Paramount Group, a REIT focused on Class A office properties in New York and San Francisco, just reported a strong first quarter for 2024, beating consensus estimates and showcasing impressive leasing momentum. Yet, buried within the celebratory tone of the earnings call lies a puzzle: the peculiar handling of their non-core assets, 111 Sutter and Market Center.

The company, after writing down these assets to zero and designating them as non-core, made a curious decision. While removing any income contribution from these properties from their “Core FFO” calculation, a common practice, they also chose to exclude the associated interest expense. This move, seemingly minor, hints at a deeper strategy at play, one that might be flying under the radar of most analysts.

Think of it as a game of financial chess. Paramount, facing the pressure of elevated interest rates and a sluggish San Francisco market, has cleverly created a buffer, a hidden reserve, within their financials. By excluding the interest expense on these non-core assets, they present a "cleaner" picture of their operational strength, while simultaneously accumulating potential leverage for the future.

Here's the hypothesis: Paramount isn't simply waiting for these non-core assets to bleed out. They're actively leveraging them, transforming a perceived liability into a strategic asset.

Let's look at the numbers. By excluding the interest expense on these properties, Paramount essentially "saves" a portion of their operating cash flow. This "saved" cash flow can then be strategically directed elsewhere, perhaps towards more promising assets in their core portfolio, bolstering their leasing efforts, or even funneled into their opportunistic fund, which is primed to capitalize on the anticipated rise in distressed assets.

"This strategy of "controlled accrual" offers a unique advantage. While the interest expense keeps accumulating on the non-core assets, Paramount retains the optionality of addressing it later, perhaps when interest rates start to ease, or when the San Francisco market rebounds, unlocking the value of these previously written-down properties."

Consider this: Paramount's opportunistic fund, poised for its first closing in the first half of 2024, is targeting a 15% to 20% unlevered IRR. Imagine the amplified returns if a portion of the "saved" cash flow from the non-core assets is injected into this fund, effectively creating a leveraged investment at a significantly discounted cost.

Leasing Momentum in New York vs. San Francisco

The following chart, derived from Paramount's Q1 2024 earnings call transcript, displays the square footage leased in New York and San Francisco during the first quarter of 2024. It highlights the company's strong performance in New York despite a more challenging environment in San Francisco.

This intricate play might seem counterintuitive, especially with the prevailing narrative surrounding distressed office assets. But Paramount, known for its shrewd capital allocation and deep market expertise, is demonstrating a different approach. They're not simply cutting their losses; they're playing a long game, using the non-core assets as a springboard for potentially outsized returns.

It's almost like a hidden engine, quietly humming in the background, powering Paramount's growth trajectory. The "ghost" in the non-core assets might not be haunting Paramount, but rather, propelling it towards future success. Whether this strategic gamble pays off remains to be seen, but it certainly makes Paramount a fascinating case study in the ever-evolving landscape of the REIT industry.

"Fun Fact: Paramount Group's headquarters is located at 1633 Broadway in New York City, the same building that houses the iconic "Glass Cube" entrance to the Apple Store. This prime location in Times Square puts the company at the heart of one of the world's most vibrant and dynamic commercial districts."