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HRPT Properties Trust (HRP), an office and industrial properties REIT reported its fiscal 2009 and 4Q09 results last week.


Source: Gridstone Research

For the fourth quarter 0f 2009, operating income declined by ~50% YOY to $30.3 million while net income declined to a loss of $(10.3M) from a profit of $63 M in the year-ago period. Excluding asset impairment charges of $31.9M in 4Q09, reported operating income declined by 3% to $62 M. However the impairment charges are related to the less than 40% occupancy in eight properties (with some having even zero occupancy). So it is only fair that the impairment charges also knock off the operating profits and reduce margins as such low leasing activity and occupancy risks are an integral part of the company's operations.

The question is if we could have more of such impairments considering that the office and industrial property leasing market is weak across all regions in the U.S. This at a time when occupancy rates are at the lowest levels of the past seven years.

Occupancies Are At Seven Year Lows

(Click to view enlarged image)

Source: Gridstone Research

HRPT's CFO, John Popeo has projected a further 100-150 bps decline in occupancy figures in 2010 in HRPT's recent earnings call. (Read full transcript here). This projection also seems a bit too optimistic as the company will be renegotiating or entering into new leases for an area of ~6 Mn sq.ft of the total lease expirations expected of ~7.7 million sq.ft

...We’re currently projecting around two thirds renewals versus one third new leases for 2010. We do expect roughly two million square feet of the 2010 expirations, situations where tenants will actually leave, where we’ve actually gotten notice that tenants will leave but when all is said and done, when you take into account new and renewed leasing of over six million square feet still results as around 100 to 150 basis point decline in occupancy to somewhere around 86.5%...

In 2009, HRPT had lease expirations for 6.6 Mn sq.ft and was able to sign leases for 4.7 Mn sq.ft only. Therefore the occupancy projections seem to have built in a much better leasing activity in 2010. Interestingly, while renewals constituted 68% of signed leases in 2009 and 83% in 4Q09, management expectations factor in only a 66% renewal share. Clearly the projections are based on a noticeable pick-up in new leases while that has not been observed even in the latest quarter.

HRPT has also spent $615M in 2009 to acquire new properties as management believed that these properties were offered at attractive cap rates of 10%. Since then, cap rates have been squeezed to 9% or lower. (Source: 4Q09 Earnings Call). These properties also helped boost company-level occupancies as the acquisitions had an occupancy of ~98%, far above the company average of 90.4% as of December 2008.

A repeat of this in 2010 is unlikely as management has indicated that it would go slow on property acquisitions in 2010 with the decline in cap rates. Therefore occupancies could be much lower than company expectations in 2010 as the organic decline in 2009 is much worse than the 300 bps decline in overall occupancy in 2009.

Maintenance Capex Could Offset Any NOI Increase

REITS also use property Net Operating Income [NOI] as an important performance measure. I thought that it would be good to observe the NOI trend over the last seven years and see how it has changed as new properties have been added and HRPT nearly doubled its total properties and area available for leasing.

Property NOI and NOI as % of Real Estate Assets

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Source: Gridstone Research

Since property NOI includes only property-related operating expenses and excludes D&A, it gives an idea of how much profits the leasing activity brings, net of regular upkeep costs. As seen from table above, property NOI has been relatively stagnant in the last three years in the range of $480-495M. Since the gross block of real estate assets has also not increased significantly in the last two years, the yields(NOI/ Asset Book Values) have remained constant at the gross and net levels. This could also explain why HRPT was aggressive in acquiring assets in 2009. It wanted to keep property NOI from falling and probably show investors that NOI and NOI as % of assets have held up pretty well under adverse market conditions.

The bigger risk of this strategy is that if occupancy levels fall even more than expected, that could trigger additional impairment charges and also lead to pressure on realized rents. HRPT's Property, Plant and Equipment [PP&E] spend as a % of gross block has been ~1-7% in the last three years. This seems quite low and therefore the free cash flow (FFO) could be impacted in the next couple of years as the PP&E spend plays catch up in 2010/11. Even if HRPT acquires no new properties, a normal maintenance capex of ~7% can be expected to reduce free cash flows as occupancies and realized rents decline in the face of continued weakness in leasing activity.

With the job market showing no signs of improvement, it looks unlikely that leasing activity will stabilize even in the second half of 2010 as HRPT expects (Source: Earnings call).

Unless HRPT expands its operations to international locations, there is little evidence that it can be a growth stock. Revenues and profits are more likely to grow in single digits unless the operating model evolves into a much more leaner and efficient model. As the operating margins trend below shows, they have seen a continual decline as the company has grown. This does question the validity of HRPT's business model in the current business environment.

One issue could be that HRPT has too many properties to manage(~520) and too many clients and that is probably leading to inefficiencies. HRPT's top 10 clients contribute less than 20% of the rent revenue. The U.S. government and its agencies are HRPT's top tenant and it is unlikely that the REIT is going to see increased space absorption from its largest tenant. A smaller client base and count properties would properly be better for HRPT in the medium-term.

Debt Burden Is Light But Valuations Seem Expensive


(Click to view enlarged image)

Source: Gridstone Research

In summary, HRPT has no debt-related concerns as of now but 2010 cash flows could be impacted by weak leasing activity and a possible increase in maintenance capex. The management expectations of a stable leasing market in the second half of 2010 also seems too optimistic.

Disclosure: No positions

Source: HRPT Properties: Overly Optimistic Guidance?