The dividends of Office Properties Income Trust (NASDAQ:OPI) appear secure for the next one year due to its low payout ratio and capital recycling program. However, the REIT carries substantial long-term risk because it specializes in the office space market, which has started to undergo a structural shift. Office real estate may never recover to pre-pandemic levels because many corporate tenants have figured out ways to work remotely such that they remain productive while cutting rent expense. The risks are likely to weigh on the stock price in the next one year, thereby negating OPI’s attractive dividend yield of over 12%. Consequently, I’m adopting a neutral rating on OPI.
Changing Work Culture Poses Long-Term Risks
Out of all the different types of real estate, hotels/motels and offices are some of the hardest hit by the pandemic. Unlike hotels and other troubled commercial real estate, the office space market is unlikely to return to pre-pandemic levels once a vaccine becomes available. Many businesses have adapted to remote working during the pandemic; therefore, some of them will be unwilling to return to full office capacities once the pandemic is over. Consequently, I’m expecting companies to make some of their employees work from home permanently to save rental expenses. Additionally, I’m expecting the shift towards work-from-home policies to continue in the coming years due to technological progress, thereby, reducing the need to be physically present at one location.
The extent of the changing work culture can be gauged by the recent announcements by many major companies that their employees can work remotely for the long term. These companies include Google (NASDAQ:GOOG) (NASDAQ:GOOGL), American Express (NYSE:AXP), Nielsen (NYSE:NLSN), and others, according to news reports. Moreover, a signal of this changing work culture comes from Germany where the government is set to push a proposal that would give people the legal right to work from home where possible, according to news reports. Consequently, I believe there is a significant risk that office real-estate owners will have to sell their properties at less than optimum rates to residential, hotel, or other real-estate developers in the coming years.
Rental Income Seems Mostly Secure for the Next One Year
During the third quarter’s conference call, the management appeared optimistic about its rental income for 2021 despite its expectations that around 7% of total annualized rental income will get vacated. One of the reasons for the optimism was a robust pipeline of 3.1 million square feet at the end of the last quarter, nearly double the pipeline from Q1 2020, and a 45% increase from Q2 2020, according to details given in the conference call.
Further, the management was confident about the renewal of leases as recent conversations with tenants did not provide any clear trends of them preparing to modify their space needs. As mentioned in the conference call, OPI’s exposure to technology companies is primarily comprised of hardware tenants that use their space for a mix of office, R&D, assembly, and showroom. Therefore, these tenants have less incentive to move out than other technology companies, like software, that can employ remote workers. Additionally, OPI has some government tenants that have high-security or public-facing requirements that restrict a significant move towards remote work.
Moreover, OPI is currently undertaking a capital recycling program whereby the mix of properties will be shifted to improve the average age of the properties and the likelihood of renewing leases. Moreover, the management hopes to shift towards properties that better position OPI to increase rents.
Considering the upcoming lease terminations, the lease activity pipeline, and the capital recycling program, I’m expecting rental income to decline by just 2% year-over-year in 2021.
COVID-19 Related Deferrals in a Good Position
OPI granted rent deferrals to 19 tenants totaling $2.5 million due to the COVID-19 pandemic, as mentioned in the conference call. However, the current balance of deferrals outstanding is now down to just $1.1 million, representing less than 0.3% of real estate properties. Moreover, the management mentioned in the conference call that rent collection stood at 99% for the third quarter. This further supports my thesis that dividends are secure in the short-term.
Expecting FFO of $5.02 per Share for 2021
Based on the expectation of a slight decline in rental income, I’m expecting OPI’s funds from operations (“FFO”) to somewhat dip in 2021 compared to 2020. Further, based on OPI’s history, I’m assuming that the FFO margin will remain somewhat stable. Overall, I’m expecting the REIT to report FFO of $5.28 per share in 2020, and $5.02 per share in 2021. The following table shows my estimates for rental income, net income, and FFO.
Long-Term Risks to Negate the Attractiveness of the Short-Term Dividend Yield
I believe OPI will be able to easily maintain its current quarterly dividend of $0.55 per share through 2021. OPI had a dividend-to-FFO ratio of only 41% in the first nine months of 2020, which shows that there is plenty of room for FFO decline before the dividend comes under pressure. Further, as mentioned in the conference call, OPI had over $800 million of liquidity, which is more than seven times the REIT’s annual dividend of $106 million or $2.20 per share. Moreover, the management mentioned in the conference call that even with the 7% of the revenue that it expects to vacate, OPI’s dividend remains well covered.
The dividend estimate suggests an extremely attractive dividend yield of 12.16% for 2021, using the November 6, 2020, closing price of $18.09. Additionally, the FFO for 2021 suggests a payout ratio of only 44%.
Unlike the short-term dividend outlook, the long-term dividend is at risk from the impending shift towards a work-from-home culture. I’m expecting the long-term risks to weigh on the REIT’s market price in the next year; thereby tarnishing the attractiveness of OPI’s short-term dividend yield. As a result, I’m adopting a neutral rating on OPI. At this point, I would feel more comfortable investing in a non-office REIT at a lower yield than an office REIT at a double-digit dividend yield.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: This article is not financial advice. Investors are expected to consider their investment objectives and constraints before investing in the stock(s) mentioned in the article.