Vornado Realty
VNO
The answer lies in the pretty substantial differences between the two main groups of investors in exchange-traded real estate investment trusts (REITs). REITs are companies whose main business has to be owning and managing income-producing real estate assets: they can do other things such as property development, but those other activities cannot account for a very large share of their activity. Each year they must distributed at least 90% of their taxable income to investors as dividends. If they meet those requirements, then they do not pay corporate income tax because, in effect, their investors pay it through their own personal income tax liabilities.
Vornado is a leading example of an equity REIT, which means that it owns income-producing properties (as opposed to mortgage REITs, which earn income from mortgages). In Vornado’s case the properties are largely office space in Manhattan, along with street-level retail, but there are dozens of other equity REITs that own many types of property (such as rental housing, warehouses, data centers, or hotels) in many other real estate markets.
Income-Focused Investors Are Upset
The distribution rules make REITs very, very dependable dividend payers. The current dividend yield across all exchange-traded equity REITs averages 4.36%, according to the FTSE Nareit Equity REITs Index, but over almost three decades since the beginning of 1994 it has averaged 5.15% and has never fallen below 2.72% (at month-end).
One main group of real estate investors, primarily attracted to the strong and steady income that properties generate, includes individual investors such as retirees who invest in real estate for essentially the same reasons they would invest in bonds: to get a consistent stream of income. When something disrupts that stream of income, dividend-focused investors want out: they will tend to sell their holdings and re-invest the money into another real estate holding whose distributions they believe are more dependable.
Total-Return-Focused Investors Are Reassured
But investing in real estate is not the same as investing in bonds: real estate is an equity asset—meaning the investor not only gets income but also participates in any appreciation that comes from owning the property. And, historically, the upside is substantial: for example, the same equity REITs index shows that the total return from equity REITs (that is, income plus appreciation) has averaged 9.23% per year since the beginning of 1994, and even higher (10.27% per year) for REITs specializing in apartment properties.
There is a different group of real estate investors who are primarily interested in those strong total returns. Total-return-focused investors tend to be institutional rather than individual—or, if individual, they tend to be investing at an earlier stage in their life-cycle when capital appreciation is just as important as (or more important than) current income. They expect to receive a similarly strong, steady stream of income as a result of having invested in real estate—but, if market conditions change, they are willing to give up some income dependability if it protects the long-term total return.
The crucial difference between those two groups of investors is this: if the company either cuts its dividend or suspends it (as Vornado did), that is unquestionably a bad thing as far as the income-focused investor is concerned. For the total-return-focused investor, though, it depends on whether the dividend cut is necessary to protect long-term total returns.
During the 2008-09 Great Financial Crisis, many REITs either reduced their dividends or suspended them altogether. After the crisis was over, I published an academic study entitled “REIT Dividend Policies and Dividend Announcement Effects During the 2008-2009 Liquidity Crisis” with two co-authors, William G. Hardin III and Zhonghua “George” Wu, who are now Dean and Professor, respectively, at Florida International University College of Business. We compiled data on whether individual REITs continued paying their previous dividends during the crisis, trimmed them, or suspended them, and on what happened to their stock prices after their dividend announcements.
What we found was striking. REITs that continued paying their dividends may have remained popular with income-focused investors, but they actually performed worse than REITs that cut or suspended their dividends. Specifically, after controlling for each REIT’s property-level net operating results (officially “funds from operations”), we found that stock price appreciation was better for REITs that reduced their dividends and worse for REITs that failed to do so.
Our interpretation of the empirical findings was that total-return-focused investors were seeking evidence that the officers leading each REIT appreciated just how severe the liquidity crisis was going to be. If the REIT ran out of cash, then it ran a much greater risk than merely failing to make a dividend payment to its stock investors: it ran the risk of defaulting on its higher-priority debt payments and maybe going into bankruptcy. In effect, total-return-focused investors were seeing a dividend cut as evidence that the REIT’s leaders understood how important it was to preserve the cash it might need later—to make payments on debts or other essential bills, to repay debt as it matured, or simply to get “back in the game” quickly when the crisis ended.
Manhattan Office is Real Estate’s Weak Cousin
It is important to recognize that the U.S. is not currently in any sort of liquidity crisis: in fact, the country’s banking system, and its macroeconomy, is reasonably strong even taking into account the recent problems at Silicon Valley Bank, Signature Bank, Credit Suisse, and now First Republic Bank
FRC
The historical record, though enables us to compare Vornado’s decision now with the decisions of many REITs during the 2008-09 liquidity crisis to form a better picture of what Vornado’s dividend suspension says about the current real estate market. In particular, the fact that Vornado’s stock price almost fully recovered means that total-return-focused investors thought the previous stock price was appropriate given the company’s long-term prospects. When the income-focused investors sold their positions, causing the initial 12% hit, the total-return-focused investors saw an opportunity to buy the company’s long-term total returns at a discount.
In other words, the dividend suspension didn’t tell the total-return-focused investors anything they didn’t already know. Yes, demand for office space in Manhattan is virtually nonexistent—in fact, on March 30 Commercial Observer, citing JLL
JLL
The Vornado announcement reminds us that there are definitely weaker and stronger segments of the current real estate market. With respect to regional differences, the weaker end of the spectrum encompasses high-cost cities with poor growth prospects—places like New York and San Francisco—whereas the stronger end of the spectrum encompasses lower-cost cities with strong growth prospects—places like Austin, Nashville, and Charlotte. The same holds with respect to property type differences: the weaker end of the spectrum encompasses sectors like office, retail, and hotel with relatively high costs (especially capital expenditure needs) in which many buildings are outdated and stuck in locations where growth has passed them. On the other hand, the stronger end of the spectrum encompasses sectors like data centers, apartments, and infrastructure (cell towers) in which new assets are designed to meet current needs and located in current growth corridors.
It’s not just Vornado, and it’s not just Manhattan: the total return on investments in the entire office REIT sector has lagged dramatically behind the more dynamic sectors such as apartment, industrial, data centers, and infrastructure ever since the COVID-19 pandemic upended living and working patterns. Over the three years from March 2020 through March 2023, total returns for apartment REITs have outpaced total returns for office REITs by 19.2% per year; for infrastructure REITs the outperformance has averaged 10.3% per year; and for data center REITs it’s been 12.6% per year.
In short, the Vornado dividend suspension says a lot about investments in laggard sectors such as office space, and a lot about investments in laggard cities such as New York. It says essentially nothing about investments in the dynamic rest of the real estate market.
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