Almost three months ago, I declared the 11% dividend from Office Properties Income Trust (NASDAQ:OPI) was appealing but not entirely safe. Since then, the trading outlook has deteriorated and the stock has fallen 21%. Consequently, it is now offering a 13.9% dividend yield, which could appeal to income-oriented investors. However, investors should be aware that the risk of a dividend cut has increased due to this real estate investment trust’s (‘REIT’) high leverage and increased risk of recession.
Office Properties is a REIT that owns more than 170 properties, with 22.5 million square feet in 32 states. Its properties are mainly leased to single tenants with high credit quality. The Trust generates approximately 20% of its rental income from US government agencies and 63% of its rental income from tenants with investment grade credit ratings. As a result, Office Properties implemented a defensive business model.
Some REITs have recovered from the coronavirus crisis thanks to the strong economic recovery that followed the fierce recession of 2020. Unfortunately, this is not the case for Office Properties, which has been significantly affected by the adoption of “working from home”. ” model by many companies. While some employees have returned to their offices, office occupancy rates in most metropolitan cities remain depressed.
Additionally, the pandemic caught Office Properties with high debt, and the REIT was therefore forced to divest many of its properties. The disposal of assets weighed on the performance of the REIT, which suffered a 20% drop in its funds from operations [FFO] per unit over the past three years, from $6.01 in 2019 to $4.80 in 2022.
On the positive side, office properties posted positive business performance in the second quarter. With increased leasing activity and the sale of some vacant properties, the REIT’s occupancy rate increased from 91.2% to 94.3% and its FFO per unit increased by 6% over compared to the quarter of last year, rising from $1.15 to $1.22, beating analysts’ estimates of $0.10. It should also be noted that government agencies accounted for approximately 30% of new rental volume. As these agencies are the most reliable tenants a REIT can have, this fact is undoubtedly positive for office properties.
On the other hand, as if the pandemic and the resulting “work from home” model were not enough, Office Properties currently faces a strong headwind, namely the risk of an impending recession. Inflation has proven to be much more persistent than initially expected, and so the Fed is raising interest rates aggressively, aiming to bring inflation back to its long-term target of 2%. Aggressive increases in interest rates are significantly reducing the total amount of investment in the economy and as a result, the risk of a coming recession has increased significantly.
It is also important to note that the management of office buildings was particularly cautious during the last conference call. He said tenants are still hesitant to return to their offices as they weigh the merits of a hybrid work environment. While some investors expect a rapid return of employees to their offices, Office Properties expects the headwind of the “work from home” model to persist over the coming quarters.
Additionally, Office Properties has significant lease expirations in the coming quarters. Specifically, leases that generate 4% of its annual revenue are due to expire in the second half of this year and leases that generate 13.5% of its annual revenue are due to expire in 2023. On the one hand, the REIT is likely to benefit high inflation and raise rents on some of its properties. On the other hand, if a recession occurs during the next quarters, it will reduce the bargaining power of the REIT with tenants.
Due to a 44% drop in its share price this year, Office Properties is currently offering a nearly 10-year high dividend yield of 13.9%.
Although the current yield is abnormally high, the stock has an adjusted FFO (“AFFO”) payout ratio of 65%, which provides a significant margin of safety for the dividend. On the other hand, investors should note that the stock has frozen its dividend for 15 consecutive quarters. This is a clear signal that the REIT is struggling to maintain its dividend.
The main reason for the lack of dividend increases for three consecutive years is the leveraged balance sheet of office properties. Its net debt (according to Buffett, net debt = total liabilities – cash – receivables) currently stands at $2.5 billion, which is more than three times the stock’s market capitalization and 11 times the annual funds of exploitation and is therefore excessive. Additionally, interest expense consumes 91% of operating income and the leverage ratio (net debt to EBITDA) stands at 7.1, well above the healthy range of 3.0 to 5.0.
Due to its high indebtedness, Office Properties is in the process of selling properties, in an effort to strengthen its balance sheet. The REIT expects aggregate sale proceeds of $100 million to $200 million this year and additional asset sales in 2023. Asset sales should improve the REIT’s balance sheet, but they are also likely to hurt to its FFO per share in the coming years.
Despite its leveraged balance sheet, Office Properties should maintain its generous dividend in the absence of a significant recession, mainly thanks to its defensive business model, which involves reliable tenants and therefore reliable cash flow. On the other hand, if a major recession hits, it could force the REIT to cut its dividend in order to strengthen its financial position. Unfortunately for shareholders, the risk of recession has increased lately due to persistently high inflation, which has led the Fed to take an unusually aggressive stance.
Office Properties is doing its best in the factors it can control, but is currently facing strong headwinds from a ‘work from home’ model and the risk of a coming recession. The REIT has a solid business model, which involves reliable tenants and a decent payout ratio. As a result, it can defend its 13.9% dividend even in a mild recession. However, in the adverse scenario of a major recession, management will likely decide to cut the dividend in order to improve its financial flexibility.