Net Lease REITS on Sale; Beaten Down ARCP Offers High Capital Appreciation Upside and Dividend Growth
Stimulus tapering by the Federal Reserve has moved REIT values down pretty hard, continuing a selloff that began in late May, 2013, and created REIT bargains even though triple net REITs are fully capable of keeping up with future increases in interest rates without overly harming spreads, adjusted FFO or yields. Triple net REITs have low cost structures and multi-year lease terms with extremely low property ownership costs that results in a cash trickle-down to investors through steadily rising dividends that outpace inflation and interest rates.
American Realty Capital Properties (ARCP) is the largest publicly-traded net lease REIT by enterprise value ($21.5 billion). ARCP is widely credited with sparking an efficiency-driven consolidation wave in the net lease sector – with size and quality attracting favorable credit ratings that increase access to capital, increase liquidity and help institutional investors diversify their income-generating assets through investments in net lease companies such as ARCP. Where earlier, institutional investors would be less interested in small net lease players, ARCP’s larger capitalization now meets their capitalization, liquidity and credit rating requirements.
ACRP focuses on leasing properties (to fund cash flow and dividends) and on acquisitions for growth and leverage. With shares at $14.04 (market close 02/19/2014), rapidly growing dividends ($1 annualized; $0.0833333 payable monthly), a dividend yield of 7.12% (well above the 3.3% REIT average), a strong investment-grade balance sheet and favorable valuation with significant upside, ARCP is a compelling buy at current levels. Management has done a stellar job of identifying and integrating strategic acquisitions and increased capitalization to where ARCP could be included in the S&P 500 index and attract institutional investors and greater analyst coverage.
Solid Property Portfolio Will Generate Stable Income for Next 11 Years
ARCP has 99% occupancy across its portfolio of 3,732 properties, leased to well-recognized retailers in prime high-traffic locations. ARCP owns a total of 102 million square feet, of which 100.98 million square feet is occupied with an average remaining lease term 11 years. 49% of its properties are leased to large investment grade firms that include top retailers such as Walgreens, AT&T, CVS, FedEx, Target, TJ Maxx, Home Depot, Kroger, 24 Hour Fitness and Bed Bath and Beyond – all established leaders in their respective retail niches. ARCP’s leased portfolio is well diversified – by industry and geography – with tenants from 71 industries and properties in 49 states, Washington DC and Puerto Rico. Region-wise, ARCP’s largest holdings are in the Southeast (26.5%), Midwest (22%) and Southwest (19.9 %). 83.1% of the company’s top 10 tenants have investment grade corporate ratings.
Attractive 7% Dividend Yield, High Dividend Growth
ARCP pays an annualized dividend of $1.00 per share ($0.0833333 payable on the 15th calendar day of each month to holders of record on the 8th), with a dividend yield of 7.1%. Historically, ARCP has returned between 7.1% and 7.7% in annual dividends, well above its direct competitors – National Retail Properties (NNN), W.P. Carey (WPC) and Realty Income (O).
At 7%, ARCP’s yield is also well above other major REIT players that average a 3.3% yield. While ARCP is attracting solid retail and institutional interest, it continues to remain below the radar for most investors, and herein lies the opportunity to get in now.
Cole Acquisition Makes ARCP Net Lease Leader (by enterprise value)
In November 2013, ARCP completed its $2.2 billion acquisition of CapLease (68 properties with 97% occupancy), with increased cash flow that allowed ARCP to increase dividends by $0.03 per share to $0.94 annualized. In January 2014, the company finalized its $3 billion acquisition of ARCT IV Inc. which increased ARCP’s property count to 2,560 commercial properties with an average remaining lease term of 9.3 years, of which 56% of the anticipated lease revenue is from investment grade tenants. Also in January 2014, ARCP acquired 120 properties from Fortress Investment Group LLC.
On February 7, 2014, ARCP acquired long-term lease specialist Cole Real Estate Investments for $11.2 billion – a significant acquisition that ARCP had been pursuing for years – and acquired assets with 99% occupancy and 10.5 years of average remaining lease term. ARCP expects $70 million in expense synergies from this transaction, with size and scale delivering lower cost of capital and higher investor returns.
With Cole, ARCP is the largest net lease REIT with an enterprise value of $21.5 billion, 64% larger than its closest competitor, and has upped its property count to 3,732 with 99% occupancy and a 10.9-year average remaining lease term. With Cole, management expects combined revenues of $1.43 billion and adjusted funds from operations (AFFO) of $814 million ($1.13 to $1.19 per share; well above the annualized AFFO run rate of $0.84 reported in Q3 2013). The Cole acquisition had an implied acquisition cap rate of 6.3% and an all-in yield (net operating income + net income from Cole private capital management) of 6.5%. I like the acquisition because ARCP did not chase a higher cap rate or compromise on asset or credit quality but picked Cole for its long-term lease orientation and high quality property portfolio.
Following the Cole acquisition, on February 10, 2014, ARCP raised dividends by $0.06 to $1.00 annualized, a 7% increase.
With Cole, ARCP has a well-diversified tenant mix with 51.1% single tenant retail, 13.9% single tenant industrial/distribution, 23.9% single tenant office and 11.1% multi-tenant retail.
In the deal, more-than-expected Cole shareholders opted for ARCP stock instead of cash, so ARCP gave up less cash than expected, leaving it with a larger war-chest for the $2.5 billion to $3 billion in real estate acquisitions that the company has planned for 2014. Also, 70 of Cole’s top managers agreed to stay on post-acquisition – this underscores confidence in ARCP management and this addition of talent from Cole should help ARCP consolidate and grow its net lease leadership position.
With its larger enterprise value, ARCP also expects to attract greater analyst coverage and believes shares could ride higher if the company gets included in the S&P 500 index, which will attract institutional investors, add liquidity and add share price support.
As the graph below shows, ARCP has been instrumental in driving consolidation and growth in the net lease sector, while also driving greater relevance of this under-covered sector. With high yields, the net lease sector now attracts investors looking for solid income and dividend growth.
Long Lease Maturities, High Quality Tenants, Prime Locations = Low Re-Rental Risk, High Rental Resets
As lease terms expire, re-renting of units is always a concern. However, because ARCP has high quality tenants and properties in prime locations, I believe re-rental risks aren’t much of a concern. In fact, ARCP could get better lease terms on renewals because of the prime location advantage its properties offer. Moreover, re-rental risk is not an imminent concern because only 4% of ARCP’s leases mature in the next five years, with a weighted average remaining lease term of 11 years. And with the economy showing strong signs of a pickup, expiring leases will likely be renewed with existing or new tenants in a manner that will likely add to AFFO with higher rental rates and long lease terms.
Maverick Management Has Changed the Face of Net Lease Industry
The company is led by dynamic and visionary CEO, Nicholas Schorsch, who has more than 20 years of experience in real estate and has overseen $5 billion in transactional value with over 1,000 acquisitions in his career.
Management recently achieved its goal of moving from an externally managed company to a self-managed entity, with direct management a part of its acquisition agreement with Cole. In November 2013, the company hired Davis S. Kay as President and completed its self-management initiative. Kay brings significant real estate M&A experience to the company and will be instrumental in integrating acquisitions and taking over ARCP operational responsibility from CEO Schorsch.
The company also rounded out its management team with Brian Block as CFO focused exclusively on ARCP, Lisa Beeson as COO after 25 years of investment banking experience and Lisa McAlister as CAO with 25 years of senior financial experience. Through better-than-expected retention of Cole’s managers, the company further strengthened its human capital for direct management and growth of ARCP.
Management intends to stay on its current trajectory of growth through acquisitions to improve economies of scale, broaden ARCP’s asset pool, improve cash flow and pay higher dividends.
Wave of Insider Trades Signals Management Bullishness
Over the past few months, key insiders significantly boosted their ARCP shareholdings. Recently, incoming CFO Brian S. Block invested $82,360 in ARCP shares through an open market purchase. And on January 17, Director Leslie D. Michelson bought 6,900 shares at an average price of $13.53 for $93,341. Purchases close to the company’s current share price signal insider bullishness on future prospects, with several purchases in anticipation of AFFO upside from early completion of the Cole acquisition.
The Company’s come a Long Way since its IPO
When ARCP went public in 2011, it had 63 properties, of which 62 had one tenant – branches of troubled bank Citizens Financial Group with a relatively short weighted average lease term of 6.9 years. Home Depot was its token other tenant. Since then, management has made huge strides in diversifying its property base, geographical presence and tenant base, while also lowering operating expenses, strengthening cash flow, managing portfolio risk and sticking to a consistent acquisition strategy.
For its third quarter ended September 30, 2013, ARCP reported record revenues of $60.9 million, up 35% from $45 million in the second quarter, and adjusted funds from operations (AFFO) of $46.7 million ($0.21 per share), up 42% from $32.8 million in Q2. Funds from operations (FFO) were $(19.7) million, $(0.09) per share, and included $38 million in one-time merger-related expenses. FFO uses GAAP accounting and excludes gains or losses from property sales but includes asset impairment write-downs, and depreciation and amortization. Property Level net operating income (NOI = revenues less property related costs) was $56.8 million, up 34% from NOI of $42.5 million in the previous quarter. The company reported a GAAP net loss of $63.1 million ($(0.32) per share) due to high depreciation and amortization expenses ($39.4 million), higher interest income ($24.1 million) and $38.5 million in contingent value rights related to past acquisitions.
In anticipation of revenue gains from the Cole merger, the company announced full year 2014 AFFO guidance of $1.13 to $1.19 per share and a target payout ratio of 85% to 90%. AFFO guidance is well above the $0.84 annualized AFFO extrapolated from Q3’s AFFO of $0.21 per share. The company also plans to significantly reduce its net debt to EBITDA ratio from 9.1x to 7.7x by year end 2014.
At quarter end (09/30/2013), ARCP had net real estate investments of $2.82 billion, up from $1.74 billion on 12/31/2012, and $150.5 million in cash and equivalents. The company’s liabilities included $269.9 million in mortgage notes payable, $301 million in convertible debt and $600 million from the senior corporate credit facility. In addition, the company had $449.8 million in Series C convertible preferred notes. Shareholders’ equity totaled $1.45 billion (vs. market capitalization of 2.83 billion).
At quarter end, the company had 1,219 properties (20.4 million square feet) with 100% occupancy and 59.4% investment grade corporate tenants, with a weighted average remaining lease term of 9.5 years. The company’s properties are diversified by geography, industry and tenancy with 183 tenants, in 32 distinct economic sectors, across 48 states and Puerto Rico.
In the third quarter, ARCP bought properties worth $95 million, with an average capitalization rate of 9.0% (annual net operating income / property cost). After the third quarter, the company made additional acquisitions as outlined above (Cap Lease, ARCT IV and Cole).
Also in the third quarter, the company issued $310 million in an oversubscribed offering of 3% Convertible Senior Notes due August 2018, worked on increasing its senior corporate credit facility to $2.5 billion and completed a private placement of common stock and Series D cumulative convertible preferred stock with institutional holders, and applied proceeds towards the redemption of Series C convertible preferred stock.
Both Moody’s (Baa3) and S&P (BBB-) have assigned investment grade ratings to the company, which helped with long-term financing at attractive rates.
After the end of its third quarter, ARCP raised $690 million through the sale of 3.4% convertible notes with a blended maturity of six years, upgraded its corporate credit facility to $2.87 billion and raised $2.55 billion in senior unsecured debt with a weighted average interest rate of 2.8% and a blended maturity of five years. ARCP issued new debt at significantly lower interest rates and paid off more expensive debt carried by Cole, and significantly de-levered its balance sheet – with total mortgage debt down from $4.6 billion to $3.97 billion, and total debt down from $11.13 billion to $9.58 billion. After the Cole acquisition, the company decreased its total debt to equity ratio from 1.15x to 0.84x, with net debt/adjusted EBITDA of 7.4x. Through refinancing’s, the company decreased its average interest rate from 3.69% to 3.5%, and reduced its exposure to floating debt with higher fixed rate debt issuances.
ARCP now has the largest, most diversified tenant base and is the strongest player in the net lease REIT sector with gross assets of $20.4 billion, only 24% of revenue from its top 10 tenants, and 49% investment grade tenants – well above its competitors.
Overall, ARCP has a best-in-class portfolio with strong diversification by property type, geography, tenants and industries, with a solid 49% base of investment grade tenants. The company’s management team deserves credit for bringing net lease REITs to the forefront through rapid industry consolidation, while maintaining a strong and flexible balance sheet that has garnered an investment grade rating. Through acquisitions and organic growth, ARCP plans to grow dividends for the foreseeable future, and with its 7.1% dividend yield, offers a highly compelling opportunity in a niche sector. In addition, if ARCP is included in the S&P 500 index, shares could get a boost from institutional interest, while increasing the permanence of its investor base and increasing liquidity.