City Office Is Truly An ‘Outlier’ Worth Owning

I just finished the content for the upcoming edition of the Forbes Real Estate Investor newsletter and I have been pleased with several of the picks in my Small Cap REIT Portfolio. Notably, Hannon Armstrong (HASI), Preferred Apartment (APTS), and Community Healthcare (CHCT) have all generated strong returns year-to-date.

There are now 18 REITs in the Small Cap REIT Portfolio and my goal is to hold at least 20 names, in hopes of maintaining optimized diversification to mitigate the volatility risk associated with the smaller investor base of these individual stocks.

Given the higher risk profile associated with the Small Cap REITs, it stands to reason that the Small Cap REIT Portfolio should generate higher returns. However, so far this year, my top performing portfolio is the Durable Income Portfolio, that now includes 39 REITs.

As I was studying the results of the Small Cap Portfolio I ran across one REIT that seems to be an outlier. Here’s how the author of “The Outlier”, Malcomb Gladwell, explains the word “outlier”.

“Outlier” is a scientific term to describe things or phenomena that lie outside normal experience. In the summer, in Paris, we expect most days to be somewhere between warm and very hot. But imagine if you had a day in the middle of August where the temperature fell below freezing. That day would be outlier. And while we have a very good understanding of why summer days in Paris are warm or hot, we know a good deal less about why a summer day in Paris might be freezing cold. In this book I’m interested in people who are outliers—in men and women who, for one reason or another, are so accomplished and so extraordinary and so outside of ordinary experience that they are as puzzling to the rest of us as a cold day in August.”

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City Office Is Truly An ‘Outlier’ Worth Owning

My first article on City Office REIT (CIO) was back in June 2016 and I summed up the small cap REIT as follows,

“As CIO continues to grow, we believe the diversification will enhance the safety of the dividend and the company will be able to generate dividend growth. The quality of CIO's revenue appears strong, and we like the fact that management has internalized operations, further suggesting an alignment of interest.”I decided to initiate coverage of CIO with a BUY rating and I warned that “our initial investment in CIO will be of modest proportions.”

As you can see, shares in CIO took off when I published my article (in June 2016), but since that time, the stock has been trading around $12.50/share.CIO was formed on November 26, 2013, to acquire, own, and operate high-quality office properties located within its specified markets in the United States. Based in Vancouver, Canada, CIO listed on the NYSE on April 11, 2014 (over three years ago), by raising ~$82 million at a price of $12.50 per share. It is the smallest office REIT in our research lab, with a market cap of around $378 million.

CIO has grown from 14 properties (3.3 million square feet) to 19 (includes 36 buildings). The properties are located in Seattle, Portland, Boise, Phoenix, Salt Lake City, Denver, Dallas, San Antonio, Austin, Houston, Tampa, and Orlando. The company invests in high-quality office properties in mid-sized metropolitan areas

with strong economic fundamentals, primarily in the Southern and Western United States.All of the properties owned by the REIT generate annual NOI of just $86.1 million. The company focuses on assets valued at $25-100 million with targeted cap rates of 7-8%. CIO does not have as much competition for these assets and this is a competitive advantage.

I’m not a big fan of traditional office REITs as I favor the more stable medical office building REITs like Healthcare Trust of America (NYSE:HTA) and Physicians Realty Trust (NYSE:DOC). However, I do like the favorable job growth that will ultimately lead to better credit quality and attractive rent growth.

Population growth is the real driver, and as illustrated below, CIO is focused on markets with strong economic fundamentals and demographics.CIO’s strategy is to produce attractive returns through a focused acquisition strategy and increasing property cash flows. If you like STAG Industrial(STAG), you will like CIO.Similar to STAG (although Stag is Industrial), CIO invests in “secondary markets” with less competition from larger institutional investors. Local real estate operators lack the capital to compete and the outsized population and employment growth are strong catalysts. CIO same store cash NOI growth for the first six months of 2017 was 9.1%, as compared to the first six months of 2016.

These secondary markets are supply-constrained and this means CIO benefits from high credit tenancy, below market in-place rents and acquisition prices below replacement cost. The company leverages local property manager relationships to source acquisition opportunities and efficiently operate.CIO is under contract to close a large portfolio in San Diego and after that closes the company will have over $1 Billion in real estate assets. VIO has increased net rentable square footage to 4.4 million from 1.9 million at IPO, operating revenue has increased to $90.6 million from $32.6 million at IPO, and it has increased average annualized base rent/SF to $21.85 from $17.95 at IPO.

The above-referenced San Diego portfolio includes a ten-building portfolio with a purchase price of $174.5 million. The portfolio includes 680,000 SF plus a land parcel and the portfolio is anticipated to generate a pro forma net operating income yield of approximately 7.4%.

San Diego is one of the most physically constrained markets in the US, only 300,000 SF of office under construction as of Q2-17. Post-recession low in office vacancy at 11.0% and Q2-17 rents increased 4.3% YoY with 1.3 million SF of positive net absorption in 2016.

CIO has waived the due diligence conditions for the San Diego portfolio and posted a $10 million nonrefundable deposit. The closing is scheduled to occur at the end of September, subject to typical closing conditions. Due to a confidentiality provision, CIO is unable to provide further details until this transaction has closed.

The Balance Sheet

During the quarter, CIO launched an ATM program through which it may make placements of its common stock and Series A preferred stock from time to time. The program was put in place to provide greater strategic optionality in accessing capital. No stock was issued under the program during Q2-17.

CIO has continued to see attractive terms for debt, during the quarter the company closed on two property level financings, which further increased liquidity. Both financings were long-term, fixed rate debt, with a weighted average interest rate of 3.8%.

At June 30 CIO had cash of $68.1 million and $24.0 million in restricted cash. It expects to put that cash to work in Q3-17 to partially finance the San Diego portfolio acquisition with the balance coming from a combination of line of credit and property specific debt on a portion of that portfolio.

If the San Diego portfolio closes, CIO would have the remaining capacity to close another small acquisition and will have additional dry powder once the Washington Group Plaza sale closes.

CIO’s total debt (net of deferred financing cost) at June 30 was $411.1 million or $402.2 million when deducting the non-controlling interest share of certain indebtedness. All of the debt is fixed rate as of quarter end. CIO’s net debt to enterprise value is 40.4%

Dividend Coverage Looks Promising

CIO believes that acquiring well-located real estate in secondary markets provides a high rate of return for investors over the long-term. On the Q2-17 earnings call, CIO’s CEO, _____________, explains,

“Recent industry data indicates that over the last 5 years, REIT holdings in secondary markets have increased at an average annual rate of 10%, while REIT holdings in gateway markets were essentially unchanged.

This trend has resulted in more capital pursuing real estate in our markets and in some cases increased sale price expectation from sellers and brokers. As demonstrated by the sale of two buildings at our AmberGlen property this past quarter and our pending Boise property sale, we have been able to opportunistically harvest value as well.

In the case of AmberGlen, we generated a net gain of $9.2 million for our 76% ownership stake. These are good examples, but we believe the rising valuation trends also apply to the rest of our portfolio.”

In Q2-17 CIO’s net operating income was $14.5 million. This represents a $1.3 million decrease over the $15.8 million achieved in Q1-17 The decrease is primarily a result of the disposition of two buildings at the AmberGlen property during the second quarter and a decrease in average occupancy at Florida Research Park collection and Plaza 25.

CIO also reported core FFO of $6.4 million or $0.21 per share. The core FFO ended the quarter $1.4 million lower than Q1, primarily due to the same reasons described.

CIO’s Q2-17 AFFO was $5.3 million or $0.17 per share. Most importantly, CIO expects to return to full dividend coverage on an AFFO basis in Q4-17 if the San Diego portfolio acquisition closes as expected at the end of the third quarter.

As you can see, CIO’s annualized dividend is $.94/share. Also, as you can see, CIO’s forecasted AFFO/share growth in 2018 is 21%.

Also in Q2-17 CIO reiterated its prior guidance and the company anticipates the Q4-17 run rate for core FFO to be in the range of approximately $0.29 to $0.31 per share. That assumes the San Diego portfolio acquisition closes late in the third quarter and assumes no additional capital raising.

Based on these assumptions CIO guided its 2017 annual core FFO to between $0.96 and $0.99 per share for the full year ending December 31, 2017.

City Office is Poised to Profit

CIO’s dividend is higher than the peers:

CIO is trading well below the peer average (based on P/FFO):

Approximately 54.5% of CIO’s base rental revenue is derived from tenants that are government agencies, investment grade companies or their subsidiaries. The Portfolio in-place occupancy is 90.1%. Here’s a snapshot of the company’s top tenants:

CIO enjoys a stable, long-term tenancy profile with well-staggered expirations (5.3 year weighted average remaining lease term). CIO targets retention of 70% to 75%.

CIO’s management team has an average of over 20 years of experience with over $1.8 billion of real estate acquisitions since 2011. The company Internalized the management team in February 2016. Furthermore, the management and board of directors own over 8% of the shares.

In conclusion: CIO is a true outlier and I believe that this REIT is well-positioned to grow AFFO/share (and eventually dividends). I am upgrading shares from a BUY to a STRONG BUY. Also, CIO makes the cut for my “High Alpha REIT” portfolio….