Orion Office REIT (ONL) - fundamental analysis

Recently Realty Income spun off Orion Office REIT after its merger with VEREIT. I took a concise look at Orion Office to determine if it is attractive at its current price of $17.59 (as of writing).

Business profile
Orion Office focuses on single tenant net lease office real estate in suburban markets, it is a pure-play in this space as it has 100% exposure to offices. It owns 92 properties of which 94.4% are leased, 71.6% of their tenants are Investement grade. Avg. ABR per square foot of $16.70.

Office Real Estate Environment
So why would anyone want to own suburban office real estate, as JLL put it in an article (see sources):

The office market showed signs of promise and the beginnings of tenants firming their longer-term utilization plans. Leasing activity rose once again in Q3, most notably in fast-growing secondary markets, while sublease space contracted modestly and occupancy losses slowed once again. With a large construction pipeline through the end of 2022, however, conditions will remain tenant-favorable for the foreseeable future, while flight to quality and an accelerated rate of relocations to newer supply will lead to even greater divergence in performance across office assets. (Phil Ryan from JLL, 2021)

From the research performed by JLL a couple interesting graphs and conclusions can be deducted:

Construction is on a historically low pace, with reduced supply additions (see image below) and some supply even being taken out through conversions (as often can be seen in distressed sectors). This, like with other surface level distressed sectors like malls, could signal though that consolidation is taking place.


(Phil Ryan from JLL, 2021)

This concentration indeed is taking place towards growth markets as can be seen below. Concentration normally proves well for the high quality moat companies in the respective sector as the total pie gets smaller but their share gets larger and they enter a more competitive position as competition is struggling. I will discuss later if I would consider Orion to be high quality and thus benefiting from industry concentration.


(Phil Ryan from JLL, 2021)

Orion Office notes that deurbaniztion is happening, but this seems to not be supported by overall data (see image above) and more of a population trend extrapolation.
image
(Phil Ryan from JLL, 2021)

Returns being more attractive in suburban markets is something to look into further:


Orion office investor presentation

Overall though office leasing seems to be recovering, albeit at a very slow pace in comparison to other sectors (and it is not a given that total leasing will return to pre pandemic levels).


Orion office investor presentation

A trend also seems to be that the leases being written are of a longer term nature. This also is another indication of consolidation as more and more business who really know they need long term office space are leasing while those who do not or offer more flexible work are going with shorter term contracts. Orion has a weighted average remaining lease term of 3.4 Years so that might increase if this trend continues in suburban office real estate as well.


(Phil Ryan from JLL, 2021)

Another note to be taken is that Orion has an average annual base rent per Square Foot of $16.7 (as of 6/30/2021) which is even lower than presented in the illustration by JLL.


(Phil Ryan from JLL, 2021)

Value Creation
Orion expects to generate value through organic growth and active asset management.

Organic Growth:
Orion expects re-leasing to generate significant value, with more than half of their tenants renegotiating before the end of 2024 this is an important proposition to evaluate.


Orion office investor presentation

So Orion notes:

  • Our team works to leverage deep tenant relationships to
    drive re-leasing and renewal activity, while minimizing
    leasing costs
  • Our leasing expertise provides us with the flexibility to
    execute early renewals, subleases and potential multitenant conversions
  • When our in-house staff can effectively represent us, we
    may not hire a leasing broker and can eliminate transaction
    costs creating additional savings

To elaborate on this matter Orion provided 3 slides consisting case studies.

  • USAA and nThrive– Plano, TX (2016 – 2020): 38% higher rent, 11.6y lease
  • Rockwell Collins Divisional HQ – Sterling, VA (2014 – 2019): 17% rent reduction, expanded building. Overall lower rent per foot of 17% but 16% sq. ft. growth with lease extension and better terms for Orion.
  • Praxair– Woodlands, TX (2020 – 2021): Increased occupancy and preserved NOI

If these are the examples Orion picks to present on the investor presentation I would be a bit more skeptical about overall achievements by re-leasing. 38% is good but the other two examples only provide preservation.

Active asset management:
As noted earlier Orion expects to have low cost deals due to low transaction costs, not much information is given on this aside from the information below:


Orion investor presentation

Idiosyncratic risk
Having looked at the overall business model and sector situation now it is time to see if this company could be considered high quality (as Orion describes itself).

Tenants seem to relatively concentrated (as could be expected when having only 92 properties). Although the industry the tenants are in do not seem to ring any alarm bells the 10.1% from GSA is noteworthy (General Services Administration, government organisation).


Orion investor presentation
Geographically Orion is partially located in what one would call growth markets (Dallas, Chicago), but due to its small amount of properties one should not expect much more diversification than this without reducing efficiency.

Orion investor presentation

Tenants seem decent quality, ABR per square foot is quite low (Simon Property Group, which owns malls collects ~$50 and also is in an industry in distress).

The company also presented some noteworthy numbers on rent collections:

The portfolio is cycle-tested. During the global pandemic, the portfolio averaged approximately 99% rent collections on a monthly basis from April 30, 2020 through June 30, 2021. The portfolio’s rent collection rate during the pandemic demonstrates the creditworthiness of the tenant base and our ability to continue to occupy these key office locations.
(Portfolio :: Orion Office REIT Inc. (ONL))

Balance sheet:
Orion notes:

  • Current low-leveraged balance sheet positioned to accomplish growth objectives

Realty Income did seem to have loaded some burdon on Orion with the special dividend and in-place debt repayment but Orion seems to be able to get access to more liquidy as well. I only see 10 million of cash and aside from that very limited numbers on the balance sheet.

Orion has not published a full on balance sheet on their site yet, which I would like to have before confirming their “low-leveraged balance sheet” statement I can not confirm, nor prove the statement wrong.

Management
Looking at management Realty Income seems to have taken all non office properties from VEREIT and unloaded VEREIT management at Orion.

So to asses VEREIT management I looked at their listed experience, no red flags there so I searched for historical prices for VEREIT to confirm that they had done decent when serving as management there. As VEREIT doesn’t exist anymore finding data proved a bit tedious so here’s a 5 year chart from Netcials:

Seems like VEREIT did decent so management does not seem like a large hurlde to shareholders here.

Valuation
Normally I would like to look at FFO numbers and projections and make an analysis based on that. Orion did not provide any FFO numbers, only total ABR (not even NAV was provided) so it is very difficult to make projections on that basis as there is just not enough data.

However, Realty Income did publish a document at the SEC (see sources) noting how much FFO the segments were generating before the acquisition and split.

Realty Income Office Segment:
image
AFFO CAGR 2018-2020: 1.47%
AFFO growth H1 2020 - H1 2021: -2.88%

VEREIT office segment:
image
AFFO CAGR 2018-2020: 1.71%
AFFO growth H1 2020 - H1 2021: -0.18%

Different methods can be used to value REITS, NAV valuation, DDM, relative comparison (multiples and cap rates) and DCF.

As the data available is very limited I will use DCF here using AFFO.

So using these numbers I will make some assumptions:

  • 2021 Reatly office AFFO will decrease 2.5% Y.o.Y.
  • 2021 VEREIT office AFFO will increase 1.0% Y.o.Y.
  • 2022 Realty office AFFO will decrease 1.0% Y.o.Y. and increase 1.0% the years after until 2025 (getting closer to their earlier CAGR)
  • 2022-2025 VEREIT office AFFO will increase 1.0% annually under their earlier CAGR.
  • Perpetuity AFFO growth of 0.5% annually for the entire company

This leads to the following numbers, Realty/VEREIT here only represent their respective office segments.

So discounting that at different rates to find the rate for which NPV is 0 results in a discount rate of approximately 1.17, so IRR of 17%.
image

This is an attractive IRR considering the tenants are not in high-risk sectors and if the balance sheet is low leveraged this would definitely be an interesting company. My estimates have been fairly conservative but even if the company basically does not grow (so rents stagnate and property prices as well) one would still expect a decent return.

Conclusion
Although its price has dropped by approximately 30% valuation is difficult due to uncertainty. The portfolio seems decent aside from low ABR per sq. ft. and the company seems to be discounted to such an extend that it is cheap based on no/very low growth expectations. If the company manages to grow or property prices increase this could be a very decent investment.

There isn’t enough data to confirm low leverage on its balance sheet.

Sources
JLL

VEREIT price chart

Orion Office REIT

SEC Realty income and VEREIT combined Office FFO
https://www.sec.gov/Archives/edgar/data/1873923/000110465921129247/tm2122336d12_ex99-1.htm

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Thanks for sharing @Etypsyno , I have looked into it separately and I think that the current valuation is very interesting.

Did you finally invest?

I got a couple of shares at 17.70, would consider buying more but am waiting for an update from the company.

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Update
Yesterday Orion came out with Q4 2021 results and they were disappointing to say the least. The quarter was a bit complex as October only consisted of Realty Income assets and from November to December the results included VEREIT assets as well. Due to this we have really only gotten about 2 months of data about Orion as a new company. Nonetheless I wanted to quickly discus the earnings report.

The numbers


Guidance for 2022 was also provided between $1.66 and $1.74 core FFO per share.
This leads to a 94 million to 99 million Core FFO range which was significantly below my (and analyst) expectations.

The quarter itself was bad but not terrible as a simple extrapolation of the numbers presented in the quarter (the Nov-Dec to a full quarter x4) would lead to a core FFO of 141 million (1.5x23.526x4), or even extrapolating the full quarter of which one month was without VEREIT assets leads to 107 million (26.806x4). Both below my expectations but still significantly above guidance given yesterday.

The earnings in the quarter themselves missed but that’s not the main issue here as it was a short quarter with many post spin off variables in it. The issue is that management issued guidance significantly under everyone’s expectations. If earnings would continue to be like the two months of income from the new company (Oct. still was only Realty and not merged yet with VEREIT) one wouldn’t be too disappointed but it seems that rent negotiations and lease extensions are expected to end up significantly decreasing FFO.

Management has noted in the earnings call that the focus was on getting the average lease term up and realigning the portfolio. Some properties would be sold while they are expanding through their JV. For the properties that they do decide to keep it could be necessary to make sizable one time investments to get the tenants to stay or keep the current rent levels.

If we keep the updated guidance in mind for FFO, the after hours drop and 4 years of annual 2% FFO declines (perpetuity 1% growth) I get to the following IRRs for the stock:
image

I significantly downgraded expectations in this newer model as the income achieved in 2020/2021 seems to be way higher than what we will see going forward. Its a bit tricky to make expectations just based on guidance, two months of full company data and the overall challenges they will face in a back to office/work from home year.

At close yesterday about 1.3% of my total portfolio was invested in Orion so its a significant position but looking at the numbers I will hold on and if results indeed do not hold up to Q4 2021 I will most likely sell out.

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