The office market still hasn't recovered from the pandemic. Many companies are realizing they don't need as much office space as they once did. Meanwhile, many companies are moving their offices to states that are more business-friendly or upgrading their space to higher quality buildings.
Because of that, many office-focused real estate investment trusts (REITs) are facing challenges when they seek to lease their available space as existing agreements expire. Occupancy and rental rates are under pressure, which is forcing many office landlords to consider reducing their dividends and conserve cash. That's a situation that income-focused investors should avoid this year.
Two office REITs that a couple of Motley Fool contributors believe investors should avoid in 2023 are Office Properties Income Trust (OPI 3.51%) and SL Green Realty (SLG 2.83%). Here's why they believe their big-time dividends are too risky for income-focused investors this year.
Too good to be true
Matt DiLallo (Office Properties Income Trust): Office Properties Income Trust currently offers an eye-popping dividend yield of more than 15%. As alluring as that payout might seem, investors should avoid this office REIT like the plague this year. At first glance, Office Properties Income Trust's big-time payout seems to be on solid ground. The REIT has a reasonable dividend payout ratio at 67% of its cash available for distribution over the last four quarters. It also has investment-grade credit with primarily fixed-rated debt, well-laddered maturities, and lots of liquidity.
But the issue is that Office Properties Income Trust has significant upcoming lease expirations that it needs to navigate in a tough market for offices. About 14% of its leases expire in 2023, and another 14.4% end in 2024.
With many employees working from home in at least a hybrid setting, companies don't need as much office space as they did before the pandemic. It will be difficult for Office Income Properties Trust to find tenants for all this space at attractive rental rates, especially since its portfolio skews toward older properties in less-desirable secondary and suburban markets. Because of that, vacancy rates could rise while its funds from operations (FFO) could decline. That would make it more challenging to maintain its dividend.
There's too much uncertainty about whether this office REIT can lease its available space. If it struggles to backfill vacated space, Office Properties Income Trust might have no choice but to reduce its dividend to align it with cash flow. With such a high risk of a dividend reduction in the next year, income-focused investors should steer clear of this high-yielding office REIT.
The Manhattan office market is slow to recover
Brent Nyitray (SL Green): SL Green is a REIT that focuses on Manhattan office buildings. Office REITs have been out of favor since the pandemic, given the success of working from home.
While some bosses prefer employees to work in the office, the work-from-home model is popular with employees, who no longer have to commute. And it raises the possibility of offices downsizing to accommodate fewer on-site employees. Manhattan has struggled since the pandemic. Companies have left for cheaper locations (primarily Florida), worsening the work-from-home problem. It's easy to see in occupancy rates. At the end of 2019, SL Green's occupancy rate was 94.3%, but at the end of the third quarter of 2022, it had fallen to 90.9%.
This decline in occupancy and this year's increase in interest rates caused SL Green to reduce its guidance for 2022 funds from operations (FFO) per share to fall to a midpoint of $6.70 per share. The company sees 2023 FFO per share falling to $5.45, an 18.7% decrease.
Given the expected decrease in FFO per share, management cut its dividend by 12.9% to an annualized rate of $3.25 per share, giving it a yield of 9.6%. This was done, it said, to "maintain substantial liquidity and repay debt amid the backdrop of a rising rate environment."
The company sees 2023 as a transition year, and hopes the market for office space normalizes later in the year. SL Green will continue to remain under pressure until we see occupancy rates return to normal.
Brent Nyitray, CFA has no position in any of the stocks mentioned. Matthew DiLallo has positions in SL Green Realty. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.