03/27/22 05:00 PM EDT

SUNDAY NIGHT REIT READ | 3.27.22 | (CXW, INVH, ONL, WE))

Rob Simone, CFA

@HedgeyeREITs

Takeaway: Hope everyone enjoyed the weekend! Adding CXW to Long Bench

Was a little under the weather last week, returning to more regular publishing this week.

Cartoon of the Weekend: U(UP)

Opened RTA Positions:

3.25.22 - Sell Signal - Shorting WE $6.95 (LINK)

* As a reminder, this is NOT a change to the Position Monitor but part of our risk management process.

Ticker: INVH

Subsector: Single Family Rentals (SFR)

Headline: "Red-tagging" and new unsecured bond issuance

We wanted to touch on a few items that became topical last week and started making the rounds in REIT circles regarding Best Idea Short Invitation Homes (INVH).
There is no change to our belief that material financial and headline risk exists for this company, related to the lack of permitting for a substantial portion of INVH's properties in California, as well as potentially elsewhere across the Sunbelt states.
First, we can confirm that on the potential fines for not obtaining permitting, penalties begin accruing on the day that a landlord is determined to be out of code or "red-tagged" by the local inspector in California, with no look-back to when the work was first performed. This has the effect of lessening the potential penalty versus our initial thoughts, but we still think it will be significant given (1) ~$200-$250 per day fines in some cases, (2) likely several months (3-6+?) to obtain permits in CA specifically to perform needed work, so liabilities will accrue, and (3) treble damages. This says nothing of the potential impact of lost rent/credits to tenants living in out-of-code homes during any remediation period, costs of new permits, and requisite capex. And again, our initial numbers focused solely on Sacramento as a sample, and easily got into the mid-hundred million dollar range, saying nothing of other jurisdictions in California or potentially other states.
On Friday INVH priced $600 million of new 4.15% senior unsecured notes due 2032, with net proceeds being used to repay all $204.6 million of remaining principal under the IH 2018-3 securitization and a portion of the IH 2018-2 securitization. We would note a couple of points here: (1) these securitizations expire in July 2022 but can be extended to 2025, (2) the company is issuing senior unsecured at roughly ~170bps above the 10YR UST versus a typical ~120bps spread for IG issuers, which all else the same does not make a lot of sense in our opinion given no urgency to do so, (3) INVH already achieved an IG rating, so taking down more securitization principal here does nothing to advance that objective, (4) the company apparently mentioned at another sell-side event earlier this week it was reluctant to issue new unsecured at ~4% versus ~3% or less previously, yet is now doing so less than a week later which is just odd candidly, and (5) with LIBOR at ~45bps today and likely already peaked heading into Quad 4, INVH is basically "trading" ~1.6-1.7% paper once floating again and with no near-term maturity for 4.15% paper, which is immediately dilutive. Even if the forward LIBOR curve is correct from a macro perspective (Hedgeye does not think it is, similar to the 10YR UST), the interest cost on the existing debt would peak at somewhere around ~3.40% and still be dilutive. Simple math. We think it would (1) obviously make more sense to wait for rates/spreads to come in before issuing more unsecured to retire principal dollar-for-dollar, especially given that INVH is already IG, or (2) use those proceeds to fund acquisitions at 6-7% unlevered yields to make the issuance accretive. So what is the objective here? We wrote about some idiosyncratic considerations HERE.

Ticker: ONL

Subsector: Secondary Office

Headline: Stock was a disaster following first quarter as new entity

Short Bench name Orion Office REIT (ONL), which was spun out from the O/VER merger, declined nearly -16% on Friday after reporting its inaugural 4Q21 results.
The company has about ~52% of its annualized rent (ABR) expiring through the end of 2024 which is a huge number, which will (1) require a significant amount of capex to release, (2) introduce risk to earnings estimates given uncertainty around renewal rates and ultimate occupancy levels at the end of that period, and (3) likely cap the dividend payout well-below industry averages given the need to preserve and retain capital to lease space. The average lease term across the entire portfolio is just ~4.1 years which is not great, and we do not like the high exposure to the GSA.
We are staying short here through Quad 4. We believe there is a reason O did not want this portfolio and spun it off as a separate entity to preserve a cleaner NNN entity post-merger.

Figure 1: Updated Position Monitor