OFC: It’s Time To Take A Look At Office REITs

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One of the hottest topics of conversation on Wall Street, and among my colleagues like Tim Plaehn and Tim Melvin here at Investors Alley, is the state of the U.S. commercial real estate market (CRE).

The story on Wall Street, as articulated by media outlets such as Bloomberg, is that a $1.5 trillion “Wall of Debt”—mortgages due before the end of 2025—is approaching for commercial property owners.

As a result, office and retail properties’ valuations may fall by as much as 40%.

This theory involves property owners being unable to refinance because their property values have fallen so much. Also, lenders—mainly local and regional banks—may be in trouble when property owners default on commercial mortgages.

Keep in mind that commercial property mortgages are almost always adjustable, so rising interest rates hurt property owners with sometimes significant increases in the cost of servicing their debt. And the CRE industry is highly leveraged and interconnected. So, the potential is there that if things go wrong, unexpected and very bad things could happen.

But let’s move away from the gloom and doom and look at the actual state of the commercial property market.

Because the reality is much better than the headlines would have you believe…

Yes, stresses are rising, but they are mostly confined to a small slice of the market: low-quality, or Class C, properties. (There are three classes of office buildings: Class A, Class B, and Class C.) For the overall commercial real estate market, vacancies and delinquencies are above pre-pandemic levels but are not soaring higher. That’s due to the fact that the U.S. economy still remains strong.

Office REITs

Despite these economic strengths, Wall Street's fears about the CRE have created an investment opportunity in a very obvious place: the office real estate investment trusts (REITs)—the companies that actually own office properties.

Even if dividends are included, office REITs have lost half or more of their value since the start of the coronavirus pandemic! Stock market participants have made a collective judgment that profits at these REITs are going to drop by half, even though these firms mainly specialize in high-end properties.

But has the market—as it often does—overreacted? Will conditions really be all that bad for these companies?

Here’s the investment angle… as revealed in a Financial Times article by its U.S. financial commentator, Robert Armstrong…

Three years into the pandemic, and almost a year into a higher interest rates regime and the damage to earnings has not been so great—at least so far. Cash flows are flat to down a bit, not diving off a cliff. In other words, disaster has not struck.

And yet, many of these companies are trading as cheaply, relative to their cash flows, as they have since the depths of the financial crisis. For example, Armstrong looked at three of the largest office REIT firms: Boston Properties (BXP), Vornado Realty Trust (VNO), and SL Green Realty (SLG), which trade at eight, seven, and six times funds from operations (FFO), respectively. As recently as March 2022, their multiples stood at 16, 13, and 11. So in effect, it’s a half-off sale!

Nevertheless, I would rather own a different type of commercial property REIT…

Corporate Office Properties Trust

The REIT I have in mind is Corporate Office Properties Trust (OFC). It has a unique focus on owning, operating, and developing mission-critical facilities that support key U.S. government defense installations and the supporting defense contractors.

These facilities account for more than 90% of OFC’s core portfolio annualized rental revenues. In the latest quarter, its core portfolio was 92.9% occupied and 95.1% leased.

OFC owns a portfolio of office properties located in select urban/urban-like submarkets in Baltimore/greater Washington, DC. The company has approximately 194 properties totaling over 23.0 million square feet comprised of 17.7 million square feet in 166 office properties and 5.3 million square feet in 28 single-tenant data center shells.

Its overall first-quarter results were strong as funds from operations per share exceeded the midpoint of the guidance range by $0.02. Same property Cash NOI (net operating income) increased 8.3% year over year, which led management to increase full-year guidance by 100 basis points. The company also raised its full-year retention rate by 250 basis points—and in February, it announced a 3.6% increase in its quarterly dividend, from $0.275 to $0.285 per share. This marked OFC’s first dividend increase since 2010! That’s quite a statement in the current environment. The current yield is a decent 4.69%.

OFC stock has vastly outperformed most other office REITs. It is down only 6.5% over the past three pandemic years and just 7% lower over the past year. Most of these declines happened this year (-6.3%) as Wall Street turned even more negative on commercial property.

However, with its unique portfolio of defense industry-related properties, Corporate Office Properties Trust will largely be shielded from whatever befalls the overall CRE market.

The stock is a buy at current price levels, in the mid-$20s per share.

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