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City Office Survived 2020, Now What?

Jan 15, 2021 by Reuben Gregg Brewer
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Like so many companies, real estate investment trust (REIT) City Office (NYSE: CIO) is likely happy to see the end of 2020. It was a pretty bad year all around as the global coronavirus pandemic changed the way people work and play. Here's what investors looking at City Office and its generous 6.1% yield need to be thinking about as 2020 gets underway.

How bad was it?

You can't look at 2021 and future years without first stepping back to understand 2020. The core of the problem last year was the coronavirus, which led to the shuttering of nonessential businesses and increased social distancing. An incredible number of people switched to working from home.

For the most part, the switch in work location didn't have a major impact on productivity. In fact, many employees liked the change and, at this point, seem to want to remain remote. That's not great for office landlords like City Office, which owns 65 office buildings in and around Dallas, Denver, Orlando, Phoenix, Portland, San Diego, Seattle, and Tampa. However, the REIT managed to get through the year in fairly good shape.

Some numbers will help. City Office expects to collect roughly 99% of the rents it is owed from 2020, demonstrating that its tenants haven't stopped paying in great numbers. Meanwhile, the REIT's occupancy rate at the end of the third quarter was 93.1%, higher than the 91.2% in the same period of 2019. It is currently projecting full-year 2020 occupancy to be roughly 91%, lower than the 91.9% seen at the end of 2019 but certainly not a frightening change. The average lease term, meanwhile, stood at 4.3 years versus 4.4 at the end of 2019. City Office is projecting net operating income growth of about 1% or so in 2020.

That said, investors didn't get through the year unscathed. City Office cut its dividend in March by 36% because of the pandemic. The goal was to reposition the company in a defensive manner so it could protect its balance sheet and portfolio. Based on the REIT's results, such caution may not have been necessary, but it sets the company up well for the future.

What's next

Based on City Office's full-year 2020 projection for core funds from operations (FFO), which is like earning for an industrial concern, its payout ratio is a very modest 50%. That leaves a lot of extra cash that it can put toward expanding the portfolio, paying down debt, buying back stock, or increasing the dividend. That's pretty good news, even though the dividend cut was hardly a welcome event.

Location wise, City Office appears to be well positioned in markets that have seen increasing population growth (specifically warmer Southern states) and in West Coast cities with material exposure to technology businesses. This bodes well for the future, assuming work-from-home doesn't become a standard practice. That said, so far, it looks like the REIT's tenants are still interested in maintaining their offices given the occupancy levels it has achieved.

As for growth, 2020 was a dud given that the full-year projection is for no acquisitions. City Office circled the wagons and focused on supporting its current portfolio. That means 2021 would be a better year if even a single new property were added to the mix. That's not an outlandish expectation in light of the markets on which the REIT focuses. Leverage remains reasonable and the payout ratio is low, so raising growth capital won't likely be a problem, either.

All in, as the vaccination effort heats up in 2021, City Office looks well positioned to start expanding its business again. And that should translate into growing dividends, though there's plenty of room for hikes even without portfolio expansion. There is, as the books are closed on a difficult year for office landlords, a lot to like here.

Not for everyone

City Office has managed through the pandemic in relative stride, putting the precautionary dividend cut aside. As the world gets back to normal, or at least more normal, it should be able to start expanding again. The only problem is that City Office is relatively small, with a market cap of just $400 million or so. So despite the positives, conservative income investors should probably sit this one out in favor of larger industry players. That's not meant to be a knock on City Office but rather a realistic look at the risk/reward trade-off of an income-focused investment. More aggressive long-term investors, however, should strongly consider a deep dive. It might be prudent to hold off on a final purchase call until after City Office starts to put money to work on the expansion front. In other words, this is a potential watch-list name... for now.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.