Office Properties Income: Catching The Falling Knife After Dividend Cut (NASDAQ:OPI)

Thesis

Office Properties Income Trust (NASDAQ:OPI) suffered a 37% decline following the announcement of a dividend cut on Jan-11. However, after examining the OPI portfolio, I believe the company has been oversold.

Since the onset of COVID, the stock has witnessed a nearly 90% drop in price, driven by concerns about debt refinancing, dividend reduction, and a decline in free cash flow.

Now, the fear of dividend cuts has been eliminated. After a thorough examination of OPI’s portfolio and debt, I am confident that refinancing should not be a cause for concern. The current stock price presents an excellent entry point for long-term investors.

This opportunity may be less enticing to swing traders, as income investors could take weeks to realign their portfolios following the dividend reduction. Additionally, there’s a possibility of further deterioration in OPI’s free cash flow and stock price in the short term if there’s a delay in renewing leases expiring in 2024 or if the terms of debt refinancing are less favorable.

Background

OPI owns a $4.7 billion investment portfolio, with 66% comprised of office properties. Prior to the pandemic, the company provided an annual yield of $2.2. In early 2023, it reduced the dividend by half. It announced another cut to 1 cent per quarter on Jan-11. This dividend reduction has deterred income investors.

RMR Group (RMR) is the parent company that manages OPI. All the REITs it manages announced dividends simultaneously, on the same day of the December CPI release. The 0.3% increase in CPI has heightened market concerns that the Fed may not cut interest rates as aggressively as anticipated. This situation could pose additional challenges for companies carrying high levels of debt. This led to an amplified sell-off of OPI shares, with almost all RMR-managed REITs experiencing a decline on Jan 11.

Despite all these negative catalysts, I maintain a bullish outlook on OPI. Considering the $34 trillion national debt and a $2 trillion interest bill, the Fed is likely to cut interest rates in the first half 2024. While OPI shares might experience short-term declines if market expectations of a rate cut are delayed, the likelihood of bankruptcy in the near term is minimal. The current price presents an appealing entry point for long-term investors.

Now debt is the major concern, with a remote chance of bankruptcy

OPI carries $2.58 billion debt. The most urgent one is the $200M revolving credit facility due on Jan-31.

To refinance the short-term stress, OPI’s options are:

• A. Obtain secured debt using unencumbered assets
• B. Recast the credit revolver with more restricted terms
• C. Asset dispositions

A. Secured debt is the most likely solution to relieve short-term distress

OPI’s 2050 $150M 6.375% Senior Notes mandate the maintenance of “total Unencumbered Assets of not less than 150% of the unsecured debt” and “Secured debt to be greater than 40% of the adjusted total assets.”

As of Sep-30, OPI’s unencumbered assets to unsecured debt ratio is 206.2%, while secured debt to adjusted total assets is only 3.3%. This ample unencumbered asset capacity allows OPI to raise secured debt, which generally comes with higher recovery and lower refinancing costs. However, it also entails additional restrictions, including limits on dividend payments. I consider the decision to cut dividends a positive signal for debt refinancing, as it alleviates concerns related to dividend constraints. This could potentially open the door for OPI to refinance by encumbering its assets.

B. Revolver

There is a chance for OPI to recast the revolver with more restricted terms. In the original term of the credit facility, “maximum aggregate borrowing availability may be increased to up to $1,950,000 in certain circumstances”.

S&P downgraded OPI’s credit to ‘CCC+’ on Dec-5, 2023, and expected the company to recast its revolver when it matures.

C. Sell assets

OPI sold $211M assets in 2022 and $23.6M as of Sep-2023, averaging $87 per square foot. The majority of these assets are located outside the top DMAs. Additionally, as of October 2023, OPI entered into a sales agreement for $21 million.

I like OPI’s strategic focus on selling non-core assets and smaller deals. As outlined in its 2023 guidelines (found in Q4 2022 earnings call), the company views asset disposition as a way to “manage leverage levels and fund other capital initiatives.” The anticipation was for fewer dispositions as the company entered 2023. This indicates that RMR does not intend to use asset disposition as a primary method to address debt issues.

Insider activities during the merger talk indicates OPI’s low risk of default

RMR manages both OPI and Diversified Healthcare Trust (DHC). In April, OPI announced a merger with DHC in an all-share transaction. However, DHC terminated the deal due to shareholder opposition on Sep-1.

Prior to the merger announcement, DHC was in a considerably more distressed debt position than OPI. DHC had $700 million in debt maturing within a year and faced difficulties in refinancing, as its ratio of consolidated income available for debt service to annual debt service fell below the mandated 1.5x threshold according to their credit agreement.

The stock price of DHC soared by 119.2% from the merger announcement until its termination, while OPI’s value dropped by -16.04%. The merger benefited DHC in resolving its immediate refinancing needs but raised concerns that it could place OPI in a worse financial position.

From May 30 to June 14, Adam Portnoy, the CEO of RMR Group, increased his share holdings by 5.5x, reaching a total of 23.2 million shares.

I think the merger decision was made in hope to resolve the DHC financial challenges by issuing additional liquidity, considering that OPI did not face the same restrictive terms in obtaining debt. This implies that the bankruptcy risk for OPI, as a standalone company, was low.

Based on the merger agreement, DHC shareholders will receive 0.147 shares of OPI for each common share of DHC. Mr. Portnoy wouldn’t have purchased such a significant number of shares if there were still lingering concerns about the combined company facing default risks.

How much does OPI portfolio worth?

As of Jan 2024, OPI has 154 properties across the US excluding JV asset.

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Note: NBV (Net book value) is recorded using the depreciated carrying value as of Dec, 31, 2022.

DC, CA, VA, IL and GA are the top 5 states, comprising 60% of OPI’s portfolio value. In both the DC and IL markets, the majority of buildings are of high quality, with class A structures constituting over 70%. Key tenants in these markets include Sonesta, with a 30-year lease for 20 Massachusetts Avenue in Washington DC, and Google, occupying office space at 1000 W. Fulton in Chicago IL. CA, VA, and GA feature a mix of class A and B buildings, primarily located in suburban areas. The NBV per building in other states is relatively low, providing OPI with flexibility if it decides to divest non-core assets.

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Note: Property NOI (LTM) is calculated using last twelve months NOI as of Sep-30, 2023.

Assuming OPI’s portfolio continues to be leased at 90%. At the current stock price of ~$3.8, OPI is trading at an implied cap rate of 12.2% and a 26% discount comparing to the portfolio NBV.

According to the Q3 investor presentation, OPI’s mortgage financing was using 6.9% implied cap rate based aggregate appraise value. The 6.9% cap rate is notably lower than 9.1% (the implied cap rate of when assuming no discount on assets). This suggests a substantial discount on the asset.

Risks

The stock price might not have bottomed yet, especially considering that income investors, mainly institutions, could take weeks to make adjustments to their portfolios. Secondly, the office sector could encounter additional challenges if the Fed delays the interest rate cut. Lastly, with 12.3% lease expiring in 2024, it’s possible to see further deterioration in OPI’s free cash flow.

Conclusion

I find OPI attractive for long-term investors and anticipate stock price to double in 1-2 years. The risk of bankruptcy is minimal, even if the office market experiences prolonged distress beyond market expectations. Going into 2024, I’d like to see the company obtain secured debt to refinance current liabilities by encumbering assets and extend expired leases. I also view the disposition of non-core assets as a positive sign to improve liquidity and potentially reinstate dividends. I will reassess this strategy if other major events occur, such as early lease termination by a major tenant or the proposal of another merger by RMR.