05/22/22 04:27 PM EDT

SUNDAY NIGHT REIT READ | 5.22.22 | (OFC, STYLE FACTORS)

Rob Simone, CFA

@HedgeyeREITs

Takeaway: Hope everyone enjoyed the weekend!

Cartoon of the Weekend: Rearview

Closed Real-Time Alert (RTA) Positions:

5.20.22 - Buy Signal - Covering MPW $18.07 (LINK)

* Not a Position Monitor change, this is part of Hedgeye's risk management process.

Tickers: OFC

Subsector: Secondary Office / Infrastructure

Headline: Reviewing some of the key points on Best Idea Long

This past week we added Corporate Office Properties Trust (OFC) to the Best Idea Long list, and we wanted to remind subs of some of the key points on the name and why it is one of the few REITs we are following actively that make a ton of sense on the long side right now. By way of background, OFC is a preferred provider of strategically located, custom-built office space to certain three-letter government agencies (think Fort Meade) and the private defense/IT complex. Over the past half-decade the company has shed non-core suburban office assets and refocused its capital deployment efforts on value-add development of high-specificity office and data center shells. As a result the company has a high degree of tenant exposure to the U.S. government and related contractors, which (1) results in a lower internal compounded growth rate over long durations but also (2) serves to create a very high-credit quality "bond" with some inflation protection. The stock backtests well in Quad 4 and has many of the key style factors that work on the long side on a relative basis: low beta, secular growth, high credit quality, modest leverage, less expensive valuation multiple, etc. Probably the weakest style factor is OFC's size with a ~$3 billion equity market cap. We think of the company as much less office, much more critical infrastructure given the "missions" it serves for the government and its strategic on- and off-base locations.
We think the company is now basically off the "earnings hamster wheel" where it generated ~$2.00/share of Core FFO earnings consistently year in and out as it recycled capital by selling non-core assets and redeploying into development. This can obviously create an earnings drag and timing mismatch given the longer lead time to develop and lease versus the immediate earnings streams lost with each sale. The math shows that the drag ended in 2020 with the bulk of the asset sale activity now in the rearview mirror (still some sales on the margin, but not huge relative to the entire pie), and is now poised to compound earnings and dividends fairly consistently at 3-5% per annum. Guidance implies +2-3% earnings growth for FY22, and that includes some additional asset sales on the margin towards the end of the year.
The balance sheet is cleaned up at nearly ~6x net debt / EBITDA, ~97% fixed-rate and an ~8 year weighted average maturity, which is an asset as credit tightens in Quad 4. The ~6x may sound high, but is much lower than a decade ago and the composition/duration has improved. Again, the quality and consistency of OFC's cash flows and underlying credit both support higher leverage levels than other higher beta subsectors.
The DoD's Base Budget is projected to grow +5.8% in FY22, above the +4% CAGR from 2017-2021, which directly supports OFC's existing tenants but also prospects seeking new developments. The "mission" of OFC's tenants is not conducive to work-from-home - it is basically impossible given security clearance/location considerations in many cases.
The multiple at ~11x forward earnings is not sky-high relative to the rest of the REIT sector (low-20x and higher in many cases), and probably is only giving OFC credit for something like +1% to +3% compounded earnings growth given recent experiences. We think OFC is coming off of trough earnings and internal compounded earnings growth is likely to be structurally higher going forward, i.e. the stock is truly "cheap."
To be clear OFC is not going to shoot the lights out so we would probably not recommend it in any other Quad but Quad 4, save for exceptional idiosyncratic factors, but it would be hard to find a better place to hide out in Quad 4 for those looking for long ideas.

Figure 1: Updated Position Monitor