City Office REIT's Occupancy Struggles Signal Concern for Stretched Dividend Coverage

City Office REIT's occupancy rate contracted sequentially by 1% last quarter to 85.8%, compared to around 92% pre-pandemic, as the outlook for office space remains murky.

The struggle to fill vacant office space persists despite the REIT's Class-A properties being located primarily in states with positive migration trends, including notable Sun Belt cities like Dallas, Orlando, Tampa, Raleigh, Phoenix, and San Diego. City Office also has locations in Portland, Seattle, and Denver.

While demand for amenity-rich Class-A properties appears to be stable as employers want to provide more desirable working conditions to entice employees back to the office, tenants are looking for smaller spaces as many companies have adapted to a hybrid workforce. 

As a result, many tenants are subletting portions of their rented space to soften the financial commitments from existing leases. 

At the same time, a glut of vacant sub-Class A offices complicates the market, leading City Office to offer prospective renters generous concessions and shorter lease terms, resulting in net effective rents trending lower despite higher face value rent.

Some investors believe a total return to the office is inevitable, especially if the economy tips into recession and employers have more leverage over employees regarding where people work.

But to this point, that seems to be wishful thinking as it relates to City Office, which has yet to show much by way of recovery. 

During its last earnings call, management even warned, "we expect elevated levels of subleasing and downsizing will continue to put pressure on occupancy rates in general."

Echoing this statement, AFFO, a metric similar to free cash flow for REITs, has failed to cover the dividend for the past four quarters. And the dividend is not expected to be covered in the year ahead either.

Given management does not expect earnings to cover the payout until at least 2024 and rising interest rates could further pressure the REIT's financial flexibility (around one-third of debt carries variable rates or matures in 2023), we are downgrading City Office's Dividend Safety Score from Borderline Safe to Unsafe. 

While we expect management to fight to maintain the dividend, if conditions deteriorate further, we could see a situation unfold where City Office reduces the payout by as much as 30% to 50%.

With the firm's history of operating with a more aggressive payout ratio and balance sheet, we would need to see a sustained and material improvement in occupancy and dividend coverage before considering upgrading the REIT.

Conservative income investors wanting some exposure to office space may want to consider alternative options like W.P. Carey, a diversified REIT that derives around 20% of rent from offices but has much healthier dividend coverage and a far stronger balance sheet.