Shelter from the storm

If the recession gets nasty, it’s well positioned to prevail.

If the recession gets nasty, it’s well positioned to prevail.

Steven Roth and Michael Fascitelli had spent the better part of last summer negotiating to buy the remaining two-thirds interest that they did not yet own in Charles E. Smith Commercial Realty, a leading Washington, D.C., office landlord. Then came September 11.

Many in the real estate community wondered if Roth and Fascitelli, respectively CEO and president of Vornado Realty Trust, would walk away. After all, even before the terrorist attacks, the Vornado team had known that the U.S. Patent and Trademark Office, tenant of nearly 2 million of the 12.9 million-square-foot Smith portfolio, would be moving out, starting at the end of 2004. But Roth and Fascitelli concluded that increased government spending on defense and homeland security would ultimately boost the demand for Washington office space. By October 19 they had come to terms with Smith; and in January they closed on a $1.6 billion deal, which gave them the Charles Smith space at an average price of $197 per square foot, about 20 percent below its replacement cost.

The move was vintage Vornado - bold and contrarian.

With a shrewd eye for value and a well-honed instinct to invest against the grain, Roth and Fascitelli have transformed Paramus, New Jersey-based Vornado in just five years from a prosaic strip shopping center owner into the biggest commercial office landlord in both Washington (12.9 million square feet) and New York City (14.2 million square feet). It’s also one of the most profitable. Vornado now ranks, by market capitalization, as the nation’s fourth-largest real estate investment trust. Analysts expect Vornado’s 2001 funds from operations (net income, depreciation and gains or losses on property sales), or FFO, a widely used measure of REIT profitability, to hit about $3.83 a share, on estimated revenues of nearly $1 billion. That’s up from $3.47 a share in 2000 and $1.45 a share in 1996. Of total assets of some $6.5 billion, about $5 billion has been assembled during the past five years. Among Vornado’s jewels: Chicago’s famed Merchandise Mart, which it bought in 1998 for $630 million. Over the past five years, through the end of January 2002, Vornado shares have returned an average annual 15.6 percent, versus 6.2 percent for the National Association of Real Estate Investment Trusts equity index and 9 percent for the Standard & Poor’s 500 index.

That, of course, is the past. Now Vornado, like landlords nationwide, faces much harsher conditions, with financial markets in a nearly two-year slump and the country in recession. Real estate occupancy rates in many markets (including Boston, Chicago, San Diego, San Francisco and downtown New York) have begun to soften and, in some cases, to sink. According to Reis, a New York-based real estate market research firm, office vacancies nationwide reached 13.6 percent at the end of last year, up from 7.9 percent in 2000. Uneasy investors are reminded of the wretched property markets of the early 1990s that followed the stock market plunge of 1987. New York City’s mounting fiscal woes (the city faces a projected deficit of $4.7 billion) only make matters more precarious.

But despite the REIT’s big exposure, a number of analysts, including Lehman Brothers’ David Shulman and Green Street Advisors’ John Lutzius, think that Vornado may be much better positioned than many of its rivals to ride out the downturn. For starters, Vornado’s portfolios are concentrated principally in two relatively strong East Coast cities, New York and Washington, which have held up better than other office markets. And true to its thrifty ways, Vornado acquired virtually all of its portfolio in the midtown New York and Washington markets at rates well below replacement costs; in Manhattan it assembled its assets at 50 percent below replacement value. Moreover, its properties boast above-market occupancy rates - 97 percent in both cities, versus an average of 91 percent in New York and 94 percent in Washington. Vornado owns only one small building in New York’s devastated downtown, and while prime midtown rents are expected to fall anywhere from 5 percent to 15 percent from their current level of $55 to $58 per square foot, they’ll likely remain very comfortably above Vornado’s $33 per-square-foot average.

“Vornado is our top pick for 2002,” says Lehman’s Shulman, citing Vornado’s Charles Smith acquisition and the company’s ability to raise rents in a soft New York market.

“The management team is among the strongest real estate managements in the country, public or private,” says Joseph Harvey, director of investment research at Cohen & Steers Capital Management, which owns 9.05 percent of Vornado’s common shares. Harvey expects management savvy will help insulate Vornado from the worst of the fallout, if the economic downturn intensifies.

Until the autumn of 1996, Vornado was a one-man show. Then the hands-on Roth, who took control of Vornado in 1980, decided to hire a strong No. 2 in Fascitelli, a Goldman, Sachs & Co. investment banker. Known for his brimming Rolodex and disarming negotiating style, Fascitelli, 45, quickly forged a successful and aggressive alliance with Roth, an imperious, old-school deal maker of 60. Fascitelli acts as “facilitator,” says Roth. “Attracting Mike to be my partner was my No. 1 coup,” says the CEO, who sets strategy and signs off on all important decisions.

Certainly, during Fascitelli’s tenure Vornado has become much more audacious and daring, taking on considerably more debt as it hunts for major buildings like Chicago’s Merchandise Mart, which it won, and New York’s ill-fated World Trade Center, which it lost to Silverstein Properties. Following a $380 million stock sale last November, Vornado’s leverage ratio (which includes debt and perpetual preferred stock obligations) stood at 51 percent of capital. That’s just below the industry average but still well above the much more conservative 30 percent level that prevailed at Vornado back in 1996.

Roth and Fascitelli’s discipline as negotiators underlies their business success. They don’t let ego drive their deals, and for the most part, they don’t overpay. “I never cry over spilled milk,” Roth says. “Nobody ever went broke from the deals they didn’t do.”

And there’s a pile of deals that Vornado, aggressive as it has become, hasn’t done. In December 2000, for example, Roth and Fascitelli bid for New York’s famed Rockefeller Center. But they refused to push beyond their $1.75 billion bid and ultimately lost out to Jerry Speyer and Chicago’s Crown family, who paid $100 million more to claim one of the country’s great trophy assets.

Then there was Vornado’s thwarted bid for the World Trade Center. Back in March 2001, Vornado executives were finalists negotiating with the Port Authority of New York & New Jersey to acquire the Twin Towers. The Port Authority wanted Vornado to sign a 99-year lease for its asking price, $3.2 billion, and imposed a tight 20-day deadline to close the deal. Roth, worried about a softening downtown real estate market, challenged the Authority’s valuation and asked for a number of concessions. The Port Authority refused and at the end of 20 days turned to its backup bidder, New York developer Larry Silverstein. He agreed to the Authority’s terms for a $3.2 billion, 99-year lease and closed the deal less than two months before September 11.

On May 1, after more than two years of wrangling, Vornado signed a 25-year lease agreement with Bloomberg, which is taking 700,000 square feet of office space in a prime Manhattan location - Lexington Avenue and 59th Street, the site of the former Alexander’s department store. Vornado’s $650 million development is projected to include 1.4 million square feet of office, condominium and retail space. “It should be done in two and a half years and be a great success,” says Roth.

But since September 11 prices for luxury Manhattan condos have fallen about 10 percent, and some believe that Roth and Fascitelli may have been better served by closing the deal sooner than they did. “While Roth held out on entering into a lease deal with Bloomberg, the whole condo market in New York radically changed. Who wants to be on the 70th floor after September 11?” says Lehman’s Shulman. Counters Roth, a bit testily, “The building isn’t 70 stories high, and there’s still a great demand for luxury apartments with dramatic skyline views.”

Roth and Fascitelli entered into one big deal that has proved extremely problematic, though - Vornado’s 1997 acquisition of two cold-storage companies. Straying from their traditional territory of office buildings and strip malls, the REIT took a 60 percent stake in the $1.4 billion acquisition (Fort Worth, Texas-based Crescent Real Estate Equities holds the remaining 40 percent interest). Vornado had hoped to expand the companies’ dominant market share. Instead, the business soured; Vornado’s $840 million investment is probably worth about 20 percent less today.

Roth and Fascitelli readily share the blame for that bad investment, as they share most major decisions about the company. Recently, though, they may have been less than close on one issue: the terms of Fascitelli’s new employment contract. When he joined Vornado, Fascitelli signed a stunning five-year contract with cash and stock options then worth $25 million. Today, when stock options subsequently granted to Fascitelli are taken into account, his vested options and stock are potentially worth $80 million. The old contract expired at the end of last year, and details of the new one must be disclosed by about the end of April, when the annual proxy is mailed to investors. Some analysts speculate about why the company hadn’t announced that a new contract had been signed and wonder if it might signal some tension between the partners.

“We haven’t heard what Vornado is doing about Fascitelli’s contract,” says Steve Sakwa, head of REIT research at Merrill Lynch & Co. “Fascitelli got paid big once. Should he get a very big package again? I don’t think investors will be happy if he gets another very large grant.”

Roth, for his part, bristles at any suggestion of a problem. “There is no tension whatsoever between me and Fascitelli,” Roth says. “There will be a new financial arrangement with respect to Michael that will be announced shortly.”

His response is not surprising for a man who can be a little thin-skinned when provoked. At an industry panel in March 2001, Lehman’s Shulman asked Roth if recent high-profile office property transactions might indicate a peak in property values. Roth snapped, “If you’re saying that I’m buying at the top, you’re calling me stupid.” He then turned to another panelist, Mortimer Zuckerman, chairman of Boston Properties, and asked, “Am I stupid, Mort?”

“No, Steve,” Zuckerman replied, “you’re not stupid.”

The Bronx-born son of a children’s clothing manufacturer, Steven Roth graduated from Dartmouth College in 1962 and from the school’s business school a year later. He made an early move into real estate two years later, when he convinced David Mandelbaum, a wealthy New Jersey real estate investor, to invest $250,000 in a new partnership called Interstate Properties. Roth and another partner, Russell Wight Jr., contributed additional capital, and the partnership soon began buying shopping centers. In 1980, operating through Interstate, Roth waged a stormy proxy fight to engineer the takeover of Vornado, then a public company that owned and operated Two Guys Stores, a New Jersey discount department store chain. Two Guys had acquired the corporate shell of a onetime fan maker - Vornado - as a tax shelter, using its tax loss carryforwards and retaining its name. (Today another company manufactures Vornado fans.)

Two Guys struggled as a retailer, but Roth used the company’s valuable real estate to develop shopping center sites in lucrative, high-traffic Northeast suburban markets. He closed the stores and began operating strip shopping centers. By 1993 Roth had amassed more than 50, plus a few regional malls.

Vornado’s earnings soared from $4.3 million in 1981 to over $26 million at the end of 1992, at which point Vornado ran out of tax loss carryforwards. As a result, in 1993 Vornado converted to REIT status.

Today Vornado sports an equity market capitalization of $5.4 billion, compared with roughly $725 million in 1993. Over the decades Interstate Properties’ investment has grown to 12.4 million shares, worth some $525 million. Separate from his share of the Interstate Properties stake, Roth owns stock and vested options worth nearly $80 million.

By 1996 Roth had begun to think about diversifying away from the strip shopping center business. The Big Apple caught his eye. He felt certain that New York real estate values and rents, which had only just started to emerge from early 1990s’ recession, were about to take off. In the fall of 1996, he approached developer Bernard Mendik to buy his multimillion-square-foot portfolio of midtown office buildings. Mendik turned him away; the longtime real estate investor was ready to cash out, but he thought he’d try an IPO.

With Fascitelli as president, Vornado’s acquisition pace exploded. By April 1997 Mendik had lost some major tenants in one of the largest of his seven buildings - Two Penn Plaza, which became 35 percent vacant. He knew that would likely reduce the value of his planned IPO. At this juncture the former Goldman banker persuaded Mendik to sell Vornado all seven buildings, which together held some 4 million square feet of space. The price: $655 million, including $260 million in cash and the assumption of $215 million in debt. Mendik also received $177 million from the sale in the form of operating partnership units, which enabled him to defer capital gains taxes. (Mendik died last year at the age of 72.)

Vornado’s first major foray outside New York was another Fascitelli creation. Thanks to connections from his Goldman days, he learned that the owners of Washington’s Charles Smith Realty were looking for a capital infusion to help expand their office portfolio. Over an 18-month period ending in February 1999, Vornado invested nearly a half billion dollars for a one-third ownership.

And in early 1998 Fascitelli convinced Roth to acquire Chicago-based Merchandise Mart for $630 million. Vornado paid $187 million in cash, assumed $322 million of debt and issued $116 million in operating partnership units to Merchandise Mart’s owners, members of the Kennedy clan. (The family patriarch, Joseph Kennedy, former president John F. Kennedy’s father, had bought the business from Marshall Field during the Great Depression.)

Since Vornado took control, Merchandise Mart, which provides office, retail and showroom space for trade shows, has delivered four consecutive years of earnings before interest, taxes, depreciation and amortization growth. Aided by subsequent acquisitions, ebitda grew from $39.4 million in 1998 to an estimated $107 million in 2001, a 16 percent gain over 2000.

Many REITs get lost when they stray too far from home, and Vornado made this mistake in October 1997. Roth and Fascitelli formed a 60-40 partnership with Richard Rainwater’s Crescent Real Estate Equities to acquire two public refrigerated-warehouse companies (since combined and now called AmeriCold Logistics), for $1.4 billion, including $828 million in debt.

The purchases gave the new owners a formidable 30 percent share of the U.S. refrigerated-warehouse capacity in a market where other cold-storage owners had no more than a 5 percent share. Roth and Fascitelli thought that would provide them with operating efficiencies and stable cash flows. Enthusiastic investors bid Vornado’s stock up by well over 20 percent the day the deal was announced.

What went wrong? Cold-storage companies make their money storing frozen foods like poultry. But in the late 1990s, an unexpected decline in the consumption of chicken meant that a big AmeriCold customer, Tyson Foods, had dramatically less need for outsourced warehouse space. That meant significantly less revenue for AmeriCold.

Labor and energy costs rose unexpectedly. And because the REITs had acquired an operating business, they had to set up an operating company in which, as landlords, they would charge AmeriCold an annual rent of $160 million. With AmeriCold doing less business than anticipated, Vornado reduced the required rent to $146 million a year. “The cash flows weren’t as stable and reliable as we had thought,” says Roth. “This deal is nothing that either one of us is proud of,” says Crescent CEO John Goff, though he still believes that “it’s not a bad business.”

Clearly, it’s Roth’s greatest blunder. Both Green Street’s Lutzius and Lehman’s Shulman expect Vornado to divest all or some of the cold-storage business within the next two years.

At the same time, a loan made in September 2000 has turned into another headache. Vornado made a $62 million loan to Primestone Investment Partners, a private partnership controlled by Chicago real estate investor Michael Reschke, which owns 7.9 million shares, or 33.6 percent, of Prime Group Realty Trust, a Chicago-based office REIT. Because of a liquidity crisis, Reschke had to pledge his 7.9 million shares as collateral for the loan. Including fees, Roth extracted an interest rate from Reschke of almost 20 percent. That would have been a terrific yield, but Reschke couldn’t pay the interest on the loan due last October. In late December Vornado moved to foreclose on the 7.9 million shares; Reschke then obtained several temporary stays. Vornado, which has since reduced its exposure from $62 million to $50 million, expects to prevail and acquire the shares.

And in a small but high-profile foray into the restaurant business, in 1999 Roth invested $7.4 million with the late Warner Leroy in a joint venture in the Russian Tea Room. After Leroy died, Vornado wrote off its investment in the famous 57th Street restaurant as a complete loss, in the third quarter of 2001.

But for the most part, Vornado has been hitting home runs. Newkirk Joint Ventures, a joint project with New York-based Apollo Real Estate Advisors, shows Roth and Fascitelli at the top of their game, buying undervalued assets. Through Newkirk, Vornado has invested $186 million in equity and debt interests in some 120 limited partnerships that own office and retail properties. Newkirk first did credit analyses to determine if the partnerships’ tenants seemed good credit risks; when they did, Newkirk bought stakes in the partnerships at substantial discounts to their net asset values. Last year the venture generated estimated ebitda of $58 million for Vornado, earning a solid 15 percent return.

For the past five years, Roth and Fascitelli have worked together to produce impressive returns for Vornado shareholders. That won’t be easy this year, in the face of a nationwide recession and New York City’s worst fiscal crisis since the mid-1970s. But Vornado’s solid assets and above-average occupancy rates should protect the company from the worst of the economic fallout. If you don’t overpay when times are good, you can sleep well when times get tough.