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Select Income REIT (SIR) is a small-cap office REIT that has most of its properties concentrated in the Hawaiian region. The stock offers a handsome and sustainable dividend yield of 6.8%, backed by sufficient funds from operations (FFO). The company has just announced a quarterly dividend hike of 5%. The stock has attractive valuations, and the improvement in the U.S. office rental and vacancy rates has the potential to grow the company's turnover in the coming quarters. Therefore, we recommend our income-orientated investors to go long the stock and reap the benefits of the company's strong dividend yield.

Company Overview

Select Income REIT operates as a property REIT in the U.S. office REITs industry with a market cap of $770 million. The company primarily invests in properties that are net leased to single tenants. The company has a large concentration of properties in the Hawaiian region, with almost 66% of the revenues coming from the 228 properties in the region at the end of the most recent quarter. At the end of the second quarter of the current year, the company owned 253 properties in 16 different states. Around 85% of the company's revenues come from rental income, while the rest come from tenant reimbursements and other income.

Most Recent Quarter's Performance

Total revenues of $27.9 million, which the company generated during the second quarter of the current year, were 2.5% above the turnover that the company generated during the second quarter of the previous year. Much of the surge in rental income was associated to a modest year-over-year improvement in rental income.

Rental income of $23.7 million, which the company generated during the second quarter of the current year, surged by 2.8% over the same quarter of the previous year. The acquisition of two new properties during the month of June 2012 was the reason for such the moderate surge in rental income. Tenant reimbursements and other income witnessed a modest 1% increase year over year, reflecting the acquisition of the two properties.

While the turnover surged 2.5%, expense surged by over 15% when compared to the same quarter of the previous year. Much of the surge was associated to other operating expenses and depreciation and amortization.

The surge in operating expenses led the 4.6% decline in operating income from 17.7 million to $16.9 million. The impact of this surge in operating expense, combined with interest expense of $1.6 million for the second quarter, resulted in a 13.5% decline in the bottom line when compared to the same quarter of the previous year.

FFO, the appropriate measure of cash generation, declined during the second quarter of the current year as compared to second quarter of the last year. The company generated FFO of $18.4 million or $0.59 per share against $20.4 million during the same quarter of the last year.

Dividend

The company paid a $0.49 per common share for one complete quarter, and an additional 20 days for which the company remained listed. However, the company announced a hike in the quarterly dividend distribution from $0.40 per share to $0.42 per share. This makes the new dividend yield to be 6.8%, as compared to the 1.75% yield offered by 10-year treasuries. The dividend distribution is well backed by an FFO yield of 9.5%, reflecting the fact that the company has enough financial muscle to continue the dividend distribution.

Outlook

During the third quarter of the current year, rents for commercial real estate, including offices, surged, offering hope to the office REITs industry in general and Select Income REIT in particular. Average asking rents increased to $28.23 per square foot from $28.17 per square foot in the linked quarter. Office vacancy rates in the U.S. fell to their lowest level since the past three years. By the end of September this year, around 17.1% of U.S. office space remained empty, against 17.4% empty space a year ago and 17.2% at the end of the second quarter of the current year. Since the company earns a majority of the income through rental income, Select Income REIT is bound to benefit from this improvement in the coming quarters.

Valuations

Select Income REIT is attractively valued when compared to most of its peers in the U.S. office industry. The stock of Select Income REIT trades at a FFO yield of 9.5%, against a 6.8% FFO yield for Liberty Property Trust (LRY). Liberty Property Trust is a similar office REIT; however, it has a much larger market cap.

Source: Buy Select Income REIT For A Safe 6.8% Dividend Yield, Declining Vacancy Rates