2018.09.29 Government Properties Income Trust (ticker GOV; $11.29) Short Thesis
This pitch is simple one so I will try to keep it relatively short and to the point. I believe that GOV, an office REIT externally managed by RMR, is a compelling short. GOV suffered a 33% share price decline in the past two weeks in reaction to the news that it would be merging with another externally managed RMR entity, Select Income REIT (ticker SIR), among other contemporaneous transactions at SIR and GOV to be effected in close proximity to the merger timing. GOV will be the surviving company and change its name to Office Properties Income Trust (and its ticker to OPI).
The crux of my thesis is that GOV plans to cut its dividend by 65-71% (68% cut at the midpoint) – from $1.72 / share annually today to $0.50-0.60 / share beginning in 2019. Ordinarily, I believe that an overly simplistic “buy/sell” decision based on a single metric to be foolhardy. But in this case I think the dividend yield of an externally managed RMR REIT takes on dramatically increased importance due to the governance framework and history of the REITs externally managed by RMR.
For most REITs, I’d be more interested in understanding a host of other valuation metrics that would likely be more relevant than mere dividend yield. Implied cap rates, TEV/EBITDA multiples, AFFO or CAD multiples, discount to private market NAV, etc would generally be more telling valuation metrics for many other REITs. When publicly traded REITs with “good” governance trade at deep discounts to private market values, for instance, we often see them taken private. Similarly, when publicly traded REITs trade at significant premiums to private market asset values, we tend to see them issue equity. But I believe that GOV (and the other externally managed RMR REITs) are less tethered to private market values because the exorbitant payments owed to RMR to terminate the management contracts act as a massive “poison pill” when GOV trades at a big discount. Similarly, I wouldn’t expect to see share buybacks (when the stock is cheap) or special dividends (when the stock is expensive) at GOV or other RMR managed entities as the contracts tend to reward asset growth over long term shareholder returns.
I believe dividend yield is a particularly relevant metric for GOV because once cash dividends have been paid, they will not later be clawed back. From a pragmatic perspective, I believe dividends are the sole/main source of positive total return that can be reasonably expected from externally managed RMR entities over the long term. This is pretty intuitive in that the structure of the management contracts incentivizes asset growth and because for tax purposes REITs must pay out much of their income rather than retaining it. History also suggests this to be a reasonable (probably generous) expectation when considering the significant underlying asset price inflation (and long term bond yield and cap rate compression) enjoyed over the long term in each of the relevant sub-classes of CRE assets where RMR managed REITs have participated. The following chart shows the long term, cumulative price change in the externally managed RMR REITs and other entities I was able to find per Bloomberg:
To belabor my point a bit, the cumulative price change in the vast majority of externally managed RMR entities has been dramatically negative over the years despite what presumably would have been the rising tide of underlying market asset price inflation and yield compression. So from a historical perspective, my argument above that the dividend yield seems like a reasonable expectation for the main/sole source of positive total return from an externally managed RMR entity like GOV would appear to be quite generous. After all, the dividend yield should approximate the total return if the price doesn’t change, but we can see above that in most cases historically (and also perhaps to be logically expected based on incentives), the price change has been quite negative. Of course, to the extent that historically low interest rates and cap rates broadly were to migrate higher over time to more historically normal levels, that would only provide additional headwind to asset prices and REIT share prices like GOV.
Today, GOV’s annualized dividend yield on the legacy dividend rate of $1.72 / share is 15.2%. The midpoint of the guidance for the new annualized dividend rate of $0.55 / share pro forma for the merger translates to a 4.9% annualized dividend yield today on the GOV share price. While GOV would argue that the new dividend rate is more sustainable than the old one as it relates to a more conservative AFFO or CAD coverage ratio, the other dividend-paying RMR REITs and closed end fund all have higher dividend yields than that today. HPT’s dividend yield today is 7.4%; SNH’s is 8.9%; SIR’s dividend yield on its undisturbed share price of $21.94 (closing price just prior to the merger announcement) was 10.2%; GOV’s dividend yield on its undisturbed share price of $16.89 was 10.2%; and RIF’s dividend yield is 7.3% today. Even ILPT, at the moment the “golden child” of the RMR REITs boasting the least debt, most “in favor” sub asset class, cherry-picked Hawaiian assets, and large discount to private market NAV trades at a 5.7% dividend yield.
GOV returning to a 10% dividend yield post merger would imply a share price of $5.50 and 51% downside. Even returning only to a 7% dividend yield post merger would imply a share price of $7.86 and 30% downside.
I believe it unlikely, but if the merger falls apart for whatever reason (i.e. GOV shareholders vote it down), I highly doubt that GOV trades back up to its undisturbed share price. Legacy GOV was in pretty dire shape, significantly worse shape than I think GOV shareholders may have realized. As of June 30, 2018, GOV had 38% of its leases expiring by the end of 2020 and 46% expiring by the end of 2021. Besides the risk associated with the potential loss of such a significant portion of its existing business and cash flow, GOV is faced with the need to spend significant leasing capital as it seeks to preserve its occupancy levels. High tenant concentration and high debt leverage compared to peers further challenged GOV’s prospects.
Standalone GOV’s dire situation is further demonstrated by the results of the heavily negotiated merger transaction, emanating from the discussions of the different advisers, special committees, boards, etc. of GOV and SIR. Based on the undisturbed closing prices immediately prior to the merger announcement, GOV shareholders were to receive no premium while SIR shareholders were to receive a 46% premium! If anything, I think that the merger call on September 17 may have shocked GOV shareholders into beginning to realize that GOV will likely be suffering a massive dividend cut in 2019 even if the merger falls apart.
The RMR REITs are significant unsecured bond issuers, generally all at the bottom BBB- rung of investment grade. It seems clear from both prior actions and commentary on calls that the IG rating is understandably sacrosanct, to be preserved at virtually any cost. Considering the incentives to RMR from the external management contracts, that is very sensible to me. But for GOV, I believe that just adds further pressure for dilutive asset sales going forward in order to reduce leverage.
I also note that GOV’s debt structure is the least termed out of the main RMR REITs, and also has the highest proportion of bank debt relative to existing unsecured bond debt. This only adds to the pressure on GOV in the near term and the need to engage in credit positive actions (i.e. dividend cut, assets sales, merger with SIR, etc.).
From the perspective of RMR incentive fees, one could argue RMR might actually have an incentive to see GOV shares trade down materially. This would essentially set a very low beginning bar, dramatically increasing the likelihood of RMR earning future incentive fees because there is no high water mark concept. And while crushing GOV shares now reduces the likelihood of RMR earning incentive fees on GOV in the shorter term, GOV had already been weak enough as to render the likelihood of incentive fees on GOV remote in the short term anyway.
When I survey the holders list of GOV, besides the passive / index holders populating the top of the list, I notice a preponderance of quant and retail shareholders. I’m not sure whether the large share price drop of GOV in the past two weeks would have brought sufficient attention to many of the quants and retail holders and caused many of them to sell now in advance of the future telegraphed dividend cut. Or whether there may yet be a further shoe to drop in the future after the new GOV (actually OPI) dividend steps down dramatically from its current level.
The biggest risk I envision in this short thesis is that ISS and Glass Lewis wind up advising GOV shareholders to vote against the merger. Presumably if the deal falls apart, there would be significant technical buying pressure on GOV as arbs cover the GOV shares they have shorted against (and expected to receive as merger consideration from) the SIR shares they’ve bought. However, I would expect that after the technicals have abated, GOV would likely trade back down materially given the dire situation it finds itself in and the likely massive standalone dividend cut at GOV that we would then see anyway.