Thesis
Despite a massive decline in their stock price over the past several years, FSP remains unattractively priced at current levels. FSP suffers from a poor capital recycling strategy that has delivered sub-par returns, declining AFFO, and outsized management expectations that will be difficult to meet.
Poor Strategy Enacted
Approximately 80% of FSP’s portfolio is currently allocated to their five core markets, which include Atlanta, Dallas, Denver, Houston, and Minneapolis. The other 20% consists of suburban office properties scattered throughout the United States. Over the past several years, FSP has engaged in a capital recycling strategy in which suburban office properties have been disposed, allowing for the purchase of office properties in their core markets. Management acknowledged in their most recent 10-K that they plan to continue this strategy, stating
From time-to-time we may dispose of our smaller, suburban office assets and replace them with larger urban infill and central business district office assets located primarily in our five core markets.
In my opinion, demographic trends appear to be shifting in the direction of suburban office, as opposed to the central business districts (CBDs) they are targeting. On the macro level, the core markets targeted by FSP were significant beneficiaries of millennials choosing to live and work in urban areas following the 2008 financial crisis. As the millennials age into their mid to upper 30s, many are now beginning to relocate to more affordable suburban regions. In 2016 and 2017, the U.S. Census Bureau reports that more than 2.6 million people moved from principal cities in metropolitan areas to the suburbs, and millennials have been largely responsible for this trend. The aging of the more than 80 million Americans who belong to the millennial generation could indicate that a suburban revival may be in the early innings, bolstering the prospects for suburban office properties.
In addition to being supported by positive demographic trends, suburban office properties also sport much higher cap rates than CBD office properties.
Source- Marcus & Millichap 2019 Office Investment Report
As FSP has disposed of their suburban office properties, they have transitioned into lower yielding CBD properties. Meanwhile, at present cap rates, suburban office properties have the potential to deliver much higher returns.
Suburban Office is Generating Higher Occupancy Rates
As of Q1 2019, FSP’s 32 operating properties (properties not undergoing redevelopment) had a weighted average occupancy rate of 86.2%. Looking at the comparison between FSP’s suburban office and core market properties, FSP’s suburban office portfolio is currently producing much higher occupancy rates than their core markets.
| 32 Operating Properties | Net rentable square feet | Weighted occupied square feet | Occupancy rate |
| 10 non-core market properties | 1,872 | 1,704 | 91.03% |
| 22 core market properties | 7,623 | 6,481 | 85.01% |
| Total operating portfolio | 9,495 | 8,185 | 86.2% |
Source- Calculations from Q1 2019 Earnings Supplement
Thus, any further dispositions of their suburban office properties will only continue to decrease their overall occupancy rate, which already under performs the broader office REIT sector.
While management should have been anticipating the potential of their investments in suburban office, as well as the possibility of expanding further in that area, they have been focused on chasing CBD office markets that have less favorable demographics than several years ago. This flawed strategy has contributed to FSP’s significant under performance when compared to its office REIT peers. Considering that FSP has not acquired or disposed of a property since December 2017, perhaps management also recognizes the unfavorable conditions that have resulted from the company’s capital recycling strategy.
Trend of Lower Earnings
Franklin Street Properties’ capital recycling strategy has contributed to a long-term decline in both funds from operations (FFO) and adjusted funds from operations (AFFO), two key earnings metrics for REITs (source of chart).
| Year | 2014 | 2015 | 2016 | 2017 | 2018 | 2019e |
| FFO per share | 1.12 | 1.07 | 1.03 | 1.04 | 0.96 | .81-.87 |
| AFFO per share | 0.89 | 0.8 | 0.7 | 0.62 | 0.47 | Not given |
Source- Earnings Supplements from 2014-2019
As illustrated from the chart, earnings peaked in 2014 and have gone down each year since. However, what is most striking about this chart is the contrast between FFO and AFFO and how significantly they have diverged in recent years. While FFO and AFFO were $1.12 and $.89 per share in 2014, respectively, they have declined to $.96 and $.47 per share by 2018, respectively. The major cause for this divergence has been a significant increase in recurring capital expenditures (tenant improvements, leasing commissions, and maintenance capex) for FSP, which are accounted for under AFFO, but not FFO. In particular, tenant improvement expenditures have seen the largest increase.
I would argue that this trend is likely to continue, considering the increasing levels of office supply both nationally, as well as in the core markets where FSP owns most of their properties. With ample new supply coming on the market, tenants have greater negotiating power with landlords. If a landlord is unwilling to meet a prospective tenant’s demands of renovations and upgrades, then they can more easily lease with a new office building that already has the quality space they were seeking through their former landlord. While management does not provide any outlook in terms of how much FSP projects to spend on capex, they acknowledge that it is higher when leasing activity is strong. Consequently, there is a good chance capex spending for 2019 will be higher than 2018, potentially resulting in another year of declining AFFO. FSP reduced their dividend payout from $.76 per year to $.36 due to their rising capex, illustrating the negative impact it has had on shareholder returns. AFFO is a wildcard to predict, given the volatile nature of capex spending. However, rising office supply and greater tenant demands appear to be enduring trends that will negatively weigh on earnings through greater capex spending for the foreseeable future.
Concerns Over Outsized Expectations
Despite their poor operating performance over the past several years, management remains optimistic about the future. Management mentioned in their Q4 2017 conference call that they expect gains from new leasing to drive occupancy to the range of 92-96%, which they reiterated in their Q4 2018 conference call. In addition to the fact that they are currently far from 92% occupancy, I am skeptical of these objectives for two reasons. For one, the company reported in their most recent quarter that a cumulative total of 21.5% of their leases are expiring through 2020, and 45.6% through 2022.
While the company is seeing strong leasing activity compared to prior years, increasing occupancy will be challenging given the significant portion of their tenants that will either be renewing their leases or moving out of their properties.
Additionally, look at the levels of occupancy in FSP’s core markets compared to their goals.
| Core Markets | Occupancy Rate |
| Atlanta | 82.90% |
| Dallas | 81.50% |
| Denver | 84.60% |
| Houston | 78.50% |
| Minneapolis | 88.60% |
Source- Marcus & Millichap 2019 Office Report
If the company projects its vacancy rate to be in the 4-8% range, then they will be vastly outperforming occupancy rates for comparable properties in markets where they are primarily invested. This is assuming they do not dispose of any more of the suburban office properties as well. FSP’s suburban portfolio has a much higher occupancy rate than office properties in their five core markets. Given that the vacancy rates in these core markets have been fairly stagnant over the past several years, as new supply has matched strong demand, I surmise this will be a very difficult feat to meet.
The Bright Side
While I have critiqued FSP throughout this article, I also recognize that there is certainly a case to be made against some of my points. For one, FSP’s concentration in their five core markets has arguably increased the stability of their portfolio. While I maintain that the right suburban office property is superior to CBD because of shifting millennial demographics and higher cap rates, this office type is also inherently riskier. Second, the amount an office company spends on capital expenditures is very volatile. The recent spike in capex spending over the past several years has substantially reduced AFFO. However, capex increases could certainly reverse in the future, depending on circumstances in the office market. Lastly, management has stated that they project current low occupancy levels to have bottomed, as they mentioned in their most recent conference call that “barring any surprises, we believe that leased occupancy will trend upward during the next several quarters due to strong prospective interest in the largest vacancies.” Thus, strong leasing activity could potentially result in progress toward meeting that 92-96% occupancy rate goal established by management.
Conclusion
The significant price decline in FSP’s stock does not represent a buying opportunity, considering its lackluster fundamentals and potential for continued earnings decline. However, with extremely low occupancy rates and strong leasing activity expected, Franklin Street Properties remains on my radar. For the next several quarters, I plan to track occupancy rates and capex spending. If strong leasing activity contributes to rising occupancy rates, and the company begins to slow the rate of growth in capex spending, then valuations could become more attractive. However, until the company proves that it can meaningfully grow occupancy and reverse its earnings decline, I will be avoiding this stock.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
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