Skarie20/iStock via Getty Images

Skarie20/iStock via Getty Images

Orion Office REIT Inc. (NYSE:ONL ) recently made its market debut. It was a rocky start after the shares came to list as a consequence of a special distribution to shareholders of Realty Income (O) and VEREIT. The idea was to separate out the office properties away from the core of Realty Income and let Realty Income focus on its bread and butter of retail properties. ONL could then leverage its investment grade office tenant base and make hay.

Investment Grade Tenants (ONL Presentation)

Investment Grade Tenants (ONL Presentation)

As it often happens with spin-offs, nobody wanted the shares, pretty much like the parent doing the spin-off.

Yet the drop had left many people positive. After all, who does not love a bargain? Unfortunately if the after-hour quotes are any indication, investors will get a bigger bargain soon.

ONL's first quarter report included only two months of the entire property set. Financial results for the period prior to November 1 (October 1-October 31) only include Orion’s assets previously owned by Realty Income. This did give it some lumpy flavor, but ONL did the best to present the adjustments.

We won't make too much out of a single quarter with too many extra variables, but we will note that even adjusted, the funds from operations (FFO) falls well short of the run rate that we saw in 2020 and 2021 according to Realty Income's SEC filing. Guidance for 2022 validated the idea that something has changed since the spin-off plans.

The $1.70 in FFO for 2022 is at least about 70 cents below what was projected and forecasted. This is also well below the adjusted Q4-2021 run rate. This is about the worst way to begin an independent spin-off's public career. Everyone who has bought in or held on, whichever way you look at it, felt that under 7x FFO the valuation compensated them for the risks. 7x FFO now is 30% lower. One could argue that the valuation could compress even more for three reasons. The first being that whatever residual goodwill there was for ONL, from being of a Realty Income pedigree, has now vanished. The second and more important reason is that ONL has just blown through its debt flexibility. The initial idea was that ONL would start off with a sub 4.0x debt to EBITDA and that would allow it to deal with challenging office market conditions. At the midpoint of guidance, we are looking at 5.1x. That will require some extra finesse, especially while half the portfolio comes up for renewal in under 33 months.

Finally, funds available for distribution or FAD, will drop even faster as we assume capex plans will stay steady to renovate vacancies. If the body blows were not bad enough, ONL also announced the inaugural dividend at $0.10 a quarter. That gave it a before 2.25% dividend yield which would be below the lowest projections that we have seen.

The office property market is tough. The only helpful factor is having great tenants locked into very long term leases. In fact, that is what got one of our favorite office REITs, H&R REIT (OTCPK:HRUFF), through 30% office vacancies in Alberta. ONL did spin the shallow weighted average lease length (WALT) as an opportunity. That is the nature of the business. The triple net REITs will tell you ultra long-term leases are an advantage and ONL will tell you that the shorter leases are an advantage. In our view, ONL's position is definitely not enviable and their FFO downgrade likely comes from ONL's early negotiations with tenants for 2022 renewals. They did not like what they heard. Either the tenants were going elsewhere or the rent reductions were unpalatably bad. This is now likely to get a draft of selling from the recently converted bulls. The ultra low dividend will hurt as well. As we have seen before, if you want to attract people to a melting ice cube of office properties, you need a good 9% yield to do so. We don't think ONL will get there, but downwards from here looks like the most likely direction. We are initiating a strong sell with a 6x FFO multiple and a $10 price target.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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Disclosure: I/we have a beneficial long position in the shares of HRUFF either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.