Small-Cap Office REIT First Potomac Downgrade - A Potential M&A Silver Lining?

On May 28, BMO Capital Markets analyst Paul Adornato published a note "Downtown Funk…" detailing why First Potomac Realty Trust

shares were being downgraded and its BMO target price reduced by over 21 percent. However, there could be a silver lining, due to $615 million cap First Potomac's potential to be acquired, or be a candidate to be taken private, in order to realize the full value potential of its portfolio over time. Notably, BMO is projecting a potential 26 percent 12 month total return for high-yielding FPO shares, even at its lowered price target. Tale Of The Tape - Shares Under Pressure During the past year FPO shares have lost just over 20 percent of their value, and YTD they are down almost 16 percent.

During the past 52-weeks FPO has traded in a range of $10.21 to $12.95 per share, and currently pays out a dividend yielding 5.7 percent. FPO Strategic Pivot Since 2010, First Potomac has acquired $1.1 billion of office assets located in various metro-Washington D.C. markets. During the same time period, FPO has shed $450 million of assets, including the sale of the majority of its 4.3 million SF industrial portfolio to The Blackstone Group

for ~$215 million in 2013. Unfortunately, the Washington D.C. office market -- heavily dependent upon Federal spending -- contracted severely in 2014, as shown in the slides below. First Potomac - At A Glance 1. Double-Down On Washington D.C. - Office

2. Shrinking Economy

3. Job Loss Slams D.C. Office Market

4. FPO Portfolio Occupancy Trends

5. High Quality Assets/Long-Term Value Creation

BMO - First Potomac: Downgrade Outperform To Market Perform, PT Lowered $16 to $12.50 The BMO new $12.50 target price represents a potential ~20.3 percent upside, based upon the May 28, FPO closing price of $10.43 per share; for a total return of ~26 percent including the 5.7 percent dividend yield.  The BMO $12.50 PT is based upon 16.7x revised 2016E AFFO of $0.75 per share.  FPO currently "is trading at 14.0x [BMO's] 2016 AFFO estimate, which represents a 31% discount to the 20.2 REIT universe average…"  Adornato's rationale included, "…DC office recovery has been slower than expected, and FPO's leverage, redevelopment pipeline, and market cap make it less compelling to public investors." FPO - Consensus Analyst Estimates The revised BMO 2016 estimated AFFO for FPO is still considerably above the consensus estimate of $0.68 per share posted by First Potomac on its website.

Source: FPO - IR website May 28, 2015 Silver Lining Playbook? While Adornato does not recommend buying REIT shares due to M&A speculation, First Potomac, is currently trading at a significant discount to NAV, as noted in the chart below.

The FPO Debt + Preferred to EV appears to be towards the middle of this group, although not nearly as high as some of the REITs in this group, the FPO leverage is still relatively high compared with REIT averages. BMO - Private Equity A Possibility According to Adornato: "With three recently announced deals in the Apartment REIT sector (Associated Estates, Trade Street Residential, potentially Home Properties) and various private firms such as Blackstone eyeing such REITs as privatization candidates, we think the environment for transactions -- fueled by the spread between best and worst -- is likely to become more friendly to M&A activity." Investor Takeaway The fact remains that REITs which are geographically concentrated can be riskier for investors. However, if the bad news is already priced into the First Potomac shares, investors are being paid a 5.7 percent dividend to wait for the D.C. "job pendulum" to swing in the favor of office landlords. Additionally, First Potomac has several major office redevelopment projects in various stages, which will likely help to increase returns when the local economy improves.