SRC - Cost Of Capital Advantage Makes Agree Realty A Better Value Than Spirit Realty

2023-06-30 07:45:56 ET

Summary

• Agree Realty and Spirit Realty share the same business model, have the same issuer rating from S&P, and have similar market caps. Execution is what sets one apart.
• A lower debt load and healthier margins translate to less volatility for Agree's stock. This in turn reduces the cost of equity.
• Agree's cost of equity advantage over Spirit Realty means that Agree can create more value than Spirit even for similarly performing assets.

Introduction

Agree Realty Corporation ( ADC ) and Spirit Realty Capital ( SRC ) are free standing, retail REITs that generate rental income on a triple-net basis. As of Q1 2023, Agree Realty had 1908 properties for lease in 48 states with 99.7% of the properties leased. Spirit Realty Capital had 2083 properties for lease across 49 states with an occupancy rate of 99.8%. Agree has an equity market cap of about $6.1 billion to $5.5 billion for Spirit. Both enjoy an investment grade rating. S&P assigned both firms an issuer rating of BBB, while Moody's assigned Agree an issuer rating of Baa1 and Spirit a Baa2 rating. S&P and Moody's have stable outlooks for both firms.

Source: Agree Realty June 2023 Presentation, Spirit Realty Q1 2023 Supplemental Investor Presentation, ww.cnbc.com.

Agree and Spirit are spread investors. They generate rental income and derive profit from the difference between the rental income earned and the cost to finance the assets for which they receive the rental income. In this article, we break down the spread into its component parts and compare the worthiness of an investment in one REIT versus the other. We look at the capitalization rate and estimate the cost of capital in some detail. We evaluate the cost of capital from each source and appraise the cost of equity using the Capital Asset Pricing Model. We opine on which issue might be a better deal and conclude with a recommended investment action.

Capitalization Rate

In theory, when a business can deploy assets and earn a return that exceeds the cost to acquire the assets then value is created. In the context of a REIT, this is akin to value creation when the capitalization rate exceeds the cost of capital. The capitalization rate, or cap rate, is the net operating income divided by the property's assets value. And the cost of capital is the cost to use the capital to acquire the assets for which income is obtained.

Please take a look at Table 1 which presents the average implied cap rate from Q1 2000 to Q1 2023 for free standing retail REITs.

Source: Nareit T-Tracker

The free standing retail REITs as a group had an equity market cap of $68.3 billion as of May 31st and Agree Realty's equity comprised 8.81% of the total and Spirit's equity was 7.86% of the group total. Neither REIT, it appears, can exert an outsize influence on cap rates. Readers may want to incorporate a macro perspective on the cap rate used as cap rates are positively correlated to interest rates.

For our purposes, we will use the average cap rate of 6.77%. For Agree and Spirit to create value, they must have a cost of capital that is lower than the cap rate.

Cost of Capital

The cost of capital can be broken down into the cost of debt, the cost of equity and the cost of preferred equity. We have to weigh the relative size of each source of capital in the capital structure and so the first step in estimating the cost of capital is to inspect the respective REIT's capital structure. Please take a look at Table 2.

Source: Latest 10-Q and 10-K for Agree Realty and latest 10-Q and 10-K for Spirit Realty Capital. REITWatch May 2023 .

The item from the table that is noteworthy is that debt forms a larger part of the capital structure for Spirit than it does for Agree. For a company, especially one that has an investment grade rating, it is cheaper to secure debt financing than equity financing. Given that both REITs are of similar size and operate in the same corner of the market and have similarly rated debt, why would Agree not opt to have more debt in their capital structure? Let us put a pin in this for now and continue with estimating the cost of capital. We shall revisit this issue.

Please take a look at Table 3 in which we present the amount of debt for each REIT as well as the median yield for 10-year Corporate (Baa/BBB) as per Fidelity. We shall use this as our estimate for the cost of debt.

Let us turn to the cost of equity.

There are different philosophies and methodologies to estimate the cost of equity capital. For our analysis, we shall employ the Capital Asset Pricing Model (CAPM) which essentially adds a spread to the risk-free rate and scales the spread by the volatility of the stock in relation to the market. Please take a look at Table 4.

Source: Seeking Alpha for the beta statistic and www.cnbc.com for the 10-year Treasury.

The beta statistic measures the volatility with respect to the market. I use the 10-year treasury as my risk-free rate and apply a spread, or an equity risk premium of 4.5%. The percentage used for an equity risk premium is subjective, I use 4.5% which I would argue is within the range of what is commonly estimated.

What is noteworthy from Table 4 is the significant cost of equity advantage Agree has over Spirit. Agree has an equity cost of 6.05% versus 7.35% for Spirit. This is probably why Agree doesn't use up more debt in the capital structure. Agree is able to secure a lower cost of equity because of a lower beta statistic. Now, why would Agree's stock be less volatile than Spirit in relation to the market? They are similarly situated REITs with comparable business models. Let us look at this a little bit further.

Beta is a measure of systematic risk or non-diversifiable risk. It is the risk to the market as a whole that we generally cannot plan for. So, when the Great Recession hit, it was difficult if not impossible to prepare and position your portfolio accordingly. Another lens to view risk is to categorize risk in terms of business risk and financial risk. Financial risk has to do with leverage. And, since Agree has less debt, they have less systematic risk with regard to interest rates. In this context, this type of risk probably relates to having to refinance debt at a higher rate in an inflationary environment. Agree does not have significant debt maturing until 2028. Spirit has $300,000,000 of debt maturing in 2026 and similarly meaningful amounts in every year after until 2032.

The systematic part of business risk has to do with uncertainty with regards to operating cost structure. The wider the margins, the more it can absorb macro-economic shocks. One way to measure margins is to see how efficiently revenue drops down to Adjusted Funds from Operations (AFFO). Please take a look at Table 5 which shows the average AFFO margin for 2020-2022 for both firms.

Agree is more efficient and generating AFFO per unit revenue by this measure, which would imply healthier margins.

We have seen the cost of debt and of equity respectively. They each have a small number of preferred shares outstanding for which the proportional cost differences is negligible in the grand scheme. We have also omitted the debt shield usually included in the cost of debt calculation by virtue of their REIT status. Taking into account all sources of capital, please take a look at Table 6 for an estimate of the Weighted Average Cost of Capital.

Despite having more equity in the capital structure than Spirit, Agree is able to secure a lower WACC than Spirit. This paints a very favorable picture of the management strategy at Agree. They are able to leverage a cost of equity advantage into a cost of capital advantage when most REITs try to leverage a cost of debt advantage into a cost of capital advantage.

In Table 7, we quantify how much value is created by subtracting the cost of capital from the cap rate.

Agree creates 74 basis points more value than Spirit by this measure.

Creating value as business is only part of the picture. While it is necessary condition for a potential investment it isn't a sufficient one. We also have to ask to whom does that value accrue to? Fixed income holders? Management? Equity investors? As equity investors with minority interests, we want to make sure that at least some of that value created shows up in our account.

To estimate which of the two stocks is a better deal for investors, we will revisit the cost of equity calculated previously.

Cost of Equity Revisited

We estimated the cost of equity using the CAPM which is a statistical way of ascertaining the cost of equity. There are other methods to estimate the cost of equity. Also, cost of equity is the terminology used from the company's perspective. It is the cost for them to obtain equity capital. From the investor's point of view, the cost of equity is the required rate of return for an investment. And for many investors, particularly REIT investors, the required rate of return has two components: the current dividend yield and the growth rate of the dividends. Please take a look at Table 8 where we look at the total return as the current dividend yield plus the 2020-2022 compound annual dividend growth rate as supplied by Seeking Alpha.

Source: Seeking Alpha

From this table, the total return estimate of Agree exceeds that of Spirit.

To quantify how much value is created for equity investors, the more relevant calculation is of the total return to the cost of equity calculated using CAPM. Please take a look at Table 9.

After taking into account volatility, capital structure and the current macro environment, Agree is a better deal by 296 basis points. If we combine what we learned from Table 7 and Table 9, we can say that Agree creates more value as a business and that the value created accrues to shareholders.

Conclusion

Agree and Spirit are both spread investors. They are similar in size and scale and often even share the same corporate tenants. Agree's higher margins and lower debt level reduces their stock's volatility which translates to a lower cost of capital than their similarly rated competitor. By having a lower cost of capital than Spirit, they can create more value even if they were to compete for properties with the same operating track records. The value that Agree creates is magnified for equity investors because the total return offered at the current price more than compensates the investor for the opportunity cost assumed as measured by CAPM. While both Agree and Spirit create value and offer a return that exceed the cost of equity, for investors seeking exposure in this space, Agree is the superior choice.

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