Description

ONL (Orion Office REIT)

Equity Market Cap: $1bn ($17ps); ADV: $10mn

Orion Office REIT is a net lease office REIT that was spun out of $40bn blue chip REIT Realty Income in Q4 2021. It is a classic JunkCo spinoff – when Realty Income acquired net-lease peer Vereit in 2021, they spun off their unwanted office properties in the form of ONL.  Our thesis is that – at ~15% AFFO yield – ONL has gotten too cheap, and it should rerate 25% once management provides more transparency and starts paying a regular dividend.

The Issues:

• The main issue is the lease expiry schedule – two thirds of ABR expire over the next three years. Many of these will be difficult to extend/backfill on attractive terms. Management has provided little disclosure/guidance as to what to expect from this process.
• This portfolio was heavily shopped prior to the spin, so a near-term take private is unlikely
• Alignment/incentives are sub-optimal. ONL is led by former Vereit executives. They are highly qualified and know the assets well, but they have not loaded on cheap options (as one might hope/look for in a below-the-radar JunkCo spinoff). The Board is similarly well-qualified, but they also don’t have material ownership alignment. The REIT has a JV with Arch Street Capital, who received warrants for 2% of the company, struck at a 15% premium to the first 30-day VWAP.

Mitigants & Merits:

• The main mitigant is value – ONL generates a ton of cash flow:
  • ONL is trading at a 2021E 11.5% cap rate, $145psf, and 15%+ 2021E AFFO yield.
  • 35% discount to tangible book value
  • This is the highest AFFO yield of any REIT. This yield is even higher than the NNN SNF REITs, which are staring down a wave of tenant bankruptcies.
  • AFFO yields this high are rare, and the examples I can recall are other spinoffs that turned out well: SMTA, RVI, and QCP. 
  • It’s a big tailwind to accrue 1% of the market cap in AFFO every 3-4 weeks.
• My estimate of fair value is in the low-$20s, which would be a 25% discount to a NAV in the high-$20s (current discount is ~40%).  That would still be a ~10% cap rate and LDD AFFO yield. 
• Another way to triangulate value: if 30% of NOI from each lease is lost upon expiry, a 15%+ five-year IRR is implied (assuming a 10% exit yield on a cleaned-up/stabilized portfolio). If we stress this with a 50% loss assumption, the five-year IRR would still be 10%. If the loss is just 10%, then the five-year IRR would be over 20%.
• Another mitigant is leverage.  ONL was spun out at 3.5x D/EBITDA – making it one of the least-levered REITs in the market. This provides a wide margin of safety to accommodate the NOI loss that one should expect over the next few years.
• The quality of the in-place tenant roster is high: ~70% is investment grade

I expect the strategy here is to manage the portfolio through the heavy lease roll period of the next few years while preparing it for sale to a private market buyer. They have not yet reported earnings as a public company, but any guidance that they give when they report in the coming weeks could serve as a catalyst.  More importantly, they should declare their first dividend. On 2021E AFFOps of $2.50, $0.40 per quarter would imply a 65% payout ratio and nearly a 10% yield.

In summary, ONL was spun out of Realty Income because its lease expiries over the next several years posed more risk/headwind than its parent was willing to bear. The headwind is very real, but, at a 15%+ AFFO yield, ONL is too cheap, and any positive news (especially a chunky dividend declaration) should cause it to re-rate.

Catalyst

• Reporting standalone results
• Improved disclosure/guidance
• Dividend declaration