Rising Rates and Lower Asset Sales Create Uncertainty for Office Properties' Payout

Rising interest rates, a looming risk of recession, and an ongoing struggle to get workers back to the office have created an uncertain outlook for office REITs like Office Properties Income.

The market seems to be accepting that higher interest rates may be around longer than previously thought, which could pressure Office Properties' funding plans for its redevelopment projects since the firm's balance sheet has stretched beyond management's target 6x to 6.5x range.

Fortunately, 90% of the REIT's existing debt has fixed rates, and less than 5% of the firm's loans mature in the next two years. This insulates Office Properties' cash flow from rising borrowing costs in the near term.

But ongoing redevelopment projects in Washington, D.C. and Seattle have been dealing with rising construction costs and longer lead times for materials, making these major investments increasingly expensive.

In fact, in the first half of the year, Office Properties' redevelopment costs consumed almost 90% of the firm's cash available for distribution (CAD), a REIT metric similar to free cash flow but excluding non-recurring spending such as development projects.

With insufficient internally generated cash flow available to cover redevelopment spending and the dividend, Office Properties has looked to plug the gap in part by selling properties to raise cash.

However, rising interest rates, volatile financial markets, and uncertain demand for office space have dampened the REIT's divestiture plans that are now expected to raise $100 to $200 million this year, down from initial expectations of $400 to $500 million.

With less liquidity than previously expected from asset sales, a payout ratio projected to rise from 68% in 2021 to 96% in the year ahead, and leverage hovering above OPI's target range, the REIT may need to cut its dividend to preserve financial flexibility.

As such, we are downgrading Office Properties Dividend Safety Score from Borderline Safe to Unsafe. 

A sizable cut (e.g. 50%) would align with notable reduced payouts by other REITs also externally managed by The RMR Group, whose financial incentives are more aligned with growing the business than preserving a dividend to protect income investors.

OPI has historically declared its fourth-quarter dividend in mid-October. Conservative income investors may want to consider alternative options before then, like W.P. Carey, a diversified REIT with some exposure to offices but much healthier dividend coverage and a far stronger balance sheet.

We will keep an eye on OPI and provide additional updates as needed.