City Office REIT Stock: 9.9% Yield And Plenty Of Upside (NYSE:CIO)

Having declined 60%, City Office REIT (NYSE:CIO) shares have massively underperformed the broader office REIT market (which declined 36% in 2022). Fundamentally, I see no reason for this underperformance. Following a series of transformational transactions in 2021, City Office boasts a high quality portfolio of Class A sunbelt assets and a strong balance sheet.

I believe that its share price underperformance is largely a function of investors not taking note of the company’s transformation (described below) and City Office’s smaller size and relatively limited trading liquidity (market cap of $330 million and trades just $3 million per day).

As such, I see the decline in the current share price as an opportunity for long-term, contrarian investors to pick up a collection of high quality sunbelt office assets at an attractive valuation.

Background

City Office REIT owns a 6 million square foot portfolio of mostly high quality buildings located in the sunbelt. As shown below, its portfolio lies in regions which are benefiting from population migration. As shown above, the company’s portfolio is reasonably well-leased with an average weighted lease term of 5 years ensuring strong medium-term cash flows.

While office has struggled since the onset of the pandemic, most of City Office’s portfolio consists of Class A office buildings which are newer and tend to feature attractive amenities including fitness centers, restaurants, and outdoor space. Class A office has fared much better than older, commoditized Class B/C office buildings which have struggled to attract tenants, particularly as employers look to give employees a reason to come back to work in the post pandemic world.

Portfolio Transformation

City Office’s portfolio underwent a dramatic transformation in late 2021 when the company sold its Sorrento Valley life science portfolio for nearly $600 million (represented nearly 80% of the company’s then market capitalization). Prior to the transaction, the value of this portfolio was largely hidden from investors as it consisted mainly of development properties which were not producing rent and NOI. Following the news, shares rocketed higher by 20% as the realization of this value was a surprise to investors.

The sale resulted in a gain of over $400 million. To avoid a large tax burden, City Office redeployed the proceeds into high quality, relatively new, long-term leased office buildings in Phoenix, Dallas, and Raleigh. These new, high quality buildings now represent ~30% of City Office’s total NOI.

As you can see, these marquee properties were acquired at relatively high prices (low 5% stabilized cash cap rate). As interest rates have increased and the broader economy has slowed, it is likely that these properties are worth 15-25% below ($100-150 million) what City Office paid for them 12-13 months ago. In evaluating this transaction, it is important to consider that most of the ‘lost’ value would have been paid in taxes had City Office acquired properties subsequent to realizing the outsized gain from the sale of its life sciences portfolio.

It is also important to note that City Office created tremendous value for shareholders through assemblage and sale of its life sciences portfolio. In just four years the company sold these assets for over 4x what it had paid for them! The divestiture of development properties (which were not generating much rent/NOI) and purchase of these new properties created a material uplift in City Office’s NOI and FFO/share (+20%).

Balance Sheet

City Office has a strong balance sheet with net debt to EBITDA of just over 6x. Assuming an 8% cap rate for the overall portfolio, I estimate a loan-to-value ratio of just 46%.

As we sit today, CIO has ample liquidity at $150 million. 73% of CIO’s debt is fixed rate and as shown above, the upcoming maturity schedule is very manageable. 2023-24 debt maturities are roughly equivalent to current liquidity – given City Office’s strong financial position, I don’t expect refinancing will be an issue, though the cost may increase as interest rates rise.

Valuation

As shown above City Office REIT trades at an implied cap rate just above 10% and just over $180 per square foot. This is a massive discount to what it paid for its most significant assets just one year ago. While valuations have certainly declined over the past year (as discussed above), I believe City Office shares have been unduly punished as it is now trading at the low end of its historical valuation range (despite portfolio quality being at an all-time high). Historically, City Office has traded at an implied cap rate in the 7-10% range. Assuming an 8% implied cap rate, City Office would be worth $15 per share (86% upside).

Further, there is some upside to the current NOI number as the portfolio is 85% leased today. City Office is in the midst of upgrading some of its properties to attract new tenants. The stock traded in the $15-20 range in late 2021-1Q22 following its portfolio transformation.

Conclusion

With a high quality portfolio and strong balance sheet, I believe City Office shares have been unfairly punished as investors have indiscriminately dumped shares of REITs and particularly office REITs. Should investors take a slightly less negative view of the office sector, I see the potential for a significant rebound in City Office shares. In the meantime, investors collect a nearly 10% dividend yield.