Highwoods Properties, Inc.

Moat: 2/5

Understandability: 2/5

Balance Sheet Health: 4/5

Highwoods Properties, Inc. (HIW) is a self-administered real estate investment trust (REIT) that develops, owns, and manages high-quality office properties primarily in the Best Business Districts (BBDs) of the Sun Belt in the United States.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview: Highwoods Properties operates as a REIT that owns, manages, develops, and acquires office properties in the Sun Belt region of the United States. The company primarily targets high-growth markets characterized by strong economies, job growth, and attractive demographics. Their strategy revolves around acquiring, developing, and managing properties in these BBDs.

The company’s operations are concentrated in core submarkets, like Raleigh, Charlotte, Nashville, Richmond, Tampa, Orlando and Atlanta which, they believe, offer both downside protection and upside potential as these markets are experiencing positive demographic shifts.

  • Revenue Distribution: HIW’s revenue comes primarily from rental income derived from its high-quality office properties. The main source of this income is rent charged for the office space, with a slight component from other sources such as land leases, parking fees, and reimbursement for operating expenses. Revenue is influenced by factors such as lease rates, tenant occupancy, lease renewals, and the overall demand for office space.
    • Tenant concentration is a relatively low risk as their largest tenant only accounts for 3.5% of revenues and top 10 tenants accounts for only around 20%.
  • Trends in the Industry: The office property market is influenced by several macroeconomic factors, such as interest rates, economic conditions, and employment trends. The increase in remote work has created a negative impact on demand for office space. The rise in interest rates has also increased the cost of borrowing for real estate companies which, in turn, has slowed down acquisitions and development.

Despite this, new trends have emerged. Companies want to lure employees back to office by focusing on better quality, greener and modern office spaces, preferably in CBDs. Also, due to hybrid work environments, many companies are interested in smaller office footprints but at similar price point. - With work from home and hybrid schedules being the norm, companies are rethinking their real estate needs, and are choosing better located properties with more amenities. As such older class B properties are facing massive headwinds.

  • Margins: HIW’s gross profit margin (total revenue minus expenses) has been consistently high, staying in the 70% range. But as you go further in the financials, operating margins and net income are variable. A good chunk of their operating profits goes in servicing debt, depreciation and property taxes which are unavoidable in real estate business.

  • Competitive Landscape: The commercial real estate market is highly competitive, with numerous other REITs, as well as private developers and institutional investors, vying for attractive assets and tenants. A lot of real estate companies are also focusing on developing “experiential” environments in hopes of getting their employees back to the office. This also includes competition to acquire assets, in a market that is already overheated.
    • What separates HIW from others is that they are laser-focused on certain “sunbelt” sub-markets of states like Texas, Florida, North and South Carolina, Georgia and Tennessee. They believe that there is a structural advantage in concentrating their assets in markets with high population growth and high business development. They also aim to develop high-quality buildings and focus on providing value-added services to their customers.
  • What makes the company different: As discussed above, the core focus of Highwoods Properties is operating in sunbelt submarkets in the US, which are experiencing a surge in business growth and employment. This allows HIW to create and maintain value in the long run. They also concentrate on high-quality class A properties in premium locations with the aim to have high-quality tenants and long-term leases. Moreover, they are conservative and disciplined with their acquisitions and growth strategy.
    • HIW also develops projects in house which allows them more control over costs and timelines. They also offer a full range of services for tenants, including design, construction, and property management.
  • Other relevant aspects: Management has been focused on improving occupancy rate and occupancy growth. Also, they have been focusing on sustainability initiatives to make the company more attractive to tenants with strong ESG policies. Their current portfolio consists of 153 properties, which are 96.8% occupied.

Financial Analysis:

  • Revenue: HIW saw a slight decline of 1.5% YoY in total revenues. Their YTD revenues for the year 2023 is $601 million, compared to $609 million in the year 2022.
  • Net Operating Income (NOI): Their same-store cash NOI growth is at 2.2% in a tough operating market. Their net operating income also declined by 2% to $422 million, compared to $430 million last year. This decrease is mainly attributed to increase in operating expenses and debt servicing.
  • Cash Flow: HIW generated FFO of $2.86 per share in 2023 compared to $3.28 in 2022, an decrease of 12.8% YOY. This is an important metric to assess the profitability of REITs as it takes in account the depreciation expense.
    • The company is heavily focused on maintaining their cash flows. Their cash flow from operations is $122 million in Q3, compared to $118 million last year. This shows that despite falling NOI, management has been successful in maintaining liquidity and free cash flows.
  • Debt and Leverage: HIW has a healthy balance sheet with manageable debt levels. Their Debt to Total Capitalization ratio stands at 34.7% which suggests that the company is not over-leveraged. This also means that the company has more wiggle room to take on debt for new investments and development.
  • Debt Maturity: Most of the debt is of longer maturity that has been locked at very low interest rates. The average weighted interest rate on their debt is at 4.07% and the debt maturity is at 5.4 years. This allows the company to enjoy the benefits of low debt servicing costs for many more years.

However, the company’s ability to roll-over debts at low interest rate is dependent on interest rate and yield curves, which are not in control of the company. With interest rates rising, any new debts will cost them significantly more and will negatively impact margins and net income.

Moat Assessment:

Rating: 2/5

  • Limited Moat: HIW’s moat is derived from some aspects of unique positioning in BBD locations and long-term leases. These allow them an advantage over smaller real estate firms who dont own the scale and size of HIW. But these advantages are not particularly very strong because they can still be overcome.
    • They have a strong expertise in selecting properties that have high demand with stable cash flows. But even when this is the case, their returns are dependent on location and the value they bring in for their tenants. Which could easily fluctuate.
    • Their focus on quality also means that they would only be concentrating on “premium” class A assets in “major” markets which exposes them to increased risks in case of any downfall in the market.

  • Intangible Assets: Brand value exists to an extent, as some companies tend to prefer high-end properties, like those offered by HIW. This acts as a very small positive factor and protects them from competition. However, they are not particularly differentiated from competitors in other markets with similar properties.

  • Switching Costs: Switching costs for tenants is negligible. Because if they get a better rate or better location in another building, then it is extremely easy to switch for them. This is the biggest weakness for a REIT company and poses a threat to its growth and profitability.

  • Cost Advantages: HIW does have cost advantages over smaller peers due to its scale and experience. Having a scale in multiple submarkets gives them an edge over new entrants or small companies.
    • Also, having an experienced in-house management team and development arm gives them good expertise over the years, which they are able to use to reduce operational costs and improve profits.
  • Network Effect: The network effect is not applicable in HIW’s business model. They do not have any strong lock-in effects which helps the business to have a strong moat.

Risks to the Moat:

  1. Economic Downturn: A recession could reduce the overall demand for office space, leading to lower occupancy rates, and lower rents. This would have a major impact on their profitability and value.
  2. Rising Interest Rates: An increase in interest rates could increase the cost of debt. This would increase operating expenses and also decrease any profitability margins as financing becomes very expensive.
  3. Oversupply of Office Space: Oversupply in any particular market could lead to a decrease in rents and an increase in vacancies. It also weakens their bargaining position with tenants. Moreover, having a strong “class A” portfolio may be a problem as lower end properties in a market are less susceptible to oversupply.
  4. Competition from other REITs and Private Investors: Highwoods Properties faces stiff competition from other real estate companies. Also, private investors and institutional investors, such as private equity funds, may try to capture the market for themselves which would severely impact HIW’s profitability and growth.
  5. Technological Disruption: The increased preference for remote and hybrid work models has negatively impacted office property demand.

Business Resilience:

  • HIW has a geographically diverse portfolio, which helps in reducing the impact of regional economic downturns and reduces the overall business volatility.
  • They have a strong credit rating and diversified debt structure which gives them more leeway and flexibility. - The long-term leases that HIW signs with tenants gives some stability and predictability to their cash flows. - Their high quality properties with state-of-the-art facilities, give them good prospects of attracting and retaining quality tenants. Also, they have a proven track record of developing properties and maximizing shareholder returns over the years. - Due to their strong balance sheets, low debt ratios and healthy cash flows, the company’s operations are very much sustainable and will provide some cushion during a crisis.

Understandability:

Rating: 2/5

*The core business model of the company is easy to grasp, but the nuances of the real estate market, accounting procedures, and financial jargon make it a bit complex for anyone who does not have prior experience to understand fully. For someone with basic finance and accounting knowledge, the company's working and operations will seem relatively easy.*

Balance Sheet Health:

Rating: 4/5

  • Strong Financial Position: HIW’s balance sheet is generally healthy with a manageable debt profile. Their low leverage ratios, diversified capital sources and long-term bonds show strong solvency of the company. However, like with every REIT, a rise in interest rates may pose some threat to their solvency.
    • Their current debt maturities are spaced out through the next couple of years which reduces their vulnerability to interest rate risks.
  • Ample Liquidity: As of December 31, 2023 the company has $52.8 million in cash and cash equivalents. Along with that the company has an existing credit facility of $1.06 billion and a commercial paper program for $750 million. The ample liquidity ensures they have sufficient capital for financing their operations, developments and acquisitions.
  • Debt Profile: Their debt to equity ratio is at 0.81 compared to a benchmark of 1, which indicates that they have a healthy mix of debt and equity. Their debt servicing is also not an issue as their interest coverage ratio stands at 3.8. But as mentioned above, there will be significant impact on the debt structure and expenses if interest rates continue to rise.
  • Credit Rating: HIW has a good credit rating of BBB-/Baa3 which increases their access to borrowing capital at attractive rates and gives them stability in their business operations.

Recent Concerns, Controversies, and Management Commentary:

  • Decline in Property Values: HIW like many other real estate investment firms, has been impacted by the rising interest rates which has decreased property valuations. As property values decline, the net book values of their assets, and in turn, their equity might fall.
  • Slowed demand for office space: As stated earlier, due to rising trends in remote work, demand for office spaces, in general, has reduced dramatically over the last few years. This will continue to put a negative pressure on their occupancy rates and revenues.

  • Increased operating expenses: HIW has also been impacted due to rising operating costs and interest rates that can negatively impact its profit margins and returns on invested capital.

  • Management Commentary: In their recent earnings call, the management has focused on their efforts to create value during turbulent times through active management of leases, focus on customer relations, and reduction of expenses by making business process more efficient. - They have indicated that they are maintaining a good occupancy rate above 90%. And with the rising interest rate, they have shifted focus on cost savings and managing debts to keep their balance sheets healthy. They are also focusing on developing properties, which are already pre-leased to top grade tenants, and have an adequate budget for new acquisitions when the market prices are favorable. Overall, management has adopted a relatively cautious stance, with an aim to sail through these uncertainties by maintaining discipline and strong balance sheets. - They believe the high quality of their holdings will mean that they can sustain above average ROICs in coming years.

In conclusion, Highwoods Properties has a business model which may provide growth in the long run, with limited moat. However, they are exposed to large risks that are outside their direct control. Though they are in a strong position financially, and with good governance and management, they are heavily reliant on the performance of the markets they operate in to create sustainable returns for the long-term.