentrated in Manhattan.

Early last year, Vornado appeared to be the frontrunner to buy the World Trade Center, but after it failed to come to agreement with the Port Authority, the property went to runner-up Silverstein properties.

Although fate relieved it of the burden of responsibility for the World Trade Center, Vornado still owned 22 properties containing 14.3 million square feet in the New York City area, primarily in Manhattan, at the end of last year, as well as some high-profile investments in other markets, including Chicago's Merchandise Mart.

In contrast with other REITs that invested heavily in technocentric markets like San Francisco, occupancy levels in the Vornado portfolio have remained strong.

At March 31, the New York office portfolio reported a 97% occupancy rate while the newly acquired Charles E. Smith portfolio was behind only slightly at 94%.

An exception to the generally strong trend was Vornado's Hotel Pennsylvania property, which recorded an abysmal 50% occupancy level in the first quarter.

Reflecting the solid operating trends and recent acquisition activity, earnings excluding an accounting change rose 30% in the first quarter to $112 million.

Strength in earnings aside, Shanley said investors considering the new Vornado debt should consider terrorism insurance.

GMAC Commercial Mortgage Corp. recently raised the visibility of this issue when it informed borrowers they were at risk of being declared in default if they could not obtain terrorism coverage.

Vornado raised the issue of mortgage covenants in its 10-K filing and, while it has since been able to obtain $200 million in coverage for terrorist acts for its New York City office portfolio, it also concedes its theoretical exposure in excess of this amount could be "material."

Aside from insurance, there are other specific concerns related to Vornado.

Although the company's management is well regarded within the real estate industry, the Charles E. Smith acquisition is big enough to present meaningful integration risks.

Reportedly, the company is also toying with the idea of additional investments, including a possible bid for the 67% of Alexander's Inc. it does not already own.

On the positive side of the ledger, Vornado issued over $400 million in common stock in recent months, but it continues to rely heavily on secured and floating rate debt.

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