01/05/22 07:30 AM EST

ESRT <--> PGRE: A WIN-WIN ALL AROUND? | 1.5.22 | (ESRT, PGRE)

Rob Simone, CFA

Takeaway: Exploring one potential take-out option on PGRE

Tickers: ESRT, PGRE

Subsector: CBD Office

Headline: Time to have the talk about pairing these two up?

Following our addition of Paramount Group (PGRE) as a Best Idea Long on 1/3/22, the most frequent question we received was "assuming an activist could gain Board representation, who would the likely buyer be in a take-out?" We believe a straight take-private transaction could be the most likely outcome, whether by an activist firm with a direct real estate arm, a REPE shop or the Otto family themselves. However, given the math we also believe it is worth considering a scenario where peer Empire State Realty Trust (ESRT) with its dry powder and likely access to capital pulls the trigger and acquires PGRE in an all-cash or cash/stock transaction. A few considerations:

ESRT has been clear for years, going back to its ~$620 million equity raise with QIA in 2016, that it intends to do something "big and transformative." It is no secret and Tony Malkin has been vocal, yet patient to his credit, on the need to increase the size and diversity of the platform.
Just taking the current FactSet consensus NAV/share estimates for PGRE/ESRT of $16.20/$14, respectively, the companies currently trade at 43 %/32% discounts to private market value (PMV), respectively, and both require catalysts to at least partially narrow those gaps. PGRE's discount to PMV is one of the largest among all publicly-traded REITs in the U.S. and the driving force behind the aforementioned shareholder frustration. So while both companies have inferior costs of capital on an absolute stand-alone basis, on a relative basis ESRT maintains a more favorable cost of capital arbitrage vs. PGRE.
ESRT is clearly eager to grow beyond a one-asset (the Empire State Building) company, and recently acquired two apartment assets for ~$307 million, or $500k/unit, which was surprising to some and somewhat "off-brand." We actually think there are advantages to pairing office and residential vis-a-vis DEI and JBGS, for what its worth. Office had been a challenging business to the say the least (we can think of more colorful language) heading into the pandemic, and in many ways we would argue is structurally impaired relative to its prior life. That is a conversation for another day, but clearly an indicator of ESRT's intent to grow.
ESRT had been more conservatively and arguably under-levered prior to the pandemic, which turned out to be prescient as office has seen its challenges and the ESB Observatory essentially went from over ~$100 million of annual NOI to zero. At ~5.6x trough Adj. net debt + pfd. / EBITDA and ~45% debt + preferred / total market cap, the company has around ~$500 million of pro forma cash on the balance sheet, perhaps ~$1-1.5 billion of additional debt capacity assuming Observatory recovery + a more "market" LTV on the office assets, and perhaps another ~$500 million of potential proceeds assuming a sale of a ~50% JV interest in the Observatory similar to KKR's purchase of the Edge. This totals ~$2-2.5 billion of "dry powder" before raising any straight third-party equity. Furthermore, QIA is a long-term holder in ESRT and could be willing to commit additional equity capital in a transformative deal. After all, that was the intention back in 2016.
Layer on top ESRT's ability to issue stock/OP units, which could be attractive to PGRE's Otto family looking to rollover their basis, avoid a taxable event and preserve income via the go-forward dividend payment. The deal could also likely be structured in a way for the Otto group to maintain control of the fund management platform if that is a sticking point. The Ottos win. The Ottos as a group maintain a ~25% economic stake when taking into account total common shares + OP units outstanding.
PGRE shareholders would clearly benefit from the premium paid in the deal, which assuming $12/share would be +30% from current levels. There is a high degree of shareholder fatigue and wide agreement that PGRE needs to exit its current inefficient structure as a public company. Under a cash/stock deal holders would have the option to remain invested under "New" ESRT with additional scale, a smaller G&A "tax" relative to the asset base, a better balance sheet (vs. the current irresponsible ~9x leverage) and better-aligned incentives versus the current conflicted structure, or alternatively to cash out. PGRE shareholders win.
ESRT holders win from a larger NYC-focused company with increased scale and diversification benefits away from the ESB which we estimate to be ~65% of the company's value. We say "focused" as the combination would obviously introduce exposure to SF - ESRT could either choose to maintain market diversification or potentially opt to sell those assets off "retail" to support funding for the combination. A deal would likely be accretive on both a value and Core FFO earnings basis given the relative cost of capital advantage, ability to eliminate PGRE's G&A layer and ability to finance in-part with lower-cost new debt. We think any effort to acquire PGRE would be received positively by an ESRT shareholder base that has been waiting for years for capital to be put to work in a significant and transformative way.
In the end there would be one less inefficient, orphaned NYC CBD Office REIT outstanding.
Everyone wins, potentially.

The most obvious impediment to this scenario is probably "social" differences between the two companies, as it is no secret that historically NYC office is very ego-driven and the management teams candidly can't stand each other / constantly bicker about each other behind closed doors at conferences and elsewhere. Additionally there is an open question on ESRT's receptivity to acquiring partial ownership interests in so many assets as historically they have preferred 100% ownership. Finally, it would probably be a very divisive debate among shareholders, as in our experience there are many competing views on the best path forward for CBD office. The probability of this scenario is probably less than a straight take-private, but we believe deserves consideration following CXP, NYC and the potential economics/math of a transaction. Lets have the discussion that the sell-side has historically been reticent to start publicly. Just a thought...

Prior Notes:

1.4.21 - REITS DAILY BRIEF | 1.4.22 | (PGRE)

1.3.21 - REITS DAILY BRIEF | 1.3.22 | (POSITION MONITOR UPDATE, PGRE)

12.29.21 - REITS DAILY BRIEF | 12.29.21 | (Position Monitor, TCN, DLR, EQIX, ELS, SUI)

12.23.21 - REITS DAILY BRIEF | 12.23.21 | (AVB, CPT, EQR, MAA)

12.21.21 - REITS DAILY BRIEF | 12.21.21 | (BRG, U.S. OFFICE UTILIZATION)

12.19.21 - SUNDAY NIGHT REIT READ | 12.19.21 | (PSA)

12.17.21 - REITS DAILY BRIEF | 12.17.21 | (Storage, Manhattan Office)

12.16.21 - REITS DAILY BRIEF | 12.16.21 | (FR)

12.15.21 - EVENT REPLAY | FIRESIDE CHAT W/ WEWORK CEO SANDEEP MATHRANI

12.14.21 - REITS DAILY BRIEF | 12.14.21 | (U.S. OFFICE UTILIZATION)

12.12.21 - SUNDAY NIGHT REIT READ | 12.12.21 | (WE)