Net Lease Office Properties Stock Analysis
Analyzing NLOP, a liquidating office REIT selling at a discount to its $58 fair value
A few weeks ago I profiled Net Lease Office Properties NLOP 0.00%↑, a spin-off company is liquidating its office building portfolio. I was quite excited because I have been wanting to find a good way to invest in office real estate since all the headlines are saying offices are doomed. In my opinion, some people will work from home, but its an exaggeration to say all offices will be dead. Just like how the headlines were saying malls are dead. Yes, in both malls and offices there will be winners and losers, but not all malls are bad as evidenced by my Simon Property Group holding. NLOPs portfolio isn’t all winners, there are some duds in there, but I think the portfolio is decent enough and trading at a discount to make it an interesting stock.
For a quick refresher the company got spun out of a larger REIT late last year. The newly created NLOP consisted of a portfolio of office properties and some high interest debt. The objective was to first sell off properties to pay off the debt, then further sales proceeds could be returned to shareholders. My goal in this post is to refine my valuation, and try to think through some of the pitfalls of holding this stock as they sell their office portfolio.
Valuation
My first priority is to figure out whether NLOP is actually undervalued. In my previous post, I started the valuation with the lease revenue figure, but I should have used annualized base rent (ABR) since that is practically their net operating income (NOI). Also, in my prior approach I used an 8% cap rate on the whole portfolio, which was somewhat arbitrary. Ideally you would look at each property and use comparable sales, tenant quality, lease duration, etc. to get an accurate valuation. I don’t feel like doing all that, but I think I can refine my initial valuation.
Doing a quick Google search on average single tenant office net-lease cap rates showed that 7.7% is the going rate. From this baseline I went down the Excel spreadsheet of all the properties and capitalized them based on their ABR and a few different cap rates. My Super Proprietary Valuation Process™ is as follows:
Any property located in a state that I deemed “desirable” got assigned an 8% cap rate. These states were California, Texas, and Florida
For the other properties I used a 10% cap rate
Exceptions to the above were if the average lease term was up within 2 years, or it was European, in which case I used a 12% cap rate
I also did not include the latest property that was sold in August, and this does not include the four vacant properties. Using my valuation process yielded an asset value of $1,047M, which is modestly higher than the current property value of $904M that is stated on the balance sheet.
In August NLOP sold one of their properties for $71.5M, and used some of the proceeds to pay down $55M of the mortgage and $8M on the mezzanine loan. Using my estimated property value, plus factoring in this recent sale, I will try to reconstruct their current balance sheet to get an estimate of the stock equity value. Here I get $1,192M in assets, and $323M in liabilities. This gets us an estimated net worth of $869M, or $58.70 a share. The stock has been hovering around $30 a share, so it appears to me there is still a lot of meat on the bone.
Valuing these properties is a very hand-wavy process, but I’m just looking to get relatively close, not perfectly accurate. But if you don’t like my valuation, there are other analysts who have made their estimates. Kingdom Capital has wrote about NLOP in their fund letters and on X, with a breakdown of the properties here. Back in January, Catapult Capital valued the properties using a DCF approach. And there is a nice Seeking Alpha write up on the stock.
My stock picking strategy is to find stocks that are trading at 2/3 fair value, meaning that I would get a 50% gain if they reverted back to my fair value estimate. A 50% increase in NLOPs current stock price puts it at $45 a share, which is coincidentally their book value. While I think it is useful to calculate the fair value of the properties, at the end of the day I just want to be confident the stock is worth at least $45. With my analysis I feel confident the stock is worth at least book value, and likely is worth even more.
Debt Service
One potential concerns with NLOP is that for whatever reason they can not offload their properties as fast as they would like, so then they are stuck paying on their high interest loans. To address this I want to see how much cash NLOP generates, but it is tricky looking at their income statement because there are so many non-cash expenses. They publish an “Adjusted Funds from Operations” that takes net income and adds back property depreciation, gains from property sales, goodwill impairments, and “amortization of deferred financing costs”, plus other small items. This gets an AFFO of $17.4M in the June quarter, compared to $27M in interest expense in the same quarter. However there is a note that the interest figure includes $17M of “amortization of deferred financing costs”. I’m not really sure what this charge is, but from the AFFO calculation it seems to be a non-cash charge and not actual interest being paid.
After the sale of the August property, mortgage balance was $74M and the mezzanine was $81M. The mortgage has a rate of about 10% and the mezz is 14%, which comes out to a quarterly interest cost of about $4.7M Therefore I’m not too worried if NLOP goes a couple of months without selling a property.
Another interesting thing I saw in their 10K is that they have to pay down levels of mortgage at certain intervals. For example, 15% of the loan has to be paid off by November 1, 2024. Then a cumulative 40% needs to be paid off by the following year, and 70% by 2026 if they use the extension. Currently NLOP is two years ahead of schedule. The company has the cash flow to pay the interest, but they could not pay off the mortgage just using cash flow within the schedule. So NLOP is basically forced to sell enough properties to at least pay off debt.
What if They Stop Liquidating?
The other worry I’ve seen people have is that what if NLOP decides not to fully liquidate and just exists as an office REIT. Or worse, sell off the good properties and exist as a portfolio of crappy office buildings. Like I mentioned, they have to at least sell a good chunk of the properties to pay off the high rate debt. It seems like they have sold some quality properties, but also have sold some lousy ones and defaulted on a few, so there is no indication they are trying to maliciously keep all the crappy ones.
I don’t think it would be the end of the world if NLOP just existed as a typical REIT, provided the property portfolio was reasonable. In this hypothetical situation, if they did to decide to stop liquidating it is hard to know how much cash flow they generate because we don’t know what properties they would have. Using my imagination, I could see a world where NLOP sells enough properties to pay off the debt, ABR is half of its current levels from the reduced property count, lease terms are reasonable, and pays out the cash flow like a regular REIT.
I would prefer NLOP to fully liquidate so I can get my cold hard cash sooner than later. But depending on what their distributable cash flow is compared to my cost basis, it could be fine to clip dividends for a while. Also, initiating a regular dividend might be the catalyst that gets the stock price closer to fair value because most holders of REITs buy them for the steady income.
Conclusion
When looking for undervalued stocks I always want to understand why the company is trading at a discount. NLOP has many things going against them: they are an office REIT which are disgusting, they are a spin-off so no large fund likes them, they are liquidating so nobody wants to deal with that, and they are a REIT that doesn’t pay a dividend. None of this matters to me as long as the properties keep selling for decent prices. I would start to worry about NLOP if were consistently selling properties north of a 10% cap rate. Or if a recession or some other credit event happened to where sales slowed down. Some people are worried about the management incentives. So its on my todo list to look through the proxy to get a better feel for the management and see how they are incentivized. Besides that I am very interested in the stock and I think its worth at least $45 and could quite possibly fetch $58.70.