EQC - Equity Commonwealth: An Outperforming Office REIT With External Challenges

2023-05-25 22:57:02 ET

Summary

• Equity Commonwealth reported Q1 2023 financial results with a net income of $20.7 million, a significant improvement from a net loss of $0.7 million YoY.
• The office sector continues to grapple with challenges from the pandemic, despite signs of gradual recovery with increasing workplace attendance.
• Public office real estate investment trusts have reduced their net asset values by nearly 35% compared to pre-pandemic peak valuations.

Investment Thesis

Equity Commonwealth ( EQC ) is an office REIT company that has 4 properties in 3 states totaling 1.5 million square feet. Before the pandemic the company was successfully managing its property portfolio; however, since COVID-19 the office REIT space has met several challenges and these challenges affected EQC as well. Despite the pandemic, the office sector is slowly beginning to make a positive recovery. Companies that are running out of space because of expanding operations have been contributing to this growth. EQC stock is fairly valued compared to other office REITs but is still a risky choice in my opinion.

First Quarter Earnings Results

Equity Commonwealth reported Q1 2023 financial results with a net income of $20.7 million, a significant improvement from a net loss of $0.7 million YoY. The increase was largely due to higher average interest rates boosting interest income. Funds from Operations were $25.1 million or $0.22 per share, significantly up from $3.7 million or $0.03 per share in Q1 2022 and also up by 9.5% QoQ. Normalized FFO was $25.3 million or $0.23 per share, also up from the previous year. The company's cash balance stood at $2.1 billion as of March 31, 2023. The same property’s NOI decreased by 20.5% compared to Q1 2022. The leasing rate for the same property portfolio was 81.6%, and commenced occupancy was 77%. This might seem low compared to REITs that could achieve a 95%+ occupancy rate but investors should not mix retail, logistics, and office REITs. The office REIT space has been struggling since the pandemic and a record number of leases ended in 2022 nationwide.

2023 expectations

Management expects the interest income to keep growing in the second quarter as the Fed raised interest rates in May and there is a slight chance that they might raise in June as well. The previous interest rate increases led to interest income growth from $1.6 million in Q1 2022 to $28.4 million in Q1 2023. The interest income could peak during the summer and come down in 2024. The management is currently evaluating a wide range of investments across asset classes. Due to the challenges in the real estate credit markets, they are revisiting various sectors such as office space, while also considering sectors like industrial and single-family rentals (specifically build-to-rent). They are hopeful that these challenges may lead to compelling investment opportunities. EQC continues to actively manage its cash balance across multiple banks to minimize risk, maximize yield, and maintain daily liquidity. They have about $2.1 billion in cash and no debt, which provides them with significant financial flexibility. EQC is a stable and secure REIT based on its strong balance sheet.

Office sector

The office sector continues to grapple with challenges from the pandemic, despite signs of gradual recovery with increasing workplace attendance. Companies are cutting real estate costs, but stable employee numbers may necessitate expansion due to space shortages. Despite cost-cutting, providing high-quality office spaces remains crucial as it's a smaller expense compared to employee salaries. The recent market volatility in the capital markets has caused some distress, leading to a reset in office investments' valuations. This turbulence may offer investors an opportunity to invest in properties that fulfill the robust demand for high-quality and differentiated office spaces. The leasing activity was very interesting in 2022 partly due to the highest volume of lease expirations ever witnessed, with approximately 400 million square feet of expired leases across the country in 2022.

The peaking and eventual decline of interest rates will benefit office tenants and investors. Increases in financing costs have led to defensive actions such as layoffs and subleases. Despite high layoff announcements in the tech sector in 2022 and early 2023, the labor market remains strong with a low unemployment rate of 3.4% (April 2023). Office-using sectors are experiencing a softening labor market and increased layoffs. Leasing volume in the U.S. fell to 38.5 million square feet, a 9.8% decline against Q4 2020, but still 2% higher than the rolling 12-month volume. The average leasing volume was almost 60 million square feet before the pandemic and the current figures are at least 25-30% lower. The question is: will the office space ever recover or home office trends are taking over forever?

With the trend of remote work decreasing, businesses have stopped cutting back on office space which may lead to a shortage of space. Companies can reduce office costs by employing workplace strategy optimization and desk sharing as they adjust their portfolios. This way, staff reductions can be balanced with smaller workspace requirements. Although maximizing space in the workplace through this approach can be beneficial, it may negatively affect employee experience and impact the advantages of physical presence. This may limit its adoption in many cases. Because of the current labor shortage and rent costs that only take up 10-15% of payroll costs, businesses should focus on allocating more resources to invest in quality office spaces. This could help them attract and maintain talented employees.

Valuation

Public office real estate investment trusts have reduced their net asset values by nearly 35% compared to pre-pandemic peak valuations. Despite this, the trading prices of these REITs are much lower than their net asset values; with office REITs trading at an average discount of more than 50%. This is the lowest level seen in decades.

EQC is trading at 1x its book value so despite the big office REIT valuation declines the company could maintain its fair valuation. EQC was one of the few office REITs that outperformed its office REIT peers but I strongly think that is because of its portfolio size. There are many risks the company faces but the vast majority of them are external risks. The largest challenge is the imminent rise of home office and hybrid work.

Dividend

EQC has been paying a variable dividend for quite a while and the management intends to maintain this tradition. The management has already distributed a $4.25 per share special dividend in 2023. There might be a need for an additional small dividend to top up the $4.25 if it's necessary based on taxable income, but I do not expect any other dividend for 2023. The CEO says the same:

“We already distributed was an estimate of what we would need to distribute… I wouldn't expect a large special dividend.” - David Helfand - CEO

While they have not repurchased any shares year-to-date, they still have $120 million remaining in their share buyback authorization. It isn't clearly stated if they plan to utilize this authorization later in the year or not. I assume if the share price falls below its NAV the management might decide to repurchase some of its shares.

Summary

Despite the pandemic's challenges and the trend towards remote work, the office sector is showing signs of gradual recovery and companies are beginning to expand due to space shortages. The million-dollar question is if this recovery is only temporary or is it going to be permanent. As leasing volume dips and businesses shift strategies, maintaining quality office spaces remains vital for attracting talent, indicating that investors could find opportunities in properties that meet this high demand. EQC’s office position and portfolio are stable with a strong balance sheet. At the moment I believe that the whole office REIT sector is risky, however, risk-taking investors might be able to earn a substantial profit if buying office REITs and EQC at these low valuations.

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