ONL - Orion Office REIT: A Speculative Buy Once The Selling Pressure Subsides

2023-10-16 15:16:58 ET

Summary

• Orion Office REIT Inc. is a new company formed from the office properties of Realty Income and VEREIT.
• The office sector is currently out of favor, but the need for office spaces will likely increase in the future.
• The stock price has been dropping, but spinoffs tend to outperform the market over time and the company has potential for long-term success.
• A conservative balance sheet and management experience should get the company through the near-term challenges.
• This speculative idea needs to wait until the selling pressure subsides.  It does look like the selling is almost done.

To buy or not to buy, that is the question. If the answer is buy, then a strategy is needed. Orion Office REIT Inc. ( ONL ) is a brand new company that first existed as a public company during the fourth quarter of 2021 . Normally, companies without a five-year public history can be considered speculative. But this company has the proven leadership of the previous management of VEREIT that Realty Income Corporation ( O ) acquired. Basically, Realty income kept everything but the office part of the acquisition, while spinning off the office properties held by both companies into the new company. This NYSE-listed company is probably worth a look because management is unusually experienced at guiding a public company - and successfully sold the last one to a company of the stature of Realty Income.

Mr. Market is not a big fan of office properties right now. But some people have to come to work every day to get their jobs done. Not everyone can work from home. As the population continues to grow, the need for at least some people to commute to work every day will rise. That means the currently out of favor office sector will likely come back into favor in the future.

Stock Price Action

The stock price has been "dropping like a brick," which has scared many investors away. Obviously, those that sold at the spinoff are very likely glad they did. But the rout has continued. What is unanswered is whether the chart below indicates that the pressure on the stock price is abating, which is what it looks like; or is the stock just taking a breather before the next leg down?

Historically, spinoffs tend to outperform the market over time. However, the real estate investment trust, or REIT, sector in particular has had a number of failures in a row that seem to indicate at least a temporary exception to history. This was particularly true in fiscal year 2020, when things took an unexpectedly grim turn for a lot of businesses.

The chart above clearly shows that a rout is underway. Like any other time Mr. Market gets going, it is best in the immediate term to let something like this run its course.

But long term, the question of the ability of the company to survive and even thrive is on the table. Obviously, Mr. Market is voting (with both feet) for a failure. But, if Realty Income spun this off, the reputation could be damaged by an eventual subsidiary reorganization after a spinoff. Especially if such an event happened sooner rather than later. It can affect a later spinoff if that prospect arises.

Even if the company struggled for years, and then finally "gave up the ghost" either through being acquired or any other solution, that would probably not look good.

Realty Income, to its credit, did isolate these assets (and get them out of the company portfolio) and was able to continue the steady dividend progress and growth. The hope of course is for a better stock price performance when the Realty Income stock gets out of the "doghouse" that Mr. Market put the stock price in. Clearly, these office building assets are not perceived to be the best in the industry. But that can change.

Risks

This market is clearly seeing some negative viewpoints and not giving management much credit for being able to resolve the issues despite the experience of management.

Clearly there is some worry about all the renewals that need to happen in fiscal year 2025 considering the conditions right now. That is very clearly a lot of business that needs to be successfully concluded.

The success of maintaining a high occupancy rate is very dependent upon location and management flexibility to tenant needs.

Location

On the other hand, the company has clearly located several growth areas. This may mean that even areas that are not obviously growth areas to the average investor may be well located in states like New York, for example.

Management further emphasizes mission critical locations and companies that lease the properties. The results so far appear to bear out what management is stating. However, the lack of a public track record is likely to make the stock very volatile (especially downward) to provide a potential bargain opportunity for those that believe in both the superior locations aspect as well as the mission critical part.

The fact that Realty Income spun off these assets may at least demonstrate that management believed that the market could care less about mission critical and superior locations for the time being. It may be a more substantial belief than that. Against that, you have a very experienced management willing to guide the new company.

Debt

In addition to the worries about all those leases expiring, there is the worry about refinancing the debt. Based upon the stock price action shown above, it looks as though the market is just worrying "itself to death" over these two issues.

Most investors are worried about having to roll over any (to maybe all) of the debt in a higher interest rate environment. This is where the ability to recover increased costs through a higher lease payment in the future is essential. Clearly, the market does not have much faith in the whole process.

What is in the company's favor is the conservative balance sheet. Equity, shown above is 40% while mortgages come in below that. It very much helps to have low debt levels at a time of higher interest rates. 100% of the value produces the income while the expense (mortgage) is on considerably less than that. Given that overall picture, I like the chances of the company remaining profitable even in periods of higher interest rates.

One of the things not considered by the market is that long term rates often come down as the market sees inflation threats waning. Clearly inflation has come down even if it is stubborn at low levels. But this has the potential for an inverted yield curve that could allow for longer term refinancing close to current levels even if short-term rates remain high.

The downside is that an inverted yield curve, if it persists, can be a forerunner of a recession. The good news is that recessions do not usually last very long and are not as bad as crisis like the 2008 downturn.

Nonetheless, until both the expiring leases and the debt refinancing are accomplished, Mr. Market is likely to keep the stock in the doghouse.

Key Ideas

One thing to consider here is that the whole sector may be in the market doghouse until further notice. A stock like Realty Income should outperform the industry due to the company reputation for consistency and the high credit rating.

Clearly it can be seen above where the stock price has dropped roughly 20% from the recent high points. If a stock like Realty Income is going to fall, then a relatively new company like Orion Office will likely fall more due to the lack of public company history.

Management quality and property location will not matter. The newness of the company is likely to be dumped into "the new issues" box and thrown out with other perceived speculative issues.

Therefore, some patience is required. Might as well allow the "sell" freight train to run its course because clearly a lot of people want out and the selling pressure has really not subsided completely just yet. But there will come a time when the stock does not respond to "bad news" to signal a coming stock price recovery.

For Orion Office, it is probably time to do the due diligence. Anytime one sees a conservative debt load, that company is likely to have as many chances as it needs to succeed. The only way this is a failure that the market is predicting is if the occupancy rate becomes so low in all the office buildings that the debt becomes a sustained onerous burden. The diversification alone should mitigate that issue. Good management should further mitigate the issue. Even with all the lease expirations in 2025 that does not appear to be a problem.

What may be an issue is all the debt due in less than five years. The challenge will be for management to keep the profit spread through something like that if high interest rates are an issue in the refinance.

Clearly, this issue is higher risk than many issues I cover. But the management experience, at least to me, makes Orion Office REIT Inc. worth a look. The price is heading into territory where only the worst is expected. So only investors that can handle that risk should consider it. But after the research is done, Orion Office REIT Inc. stock is likely to be a speculative buy based upon the management experience and low debt levels to get through the coming challenges. I would also wait until all that selling pressure runs its course.

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