I Went Heavy On Buying City Office REIT’s 9.7% Yielding Preferreds (NYSE:CIO)

City Office REIT’s (NYSE:CIO) preferreds (NYSE:CIO.PR.A) are a buy and I’ve taken a significant position after first considering the commons when I last covered the internally managed office REIT. While rising office vacancies across the US will continue to form a fundamental headwind for office owners, CIO’s fiscal 2023 fourth quarter occupancy rate at 84.5% remains healthy albeit dipping by roughly 90 basis points sequentially. Critically, the dip was mainly led by a single submarket as Portland, Oregon saw occupancy dip to 79% from 100% due to 70,000 square feet of lease expirations. CIO saw occupancy grow or stay constant across 7 other submarkets with a marginal dip recorded in Raleigh.

Why are the preferreds so safe? The REIT generated rental and other revenues of $44.3 million during its fourth quarter, down 0.7% from its year-ago comp to drive core funds from operations of $13.5 million, around $0.33 per share. Again this dipped by roughly $200,000 from the prior quarter and down from $15.4 million in the year-ago comp. Higher interest rate expenses are eating into FFO, which isn’t controversial with higher base interest expenses on floating rate debt driving the dip.

The 6.625% Series A Cumulative Preferreds

The preferreds started trading in 2016 when CIO sold 4 million shares at $25 a share for an initial $96.85 million in proceeds after underwriting commissions. There are 4,480,000 series A preferred shares now issued and outstanding with a headline coupon rate of 6.625%. With the preferreds currently trading at $17.22 per share, the $1.66 annual coupon means a roughly 9.7% yield on cost. Further, the REIT spent $7.42 million on preferreds payments through its 2023 fiscal year. That’s how much they spent in 2022 and 2021 and are set to spend every year until they exercise their option to redeem these perpetual securities partially or in full. Their call date was just before the Fed started hiking rates on 10/04/2021.

CIO is guiding for core FFO of $1.18 per share for its full fiscal year 2024. The $7.42 million preferred payments work out to be a $0.19 per share expense against 39,922,000 outstanding common shares at the end of the fourth quarter. Hence, CIO is set to cover its preferred expenses by 635% against core FFO guided for its full year 2024. To be clear, CIO can cover its annual preferred payment with core FFO generated in a single quarter. The self-managed REIT would have to see core FFO dip by close to 80% for its ability to meet its preferred payments to come under threat.

Bears would be right to flag risks around lease expirations aggregating core FFO headwinds. CIO is set to see 9.7% of leases expire in 2024 with another 8.8% expiring in 2025. The REIT’s leasing activity during the fourth quarter saw 134,000 square feet of new and renewal leases signed with leasing activity of 599,000 square feet for the full year. New leases formed 81% of fourth quarter leasing activity and were signed with a deep weighted average lease term of 8 years at a weighted average annual rent of $38.04 per square foot, albeit with a weighted average cost of $10.83 per square foot annually.

Debt maturities are also well staggered with around $101.44 million coming due in 2024 which CIO’s $90 million undrawn credit facility should be able to help address. CIO expects its 2024 portfolio occupancy levels to be higher than its current level with the start dates for new leases weighted towards the second half of the year. Hence, the preferreds face an extremely constrained credit risk profile with CIO facing manageable debt maturities and lease expirations.

Credit risk forms the most salient consideration when investing in what’s essentially a quasi fixed-income security and the preferreds will be set for a further boost when the Fed cuts base interest rates sometime in one of the summer meetings. The CME FedWatch Tool is currently pricing in at least 75 basis points worth of cuts to exit the year, a reduction from earlier expectations of 150 basis points worth of cuts.

As the preferreds are currently trading for roughly 68 cents on the dollar to their $25 per share liquidation value the preferreds stand to benefit from any capital growth in response to future Fed rate cuts as a result of the positive duration effect. However, they should currently be trading near their 52-week high of $21 per share against the current fundamentals especially when compared to the preferreds of other Class A office REITs like SL Green (SLG). I continue to rate the commons as a hold with the preferreds as a buy.