- City Office is one of our New Money portfolio picks.
- I am becoming more convinced that the company is a gem to own.
- We are maintaining our STRONG BUY recommendation and we believe that as CIO’s dividend becomes safer (payout ratio under 100%) and the valuation gap should tighten.
“…bargains are sometimes inexpensive because they have no shelf space…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.”
Recognizing shares were cheap, I made a “modest” investment in CIO shares, hoping to build confidence over a few quarters of results. Then in February 2018 CIO shares took a nose dive, and I subsequently increased my exposure, as I explained:
“The lack of Wall Street coverage and investor interest can result in shares remaining undervalued - especially in down markets - for extended periods of time. I purposely designed my Small Cap REIT portfolio with a clear mission of reducing volatility (through diversification) and to generate better than average risk-adjusted returns. I decided to upgraded CIO to a STRONG BUY suggesting that “investors could see outsized returns”.
As my newsletter (Forbes Real Estate) subscribers know, “we added a new portfolio in May 2018 consisting of only STRONG BUY picks. Recognizing that the portfolio is designed for deeply-discounted REITs, we are targeting annualized returns of 25% or greater.”
The top performers in June were Kimco Realty (NYSE:KIM), with a total return of 14.1%, Brixmor Property Group (NYSE:BRX), gaining 14.0%, Tanger Factory Outlet Centers (NYSE:SKT), up 12.4% and Kite Realty Group (NYSE:KRG), returning 10.7%. Their performance helped to boost the portfolio results for the month—gaining 4.6% in June.
City Office is one of our New Money portfolio picks and this means that we are monitoring shares closely in hopes of owning this outlier, betting that shares could return 25% in 12 months. Since inception, the New Money Portfolio has returned 10.9%, on target to achieve our targeted results, and hopefully City Office will deliver the goods.
The City Office Story
City Office 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 one of the smallest office REITs in our research lab, with a market cap of around $420 million and total enterprise value of $934 million.
CIO has grown from 14 properties (3.3 million square feet) to 46. The properties are located in San Diego, 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.
City Office 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. The company leverages local property manager relationships to source acquisition opportunities and efficiently operate.
The company'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.
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.
In terms of acquisitions, CIO maintains a very robust pipeline of over $700 million and is evaluating a few portfolio opportunities.
Subsequent to quarter end, CIO acquired Pima Center, a 272,000 square foot, two-building complex located in the Scottsdale submarket of Phoenix. As CIO’s CEO explained on the recent earnings call:
We are excited to add Scottsdale to our portfolio, a submarket known for its desirable amenity base, highly developed workforce, executive housing options, and the largest concentration of Class A office space in the region.”
Pima Center is 99% leased and is situated on a favorable ground lease, with over 70 years of remaining term. The pool of potential buyers for the property was thin, due to the protracted marketing process, asset size (below $100 million) and the ground lease, despite seven years of remaining term. These favorable dynamics helped produce an attractive 8.3% year one cash cap rate.
CIO previously provided guidance of total property acquisitions of between $210 million and $240 million for 2018. After the $56.5 million acquisition of Pima Center, CIO is targeting another $155 million to $185 million in acquisitions and based on the current pipeline, CIO expects to deploy that capital by the end of Q3-18.
Proven Value Creation
Including the San Diego portfolio acquisition that closed in 2017 and more recent Scottsdale transaction, CIO has been able to achieve economies of scale with G&A costs, property operational costs and third-party vendors.
CIO’s acquisition strategy has concentrated on some of the fastest growing markets across the country. Industry projections indicate that these cities will continue to perform well, with healthy employment growth and limited competition from new development.
Over 45% of CIO’s base rental revenue is derived from tenants that are government agencies, investment grade companies or their subsidiaries:
Rents in these markets continue to grow, and CIO estimates that its in-place rents are approximately 5% to 10% below current market levels. This spread, as well as the embedded 2.5% average contractual rent increases over the next 3 years, sets up the company for continued NOI growth.
CIO’s continued focus has been to push out-lease terms, with high credit tenants, reinvest in buildings to elevate their market position and find creative ways to unlock value at the properties.
During Q1-18, CIO executed 130,000 square feet of new and renewal leases, and despite the move-out of a 44,000-square foot tenant at the Sorrento Mesa property, which was expected in acquisition, occupancy increased 60 basis points quarter-over-quarter to 88.3%.
CIO’s focus continues to be on driving occupancy across the portfolio, which will lead to higher property-level NOI. CIO guided targeted occupancy at between 90% and 93% by year-end 2018.
The Balance Sheet
CIO’s strategy over the past four years has been to lock in long-term fixed rate debt. As of Q1-18, fixed rate debt represented 100% of total debt, with the weighted average interest rate of 4.2% and a weighted average maturity of 6.8 years.
During the quarter, CIO replaced its secured credit facility, with a new unsecured credit facility. The new facility was undrawn at quarter-end, and is authorized for up to $250 million, a $100 million increase over the old facility. CIO’s total debt, net of differed financing costs at March 31, was $421.8 million and the net debt-to-enterprise value was 42.9%.
Through capital raises and an expanding shareholder base, CIO has improved the liquidity of the common shares. With these initiatives, the company is well-positioned to grow efficiently and flexibly, and benefit from increasing economies of scale.
The Latest Earnings Results
Over the past four years, CIO has recycled around one-third of its initial properties and generated over $70 million in gains from an (initial) portfolio of about $300 million. The remaining properties in that initial portfolio have seen in place annualized base rent increase by 23% in four years.
This speaks to the strength of the markets CIO has selected and the success in negotiating favorable lease terms through active asset management. CIO is Internally Managed.
In Q1-18 and on a GAAP basis, CIO’s net operating income was $19.9 million. This represents a $0.6 million increase over the $19.3 million achieved in Q4-17. The increase was the result of a combination of a couple of offsetting factors; NOI increase due to the impact of a full quarter of income from the Papago Tech acquisition, and a further increase in termination fee income received at the Sorrento Mesa property.
These increases were offset by the disposition of CIO’s Washington Group Plaza property at the beginning of March 2018, which resulted in a $47 million gain.
Also in Q1-18, CIO reported core FFO of $10.3 million or $0.28 per share. The company’s core FFO ended the quarter $0.7 million higher than Q4-17, primarily due to the same reasons described above.
Note that CIO expects that NOI and FFO will be lower in the second quarter, due to the disposition of WGP and the reduction in termination fee income, which together, contributed $1.8 million of NOI in Q1-18. This decrease will be partially offset by NOI from the acquisition of Pima Center, which occurred at the beginning of Q2-18.
CIO’s Q1-18 AFFO was $6.7 million, or $0.18 per share. Due to the relative size of the portfolio and the impact of significant leasing in any one quarter, CIO’s AFFO numbers will continue to move around some, from quarter to quarter.
For the remainder of 2018, CIO continues to track its previously issued guidance and believes that the assumptions underlying guidance remain intact at this time. As noted above, CIO expects that the dividend will be covered on an AFFO basis in Q4-18.
Why the Strong Buy?
First, let’s examine the dividend yield:
As you can see, CIO has an attractive 7.2% dividend yield, and the company has generated a steady quarterly payment of $.235 per share:
As referenced, CIO’s dividend is $.235 per share and the company generated $.18 per share in Q1-18; however, the company expects it will cover the dividend (by AFFO) in Q4-18. The next chart is important:
Based on analyst estimates, CIO will not only be able to cover the dividend in Q4-18, but it will likely reduce the payout ratio in 2019. This should allow the company to close the valuation gap, as viewed below:
I’ll be the first to admit, I was a little bit early with City Office (first article back in June 2016), but as I have been tracking this small cap REIT, I am becoming more convinced that the company is a gem to own. A few others agree with me, notably Dane Bower, who said
“CIO’s market price is held down by perceptions of an unsustainable dividend. A combination of growth and AFFO catching up to FFO can cure this ailment and unlock multiple expansion. We see a fair value of $14 with potential for realization by the end of 2018.”
In closing: We are maintaining our STRONG BUY recommendation and we believe that as CIO’s dividend becomes safer (payout ratio under 100%), the valuation gap should tighten, providing investors with an attractive total return thesis. Also note, there’s substantial insider ownership:
All Strong Buy picks can be viewed in my Marketplace service (The Intelligent REIT Investor). We recently announced our first subscriber-only call with Brad Thomas. Join Brad every Friday at 2:00 PM ET. Subscribe Now.
Note: Brad Thomas is a Wall Street writer, and that means he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos, and be assured that he will do his best to correct any errors if they are overlooked.
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Sources: FAST Graph and CIO Investor Presentation.
This article was written by
Brad Thomas is the CEO of Wide Moat Research ("WMR"), a subscription-based publisher of financial information, serving over 175,000 investors around the world. WMR has a team of experienced multi-disciplined analysts covering all dividend categories, including REITs, MLPs, BDCs, and traditional C-Corps.
Thomas has also been featured in Barron's, Forbes Magazine, Kiplinger’s, US News & World Report, Money, NPR, Institutional Investor, GlobeStreet, CNN, Newsmax, and Fox.
He is the #1 contributing analyst on Seeking Alpha in 2014, 2015, 2016, 2017, 2018, 2019, 2020, 2021, 2022 and 2023 (based on page views) and has over 111,000 followers (on Seeking Alpha). Thomas is also the author of The Intelligent REIT Investor Guide (Wiley) and is writing a new book, REITs For Dummies (Wiley/Amazon).Thomas received a Bachelor of Science degree in Business/Economics from Presbyterian College, and he is married with 5 wonderful kids. He has over 30 years of real estate investing experience and is one of the most prolific writers on Seeking Alpha. To learn more about Brad visit HERE.
Analyst’s Disclosure: I am/we are long ACC, AVB, BHR, BPY, BRX, BXMT, CCI, CHCT, CIO, CLDT, CONE, CORR, CTRE, CUBE, DEA, DLR, DOC, EPR, EQIX, EXR, FRT, GEO, GMRE, GPT, HASI, HT, HTA, INN, IRET, IRM, JCAP, KIM, KRG, LADR, LAND, LMRK, LTC, MNR, NNN, NXRT, O, OFC, OHI, OUT, PEB, PEI, PK, PSB, PTTTS, QTS, REG, RHP, ROIC, SBRA, SKT, SPG, STAG, STOR, TCO, TRTX, UBA, UMH, UNIT, VER, VNO, VNQ, VTR, WPC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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