Office-focused real estate investment trust (REIT) Orion Office (ONL -2.98%) was spun off from net-lease giant Realty Income (O -0.63%) after it bought peer VEREIT. That spinoff took place in late 2021, and Orion has yet to report a full quarter of results. Although there is a lot that investors already know about this new REIT, there's one thing that is still up in the air -- the dividend. Here are some thoughts on where it might end up.
The portfolio
Both Realty Income and VEREIT owned office properties in their net-lease portfolios. Neither made the property type a key focus, however, because offices are a bit more complicated to manage than other properties typical of the net-lease sector, such as retail. Essentially, net-lease properties are occupied by a single tenant with a long-term lease that requires the tenant to pay most of the property's operating costs.
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Retail properties, like a pharmacy or grocery store, are fairly generic, and new tenants can be easily found, with modest improvements to the asset, if the old renter decides not to renew. Office properties are much larger and are often unique to the lessee. When a property loses a tenant, it can take a long time and require a large investment to get it occupied again. In fact, VEREIT had been paring down its office exposure before it was acquired by Realty Income.
That's not to suggest that office properties are bad, just that they are more complex than other investment options in the net-lease market. Orion Office's stock, meanwhile, has fallen dramatically since the spinoff and is now down more than 15%. One of the biggest problems, however, is not the basic business model but the fact that the new REIT has yet to announce a dividend.
How do you measure?
To be fair, a spinoff falling after being spun off is not unusual. That said, REITs are specifically designed to pass income on to investors; until Orion Office announces a dividend policy, it will be hard for investors to figure out how to value it.
In Orion Office's most recent Securities and Exchange Commission filing, it provided some useful pro forma numbers. VEREIT's office-related net income totaled about $6.4 million in the third quarter of 2021, while Realty Income's came in at $1.4 million, for a total of about $7.8 million, using back-of-the envelope math.
In order to get to funds from operations (FFO), non-cash expenses such as depreciation and amortization must be added back in. VEREIT's depreciation and amortization was about $14.5 million and Realty Income's was $5.9 million, for a total of $20.4 million. Add that with the net income and you get a very rough estimate of $28 million in FFO.
Shareholders of Realty Income received one share of Orion Office for every 10 shares of Realty Income they owned. Realty Income had roughly 392 million shares outstanding at the end of the third quarter. To acquire VEREIT, it issued 0.7 share of Realty Income for every VEREIT share. VEREIT had around 230.2 million shares at the end of the third quarter, which multiplied by 0.7 gives us 161.1 million new Realty Income shares. Add the 161.1 million to 392 million and you get about 553 million shares.
Divide 553 million by 10 and you get 55.3 million shares of Orion Office. So, continuing with the estimates, $28 million in FFO divided by 55.3 million shares gets us to $0.50 per share in FFO for the third quarter, or around $2.00 a year.
Office REIT giant Boston Properties had an FFO payout ratio of roughly 55% in the third quarter of 2021. That would seem like a good number to go with, but there's a fly in the ointment here: Orion Office has nearly $100 million of rent coming from leases that are expiring during the next three years. That's an opportunity to release these assets at higher rental rates, but getting through this period will likely require material investment. In other words, the best-case scenario would be a payout ratio similar to Boston Properties (which would mean a dividend of about $1 per share assuming a 50% payout ratio).
However, something lower to start will probably be more likely. The REIT minimum payout is 90% of taxable income, which, roughly, would mean multiplying the combined net income of $7.8 million by 0.9 and then dividing by 55.3 million shares, coming up with a tiny annual dividend of $0.13 per share or so. That would be extremely low, netting out to an FFO payout ratio of less than 10%. Investors would likely be unhappy with such a low dividend and react accordingly.
So let's take a nice "round" number balancing Orion Office's cash needs and investors' desire for dividends and go with an FFO payout ratio of 33%. That would mean an annual dividend of roughly $0.66 per share. Given today's stock price of about $18, the yield using that dividend would come out to 3.7% or so. That yield is more or less in line with the 3.3% yield on offer from Boston Properties. As such, it's not an outlandish estimate, even though it may be lower than what some might be expecting.
Probably not an income story
These are all very rough estimates because Orion Office hasn't issued any financials yet. However, given the backdrop, the modest dividend and yield sketched out above seem reasonable as conservative initial targets. That's not likely to excite income-focused dividend investors. And it would likely put Orion Office into a show-me position with more growth-minded types who would be looking for it to expand its portfolio while dealing with the rent rollovers coming up. In fact, until it gets the next few years' worth of lease expirations behind it, it might even be best to consider this a special-situation stock.
