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Orion Office REIT Inc. (NYSE:ONL) has been a painful experience for those that embraced the long thesis. The Spin-off from Realty Income Corporation (O) created hope that this would create material upside, and yet the problems started surfacing almost from day 1. Our own coverage on this was most focused on the fact that leases would not be renewed and earning out even its enterprise value on Day 1 of its listing, would be impossible.
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But time and price cure some ailments and on our most recent coverage, we upgraded it to a “hold”, as the valuation improved the possibility that investors might make a little dough.
The stock is trading for 4X funds from operations (FFO) so again downside bias is low. Weighing all the evidence so far, we see no reason to change our earlier price target of $6.00 per share. However, since the stock is so much closer to our target than when we last wrote on it, this time we go with a “hold” rating.
Source: An Upgrade Is Warranted
The stock is broadly at the same point as when that article was written. We now tell you three reasons that you should consider exiting (if you are long) on any bounce in 2024.
1) Weighted Average Lease Term (WALT) Still Low, 27% Coming Up For Renewal
The REIT has had time in its public career to fix the legacy issues. The main issue there was that the WALT was extremely low. The earliest presentations (March 2022) showed a WALT of 4.1 years.
ONL Q1-2022 Presentation
Fast forward to today and the latest presentation shows a lower number.
ONL Q3-2023 Presentation
It is not like the REIT has not tried to get this going up. Leasing team has worked about as hard as possible, but the fundamentals for office, especially single tenant office buildings, remain extremely poor. Add to this that 27.2% comes up for renewal in 2024.
ONL Q3-2023 Presentation
That would be daunting for most property types, but single tenant office is unlikely to hold up well for certain. If you see the history here, OPI tends to sell vacant properties and that is part of the process of keeping occupancy levels high. We started off with near 110 properties in 2022.
ONL Q1-2022 10-Q
We are down to quite a bit less.
ONL Q3-2023 Presentation
Note the occupancy level on the right as well. ONL was hoping to have the Walgreens (WBA) properties off their books, but have not got that done yet.
Regarding the six property former Walgreens campus in Deerfield, Illinois, that we have had under contract to sell for the past several quarters, the buyer continues to progress with its redevelopment plans for the property despite the challenging financing environment, and has reached an additional milestone, therefore, adding to their at-risk deposit towards the purchase price. We are now targeting this sale to close sometime in mid-2024.
These delays will add to carrying costs in 2024. Overall, our outlook is that renewals will be tough to come by (we expect 50%-60% of expiries to get renewed) and where they do happen, will require very large levels of capex.
2) Estimates off on interest expense
With few Wall Street analysts (one that we could actually find) covering this, it is easy to forget that estimates can be really off. Here, the estimates are for interest expenses to actually drop in 2024.
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So let us tell you why that may be wrong. The current debt structure is shown below. The 3.92% on the credit facility is what we are referring to. That is a variable rate facility (SOFR+3.35%) that is effectively fixed thanks to swaps. Hence the rate on it is shown as just 3.92%.
ONL Q3-2023 Presentation
That was a Q3-2023 presentation and as of November 12, 2023, the swap is gone.
the Company terminated the interest rate swap agreements that had been entered into during the year ended December 31, 2021, and entered into new interest rate swap agreements with an aggregate notional amount of $175.0 million, effective on December 1, 2022 and terminating on November 12, 2023, which were designated as cash flow hedges, to hedge interest rate volatility with respect to the Company’s borrowings under the Term Loan Facility. As of September 30, 2023, these interest rate swap agreements remain in effect for the $175.0 million of borrowings under the Revolving Facility until November 12, 2023.
Source: ONL Q3-2023 10-Q
When you adjust for where SOFR is, interest rate jumps to well over 8%. So we don’t see any possibility of a decline in interest expense, even taking into account potential 3 interest rate cuts by the Fed.
3) Vacant property sale prices remain extremely low
During the third quarter and shortly thereafter, we closed on the sale of three vacant properties, representing 452,000 square feet for an aggregate gross sales price of $15.4 million or $34 per square foot. We also have agreements to sell nine additional properties representing 779,000 square feet for approximately $47 million.
Source: Q3-2023 Transcript
That works out to about $50 a square foot in total. This is actually a better rate than what they got during all of 2022.
In 2022, we deliberately focused our resources on this strategy and closed on 11 sales of approximately 900,000 square feet for approximately $33 million. This equated to a price per square foot of about $36, both reducing existing vacancy and avoiding near term vacancy as the leases expire. 8 of the 11 properties were vacant as of the date of sale, and the remaining three had near term lease expirations where we knew the tenants were not renewing. We estimate that the sale of these 11 assets will allow us to save annual vacant property carrying costs of about $7.5 million.
Source: Orion Q4-2022 Conference Call Transcript
The higher number likely comes from the fact that some of those properties were not yet vacant. Our point here is that even if you take $50 a square foot (which is unlikely) and apply it to the entire 9.5 million square feet left, you get $475 million. That does not even cover the existing debt ($557 million) on the company.
Verdict
We think the bounce is now due to run-out and the stock should start to head lower once again. Our estimates call for about $1.20 in FFO in 2024 and the stock will likely trade close to 3X-4X this FFO or at $3.60-$4.80 per share. In case anyone wanted to hurl at the idea of a 3X multiple, please see Office Properties Income Trust (OPI) that trades at 1.85X 2024 FFO.
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The only thing the real smart money is going to calculate on this is whether the company can out earn its current enterprise value. While we had earlier thought it was possible around this price, we now think it is unlikely as office distress has materially picked up. We are once again shifting to Sell and looking for a sub $5.00 price by the end of 2024. The biggest risk to our short thesis is that this may first have a material bounce as tax-loss selling ends and you might get a $7.00-$7.50 price in early 2024, before we head down.
Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
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