2023-06-15 08:11:07 ET
Summary
- Double-digit yield to maturities offer equity like return.
- Strong asset coverage and significant unencumbered property base makes refinancing likely.
- The firm's external manager will be highly motivated to avoid Chapter 11 as that would end their fee stream.
Office Properties Income Trust ( OPI ) is a real estate investment trust [REIT]. There are plenty of things to not like about the firm from the perspective of an equity investor. They recently announced a large dividend cut. They are managed by RMR Group ( RMR ) which means the fees they pay are relatively high, especially if their performance is good, which limits investor upside. They're pursuing a controversial merger with Diversified Healthcare Trust ( DHC ), which is also RMR managed. However, in my opinion none of that is disqualifying for an investment in their bonds.
The dividend cut is very welcome for fixed income investors, as every dollar that doesn't go out the door to the equity is available for debt repayment. Similarly, RMR isn't a huge concern because their fees are effectively junior to the debt - if the company ever defaults on its unsecured debt it will need to declare Chapter 11, resulting in the end of the fee stream. RMR would almost certainly want to prevent that. Finally, while the merger is probably a modest negative for the short-dated debt, I don't think it's especially significant, and given DHC shareholder opposition might not happen anyway.
Specific Bonds
I'm long the two shortest dated debt securities they have
- 4.25% due May 2024 (CUSIP 81618TAE0) at $93.68 with YTM 11.74%
- 4.5% due Feb 2025 (CUSIP 81618TAC4) at $86.50 with YTM 14.07%
The shorter term paper has a lower yield to maturity but comes with lower risk as it will be repaid sooner and is the first tranche due after their revolver, so they'll have the most options for that maturity. I own both, and think both are attractive.
Valuation/Ability to Pay
While I'm very much a trust-but-verify kind of guy for financial strength of fixed income investments, I do think mentioning the credit rating of the firm is appropriate here. Interestingly, they are split-rated. S&P has them at BB+, which is the highest rung below investment grade, whereas Moody's has them at Ba3, which is a couple of rungs down. Given the short time to maturity here I mostly expect to hold these to maturity, although I'd likely sell if the price bumps enough that the YTM is no longer attractive, which is only likely if they receive a ratings bump.
They have $2.461 billion worth of outstanding net debt, so the fundamental question here is will they be able to repay that.
With $83.7 MM of NOI in the most recent quarter that annualizes to $334.8 MM of cash basis NOI. They do have 24% of their rental income from leases that expire in either 2023 or 2024. That said, they have had reasonable success on extensions and re-leases recently, and occupancy has been mostly steady. Over 25% of their rent is from government tenants, which I think are less likely to move as they are generally already paying fairly low rental rates, and are often in specialized type buildings (e.g. the FBI isn't likely to move into vacant shared office space). I think it's reasonable to assume they'll be able to re-lease enough of the space that cash basis NOI won't decline by more than 12% (half of the income from expiries). In 2022 they were able to re-rent 89% of expiring space at an average positive spread to prior leases, even after significant costs of re-renting in the form of tenant allowances/free rent periods. So I think a 12% decline is relatively reasonable, which would imply $294.6 MM of cash NOI annually. That implies that buying the unsecured debt at par creates the company at a 12% capitalization rate, which I believe is reasonably attractive for these assets, especially considering that if they did go through Chapter 11 the directors would almost certainly need to reject the RMR management contract, so the assets would then be unencumbered by a management contract.
One big advantage of their unsecured debt is that there are no annual principal payments, unlike mortgages which generally require yearly principal pay down. With $103.5 MM in interest expenses last year, that is more than 2.5X cash NOI coverage of interest expenses. Interest expense should be fairly stable as the only maturity in 2023 is their floating rate credit facility (which they have the option to extend) and which is less than 10% of their outstanding debt.
Capitalization Structure
The biggest security blanket here is that the vast majority of their debt is unsecured, which means the vast majority of their buildings are unencumbered. If they aren't able to roll these bonds at maturity into new unsecured debt, they will absolutely be able to take out mortgages on properties to pay them back, and I think they'd prefer to do that as compared to defaulting. If they default, it's likely that the RMR contract would get cancelled as part of the chapter 11 process, so RMR has a big incentive for that not to happen, and they're the ones making the decisions on these matters.
That's the primary reason I like the near term debt here. They have nearly $4 billion in real estate at cost on their balance sheet, so it seems quite likely they'd be able to get $1.2 billion in mortgages to cover the 2023-2025 maturing unsecured debt if they needed to. While that is almost certainly not their preferred funding option, it is very likely to be open to them at some cost and I think they're prefer it to a bankruptcy filing. I also think it's likely they'll be able to fund the maturities (especially the 2024) with a mix of new unsecured debt and property sales, but even if that isn't the case I think this will end up being money good.
DHC Deal
The deal to buy DHC is probably a negative on credit quality, although not dramatically. Generally speaking I think DHC has better longer term assets but a worse near-term credit situation. DHC has $250 MM of unsecured notes due 2024 that would also have to be refinanced if they merge, but the combined company would have commensurately more unencumbered real estate so the thesis around a near-term refinancing being possible and in the interest of RMR still holds. All that said, I think it's at least possible that the DHC deal doesn't go through - shareholders have been strongly against it and DHC shares are trading well above the value of the merger consideration, so it isn't likely that they'd get a shareholder vote through at this time, which makes it somewhat moot.
Conclusion
With cash NOI comfortably covering the interest payments and asset value well in excess of the debt, I think the earliest maturities are very likely to be repaid in cash. With equity-like yield to maturities I think these are a reasonable place to put cash. Those who have a stronger opinion on the rebound of office space could go further out the maturity curve, as the longer paper also trades at elevated yields. That said, the longer debt is definitely more risky, as you're also taking interest rate risk there, and they have to survive for much longer for it to work out. Because the 2024 maturity is relatively small, I think it's unlikely they default on it unless things are dire.
For further details see:
Office Properties Income Trust Bonds Are Compelling