This article was coproduced with Leo Nelissen.
I don’t think anyone has ever used “dumpster diving” in a positive context.
However, did you know some people make decent money dumpster diving?
Last year, Business Insider published an article with the interesting title:
“We met dumpster diving 14 years ago and now make up to $3,000 a month selling our trash treasures.”
$3,000 a month is $36,000 a year.
The median household income in the U.S. is roughly $74,600.
However, in addition to getting a serious relationship out of it, it needs to be said that this couple does this as a hobby, as they dive into dumpsters on their way home from work!
“Now we dumpster dive multiple times a week, making stops at dumpsters on the way home from work, and we make $2,000 to $3,000 a month from selling our trash treasures. Some of the money we've earned from dumpster diving has gone toward trips we have planned for Norway and Mexico later this year.” – Business Insider.
The reason we bring this up isn’t to get anyone to jump into dumpsters. It can actually be quite dangerous as people can get exposed to biohazardous matter, broken glass, and a whole range of unsanitary conditions.
Do you know what this reminds us of?
The stock market.
When people think of dumpster diving, it’s often related to the stock market. Whenever we buy assets that are beaten down and unloved, it’s as if we dive into a dumpster to see if there’s anything worth saving.
Sometimes, this can be highly profitable. Other times, it’s just dangerous, gross, and a waste of money and time.
In this article, we’ll present three stocks that certainly fall in the “dumpster diving” category.
All three stocks operate in the office REIT space, which has been under tremendous pressure. It may actually be the worst place to be right now in the REIT space, which is reflected in the stock prices of the stocks we are about to discuss.
On February 27, we published an article for our Investing Group subscribers that discussed ongoing developments among the most important sectors of the REIT universe.
The worst sector, by far, is office real estate.
Here’s an important quote from that article (emphasis added):
“[…] demand for office space remains subdued, with vacancy rates reaching a record high of 13.5% in 4Q23.
While net absorption improved slightly, it remained negative, which reflects the ongoing trend of firms downsizing office space due to pandemic-related work-from-home arrangements that are really hard to roll back.
The bad news continues, as despite recent growth in office-using employment, overall demand remains weak, which doesn’t do the demand/supply imbalance any favors.”
With this horrible news in mind, we’ll now show you three high-risk office plays that not only tell us more about the industry they operate in but also offer some value for investors willing to take on investments with elevated risks.
- Two REITs are spinoffs.
- Two are focused on single-tenant offices.
- Two have been punished severely on the stock market.
- One went public just recently.
- All of them are dirt cheap and face elevated uncertainties.
So, let’s get to it!
City Office REIT, Inc. (CIO) – Small But Resilient
With a market cap of $180 million, this is one of the smallest REITs on the market.
Founded in 2013, this company is focused on owning, operating, and buying high-quality office buildings. It mainly looks for Sunbelt markets, where it sees the biggest demographics and employment tailwinds.
Led by a team of experienced managers, including CEO James Farrar and COO Gregory Tylee, both with more than 20 years of experience, the company looks for assets in well-located and “highly-amenitized” areas that are expected to support long-term asset appreciation and rent growth.
Going into this year, the company owned 58 office buildings that cover 5.7 million square feet.
As we can see in the overview above, these assets are well diversified, with a bigger focus on growth markets like Phoenix, Raleigh, Tampa, Dallas, and Orlando.
According to the company, these properties are strategically positioned near transportation hubs and neighborhoods with high income, offering extensive amenities and a stable, diverse tenant profile.
The tenant profile includes governmental agencies and national and regional businesses.
As we can see below, no tenant rents more than 3.6% of its total rentable area, with its top ten accounting for roughly a fifth of its rentable space.
Moreover, the company has an occupancy rate of 84.5% and a weighted average remaining lease term of 4.6 years.
Adding to that:
- The majority of its assets are Class A assets.
- During the pandemic, it had >99% rent collection.
- Between 4Q14 and 4Q23, the annualized gross rent per SF has increased from roughly $20 to $33, boosted by the attractiveness of its locations and its buildings.
- Since the pandemic, it has grown core FFO (funds from operations) by 32%.
For 2024, the company is upbeat, expecting an occupancy rate of no less than 84.5% and flat-ish same-store cash net operating income (“NOI”) growth, which is quite good in this environment.
This also bodes well for its dividend.
The company currently pays $0.10 in quarterly dividends for every share. This translates to a yield of 9.1%!
As analysts expect the company to generate $0.54 in adjusted FFO this year, we’re dealing with a 74% payout ratio, which means the dividend is sustainable unless it were to run into much lower FFO or unforeseen issues.
With that said, so far, CIO isn’t a bad REIT – at all!
However, there are some issues that have caused investors to stay away.
On top of the general issues facing the office market, we are dealing with elevated rates that pressure demand – and financial stability.
To use the company’s own words:
“Debt capital also continues to be effectively frozen for new originations, with lenders seeking to reduce their office sector exposure. We're closely monitoring these trends and remain in active dialogue with our own lending relationships.” – CIO 4Q23 Earnings Call.
CIO currently has a 4.8% weighted average interest rate on its debt. It has a 6.6x net leverage ratio and more than 90% fixed-rate debt.
These numbers are not bad.
However, its weighted average debt maturity is only 2.6 years, with more than $350 million in debt maturing through 2025.
A big part of this is from its credit facility. Note that this facility may be extended, which would buy the company another year.
The company currently has more than $100 million in available cash, which should allow it to get through 2024 without major issues.
Unfortunately, if rates remain elevated, it could see a higher rate on its debt, which could translate to lower earnings.
Its valuation reflects these concerns.
Looking at the chart below, we see that the company’s stock price did relatively well until 2021. CIO’s stock actually soared higher before the market turned bearish on offices!
Now, it trades at a blended P/AFFO ratio of just 6.1x, which is substantially below its normalized P/AFFO multiple of 15.1x.
Analysts expect a 29% AFFO per share contraction in 2024 to $0.54. That number is expected to remain stable in 2025.
CIO is definitely one of the best-managed REITs in the office space. We actually like the business a lot. The problem is that macroeconomic risks are elevated.
If the Fed were to achieve a no-landing followed by gradual rate cuts, City Office REIT could soar in the years ahead.
However, if rates remain elevated for longer, potentially with the risk of higher unemployment, we may not have seen the worst.
The same goes for the next stock.
Orion Office REIT Inc. (ONL) – Finding Value In A Deep Dumpster
With all due respect to the company, ONL’s stock price performance is horrible. The stock is down 40% year-to-date, falling 85% since it went public in 2021.
Without having looked at any numbers, Orion Office seems to have been the perfect opportunity for Realty Income (O) to get rid of its office exposure before the “big crash.”
Originally established as a subsidiary of the famous Monthly Dividend Company, Orion Office REIT now is an independent office REIT that resulted from the merger between Realty Income and VEREIT.
Essentially, the transaction, which was completed on November 1, 2021, allowed Realty Income and VEREIT to spin off their office assets.
As of December 31, 2023, the company owned 75 office properties in 29 states, covering 8.7 million square feet. It has a market cap of $190 million.
As we can see above, it has an occupancy rate of 80.0% and a weighted average remaining lease term of roughly 4.0 years.
The company, which focuses on single-tenant net leases, has most of its buildings in high-quality suburban markets, where it tries to make sure that no single tenant accounts for more than 10% of its annualized rent.
However, the company has broken this rule, as the General Service Administration accounts for 13.5% of its annual base rent.
The good thing is that this company has an AA+ credit rating.
In general, most of its largest tenants have investment-grade credit ratings, which is not very common in this industry.
Moreover, it has roughly 20% exposure in New Jersey and New York, two markets that are currently suffering due to oversupplied office markets.
Its largest market is Texas, accounting for 17.2% of its annual base rent.
The Sunbelt accounts for roughly 36% of its rent.
With that said, the net lease comes with benefits – especially in times of elevated inflation.
For example, by shifting operating expenses to tenants through net leases, the company improves cash flow stability and benefits from embedded rent growth, providing inflation protection.
Unfortunately, this hasn’t helped its stock price, as losing major tenants means that it takes a while to improve the occupancy rate again.
“Highlighting these challenges, we expect that several of our largest tenants with leases rolling in 2024 will not renew, causing revenues and earnings to decline materially and carrying costs to rise until we can get these properties released. While we are extremely proactive in our efforts to retain tenants when they leave, it takes longer to release a full building vacancy, and this timeline is further pushed out by market conditions.” – ONL 4Q23 Earnings Call (emphasis added).
Another reason for stock price weakness is its balance sheet. The company has roughly $500 million in debt. This has a weighted average maturity of 2.8 years and an interest rate of 5.8%.
While the company is currently complying with all required covenants on its credit facility (see below), it could see a surge in interest payments if it has to refinance its debt at higher rates in the years ahead. The same applied to City Office REIT.
The good news is that the company had $332 million of liquidity going into this year. Most of it comes from the available capacity on its $425 million credit revolver.
It expects to end this year with a net leverage ratio of no less than 6.2x EBITDA.
With that said, ONL currently yields 11.6%. That’s based on a $0.10 per share per quarter dividend announced on February 27.
This year, analysts expect the company to generate $0.93 in AFFO, which translates to a payout ratio of 43%.
It also hints that ONL may be trading at a very low multiple.
That’s indeed the case.
ONL trades at a blended P/AFFO ratio of just 3.0x!!
That’s extremely low and likely the result of a tough operating environment, single-tenant risks, debt risks, and the fact that analysts expect a 22% AFFO contraction in 2024, potentially followed by a 10% contraction in 2025.
These numbers reflect the loss of potentially multiple tenants in 2024 (and beyond?).
While ONL could easily return 400-500% if rates were to come down rapidly with a massive comeback of office demand, investors aren’t buying the turnaround story yet, expecting the company to run into bigger issues in the future.
Net Lease Office Properties (NLOP) – An Externally-Managed Office Spinoff
Like Orion, NLOP is the result of a spinoff.
In this case, the company was spun off from net lease giant W.P. Carey (WPC).
(I'm sure you remember the head fake, I mean dividend cut)
Through a separation and distribution agreement, WPC spun off a portfolio of 59 office assets into NLOP.
This deal was completed on November 1, 2023, and resulted in NLOP becoming an externally managed vehicle managed by “certain wholly-owned” affiliates of WPC.
Essentially, the “Advisor” oversees a wide range of operational aspects, including asset management, dispositions, financial reporting, and compliance. All of this happens under the supervision of the Board of Trustees.
Unlike NLOP, the other two REITs we discussed in this article are internally managed REITs.
Like Orion, the company is a net lease REIT that focuses on single-tenant assets.
The company’s deals typically include a base rent with periodic increases and require tenants to cover the majority of operating and maintenance costs associated with the properties.
Going back to its assets, its current 55 offices have a weighted average lease term of 5.8 years. 43% of its tenants are classified as investment-grade tenants, which is one of the benefits that come with being spun off from a landlord that has a strong focus on high-quality tenants - the same applies to Orion.
The example below shows its office in Collierville, Tennessee. This is leased to FedEx (FDX). Renovated in 2016, the building has a lease through 2039.
89% of its offices are in the United States.
As of December 31, the company had an occupancy rate of 97%!
74% of its rents have a fixed rent escalator. 20% of its contracts are tied to CPI (or similar).
However, at this point, I need to add that NLOP sold four U.S. office properties in January, which brings its count to 55 offices. That’s why the company went from 59 properties after the spin-off to 55.
The company received $43.1 million from these sales. The company used this cash to repay roughly $46 million on JPMorgan’s (JPM) senior secured mortgage and roughly $6 million on its mezzanine loan.
It now has an outstanding balance of $203 million on both loans.
As of December 31, the weighted average interest rate on its debt was 9.5%. That’s up from 4.8% in 2022 and a great example of the risks that REITs face in an environment of elevated rates.
In 2024, it has debt due worth $39 million, followed by $412 million in 2025. The company expects to service these obligations through operating cash flow and disposition of properties.
This, too, is increasingly common and could increase office supply, further pressuring selling prices.
Anyway, because of the company’s young age and uncertainty, it does NOT intend to pay a regular dividend – unless it risks losing its REIT status.
“While the Company paid a dividend in January 2024 of $0.34 per share, it does not intend to pay regular dividends going forward, except as may be necessary to maintain its REIT qualification.” – NLOP 2023 10-K.
With that said, in 2023, the company generated $94 million in AFFO. This brings the LTM AFFO multiple to just 3.7x, making the stock extremely cheap.
While it needs to be seen how the company will develop itself, I have to say that both ONL and CIO come with more visibility.
Takeaway
Like dumpster diving for hidden gems, delving into beaten-down stocks can lead to lucrative returns.
However, caution is warranted; just as dumpsters come with hazards, risky investments can lead to losses.
The office real estate sector is a perfect example of this, with plummeting stock prices reflecting industry challenges.
Yet, within these issues lie opportunities for investors who do not shy away from risks.
By diving into overlooked stocks like City Office REIT, Orion Office REIT, and Net Lease Office Properties, one may find undervalued assets with significant capital appreciation potential and elevated income.
Our personal favorite of these three is the City Office REIT, followed by Orion, which comes with higher tenant risks, and NLOP, which is not yet dedicated to its dividend and needs to potentially sell more assets in the years ahead to cover maturing debt.
Needless to say, the risks are significant, as a prolonged period of elevated rates and sticky inflation could force a wide range of office REITs to sell assets, pressuring selling prices and supply/demand dynamics even further.
In other words, just like a box of plates, these stocks need to be handled with care!
Any takers?
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