“How can you invest in Office Property REITs”?

That’s literally a question that we got over a year ago when we started putting capital to work in companies like Highwoods Properties (NYSE:HIW), BXP Inc. (BXP), and Kilroy Realty (KRC), a few of our choices in the office REIT sector.

Our answer to the question was simple: Their valuation and their fundamentals spoke of a situation that undeniably implied a significant upside to their at-the-time valuation.

Perhaps a victory lap?

Highwoods Properties has returned round 34% since our Strong Buy pick just a few months ago (Mar. 19, 2024) when I explained, “All things considered, we are maintaining a STRONG BUY on HIW, as we believe shares could return 25% annually over the next two years.”

As such, this takes the place of a successful investment in a situation where we have a rapid recovery and profit. Just take a look: This is when we recommended Highwoods around a year ago.

We believe firmly that this puts to bed the discussion that an entire sector can be unattractive or uninvestable.

This was the argument that many people seemed to have at the time – that the entire office sector was “poison”, and therefore uninvestable.

Of course, we disagreed and put money to work.

Our returns in the other investments are of similar development, even if Highwoods is the best of these investments due to timing and valuation.

At this point, we will tell you that Highwoods has materialized much of the upside we saw for the company in our initial thesis.

To remind you, that thesis saw the company having a share price target of about $40/share, currently at about $32/share, and we forecasted a double-digit upside.

Now I’m going to show you why this company has outperformed, and what we can expect going forward. Because as of this article, we’re actually slightly cutting our target for HIW.

Highwoods Properties – a quality office that was worth much more than 7x P/AFFO

Our argument, even at the time, wasn’t that Highwoods was the sort of company that could or would survive anything because we do not believe such companies to exist.

Our argument was that based on estimates and what we see in company fundamentals, it was worth more than 7x P/AFFO and worth more than a share price of $18/share.

Since that time, we’ve seen revisions of the company’s AFFO estimates, we’ve seen troubling times in the office that have impacted estimates to where the next 2 years are estimated to be negative in terms of funds from operations, but where the company still has been determined by the market to be with well in excess of 7x.

The question now becomes, how high can the company rise from the lows it had?

Because it’s risen above $31/share now.

Company results have been good – not great, but good enough.

The company has managed to maintain a very solid occupancy of above 88% for its roughly 27.6M square feet of space.

HIW, different than other players, owns a portfolio of relatively new office spaces with a WALT (weighted average lease term) of 5.6 years, which is above average, and because 95% of the company’s assets are sunbelt-focused, the company lacks some of the operational risks we found in coastal markets.

There’s also population growth well more than what we find in other geographies for this company.

When speaking about HIW, the company often speaks about the “flight to quality” it sees.

What they mean is that HIW occupancy has generally trended a lot higher than we see in other companies in the same segment. Quality is as follows.

The company remains heavily market-diversified, with Raleigh, Nashville, Atlanta, Charlotte, and Tampa as its primary markets, and in terms of tenants it remains one of the best office property REITs out there, with no office segment higher than 19%, and only 2 higher than 11% – those being legal and finance respectively.

The top 10 customers are also well-diversified – the largest is Bank of America (BAC) at no more than 3.9% of GAAP annualized revenue, the top 10 being less than 20.5%, and the top 20 being less than 28%.

The company’s overall rent growth rate has continued upward unabated, at a 4-5% CAGR over the past 10 years or so.

Same-property NOI growth is spottier and more volatile, and rent growth on 2nd-gen leases is down more than average rent for all in-place leases over time.

The occupancy is trending down, if we compare it to the highs of 2016 when we were looking at levels of around 93%, but is still among the 10-year average, and is not worryingly trending down here.

The company has maintained its track record of financial outperformance in a way that gives confidence to us.

Cash flow for the company has been very consistent, and we have a solid upside here.

For the past 14-15 years, we’ve seen consistent cash flow growth of 5.8% CAGR while the company’s average shares have grown at around half that pace – meaning that the company has grown its profit above this pace, another good indicator.

For 2Q24, the company has upgraded its company outlook and its current development pipeline estimates.

HIW also ended the quarter with only 5.8x net debt/EBITDAre and managed an FFO of almost $1/share. This represents NOI growth of 3.3%, with an increased rent level of 4.8% YoY and on a square-foot basis. Overall, most KPIs are pointing in the positive direction here.

But looking at estimates, the company’s FFO is expected to flat-line or decline, which means that it becomes a question as to how much the company can grow (or not grow).

Because based on estimated growth, the company does not warrant a high multiple here.

The current forecasts are for an FFO growth of around 0.21% per year for the next few years. This, of course, isn’t enough to warrant a premium.

So how much has the company reversed, and how much more can we expect?

Highwoods – The upside has faded – time to revisit our investment options and potential

So, the question about the investment and potential of Highwoods Properties.

That there is further upside potential, to that I say ‘maybe’.

The company is trading at what we consider to be a fairly high valuation, given what sort of development it is expecting.

That is also why we’re cutting our PT.

The company cannot be expected to reach $40/share, which would represent well above 14x P/FFO when the growth rate is less than 3%, and in the negative numbers for 2024 and 2025, with a tail-end heavy sort of development.

These are not good circumstances for an upside in the near term if we look strictly at the valuation.

For Highwoods, we will be using the short-term valuation upside and average.

Why is that?

Because the company is unlikely, in our best estimate, to generate above-average rates of return from here on out.

Rather, we expect AFFO to flatten out, which means that there’s less support for an upside.

We’re more or less limited to rate cuts, which will support most REITs, but we believe this is already baked into the estimates we see here.

At a conservative forward multiple of between 12 and 13x, which might sound low, but it should be lower given the forecasted trends, we’re now seeing returns in the single digits and share price implications of $27-$32/share.

This is the conservative scenario we work from – even bearish.

The more realistic in our view is somewhere at 14-16x P/AFFO, with a long-term trend of 18-20x – but that 18-20x has also come with growth.

14-16x implies around 8-12% per year, and share price levels of $34-$36.

You may be able to start seeing where we’re going with this. Because of lower growth estimates, we’re cutting our target for Highwoods to a 15x P/AFFO average, which comes to around $35/share and implies only about 9-11% depending on what forecasts you’re using.

Given the company’s other risk factors (office, etc.), this is starting to look like a less favorable investment to put new capital into.

How about waiting for further upside?

Tricky, since we don’t see it as likely that Highwoods seems able to outperform here.

Or rather, we believe other REITs are much more likely from this valuation and forward to outperform.

We can also remember that Highwoods actually has a 41% likelihood looking at analyst forecast accuracy of missing the target negatively.

Consequently, we believe the market and the company have been “pushed” as high as we’re likely to expect it to be here – and this is why we’re changing our rating to “Hold”.

It’s entirely possible to divest your position here, and invest in something with a 15-25% annualized upside.

There’s also room to keep your investment.

The company’s yield is good, and we also don’t see it going down to the bottom-level valuations we’ve seen for it prior.

But we also don’t see dividend growth.

We don’t see much FFO growth.

We don’t see many fundamental improvements – the company is already doing what it can.

For that reason, our thesis for Highwoods at this time comes to the following and constitutes a rating change.

Thesis

• Highwoods Properties is one of the four strongest Office REITs that we invest in, and we consider it to be one of the office names one should focus on as a conservative investor in the space. The combination of portfolio and geographical quality together with proven management expertise and FFO growth will sustain the company in the face of significant forward pressure in this economy.
• The eventual upside to the company once things normalize within a 3-5 year period is no less than double digits on an annual basis, with full normalization having the potential to deliver triple-digit growth. We have now realized this sort of upside as of September 2024, with over 89% RoR, meaning that we have thesis materialization earlier than expected. Forecasts have also been adjusted downward, and the company is expecting flat development.
• For those reasons, we view HIW as a “Hold” here and cut our price target to 35$/share for the long term. This marks a cut of $5/share, but we believe the resulting target is far more realistic at this juncture.

Remember, we’re all about :

1. Buying undervalued – even if that undervaluation is slight, and not mind-numbingly massive – companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.

2. If the company goes well beyond normalization and goes into overvaluation, we harvest gains and rotate our position into other undervalued stocks, repeating #1.

3. If the company doesn’t go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, we buy more as time allows.

4. We reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.

Here are our criteria and how the company fulfills them (italicized).

• This company is overall qualitative.
• This company is fundamentally safe/conservative & well-run.
• This company pays a well-covered dividend.
• This company is currently cheap.
• This company has a realistic upside based on earnings growth or multiple expansion/reversion.

The company isn’t cheap here, and we don’t believe the upside as high enough. Highwoods Properties is therefore a “Hold”.