Summary

By their very nature, REITs are often difficult for investors to perform accurate due diligence on. The required investment needed to continually grow the business (i.e. purchase additional properties) and the high cost of capital expenditures will often result in a negative free cash flow for the business, making investors sensitive to any earnings related performance problems, and in this respect Dream Office in no different.

Over the past 12 months, Dream’s share price has declined 21.15%, and while this has eroded existing shareholder value, the aim of this article is to assess whether the current share price represents a potential buying opportunity for income-seeking investors.

5yr Fundamentals

Funds from operation have been growing at 81% CAGR over the past 5 years, suggesting that Dream is rapidly expanding and that their previous investments and acquisitions have been paying off, although FFO per share has not been growing at the same rate, 22% a share still represents a significant amount of added shareholder value.

However, adjusting the FFO to take in consideration capex does raise some concerns around the company’s cash flows. In the previous 5 years, Dream has only managed 1 year with a positive AFFO value, leaving a gap in earnings.

Instead of leveraging their assets to raise long term debt, Dream makes up this shortfall by selling additional equity, which is good practice for REITs.

A quick look at the income statement shows us that Dream has managed to consistently grow revenue, operating and net income. Although they have issued a lot of new stock and this has diluted EPS (this is not a measure investors should be too concerned with for REITs), overall we would agree that Dream’s management team are making the right decisions and that the company is moving in the right direction.

Forecast

REITs are not affected by seasonality in the way that industries such as retail are, so by extrapolating their Q3 result we can forecast 2014 full year results with a reasonable degree of accuracy:

Here we see why investors have been selling the stock during 2014. Although revenue has been growing, FFO is forecast to decrease by over 50%.

This aggressive drop in FFO probably answers our question of why the share price has decreased over 20% in the past 12 months. Yet is it really a huge cause for concern? To answer this we need to look deeper into the interim report.

Income from rentals has actually grown over the first nine months of 2014 in comparison to the same period in 2013. The significant change in income comes about from the fair valuation adjustment. Dream’s business model is to generate income through leasing, not the sales of assets, so this revaluation should not be of huge concern to investors.

The real gamble for investors is whether the dividend is sustainable. At its current share price of $27.23, to maintain an 8% yield, Dream will have to distribute $2.15 per share — which is well above the forecasted $1.93 FFO per share, requiring a dividend payout ratio of 112%