SRC - I Am Playing Defense With This 8%-Yield REIT: Spirit Realty

2023-10-17 07:35:00 ET

Summary

• High-quality REITs at deep discounts are excellent buys for a rate-agonistic income portfolio.
• Spirit Realty Capital, Inc. has no near-term debt maturities, ample liquidity, and a solid portfolio composition, making it an attractive investment opportunity.
• The safest dividend is the one that was just raised.

Co-authored With "Hidden Opportunities."

REITs are Deeply Discounted

Amidst concerns that interest rates may remain elevated for longer than the market hoped, the Property real estate investment trust ("REIT") sector continues to experience a selloff. Valuations are low, and there are terrific valuations in the rubble, even though all companies in the industry are not in trouble from the elevated interest rates.

In fact, balance sheet-wise, the sector is much more resilient than the GFC (Great Financial Crisis), and companies can weather the right lending conditions. 90% of eREIT debt is fixed-rate with an average maturity of seven years, and three-quarters of the debt is unsecured.

Notably, sectors like industrial properties, warehouses, logistics, data centers, medical office buildings, and apartment buildings are thriving. Yet, Mr. Market's reaction has been relatively similar for the broader REIT sector since mid-July. Here is the stock price performance of a few prominent Net Lease REITs without much regard to their operating fundamentals or balance sheet health.

While this sector is experiencing downward price pressure due to rising rates, we are not looking to buy today to sell tomorrow. As such, we will now discuss a high yield Net Lease REIT with strong liquidity levels, and a comfortable debt maturity schedule to ride this interest cycle with big dividends. Let's dive in!

Introducing Spirit Realty Capital

Spirit Realty Capital, Inc. (SRC) is a premier net-lease property REIT operating a robust portfolio of single-tenant long-term leases. SRC's real estate assets are leased out to 345 tenants from 37 industries with a 10.3-year Weighted Average Lease Term and currently reports a 99.8% occupancy. Notably, the REIT maintained such elevated occupancy levels through the COVID-19 pandemic, indicating the overall operational resilience of its tenants and the physical location dependence of its business models. Source .

Highly Diversified Location-Dependent Tenant Base

SRC's top tenants constitute 34.7% of the REIT's ABR (Annualized Base Rent) and are unlikely to have their business disrupted by the e-commerce shift.

Forty percent of SRC's ABR comprises industrial or service-oriented retail businesses where significant investment is made to establish at a specific location, and these tenants typically sign long-term leases and are likely to renew.

About 85% of SRC's tenants generate revenues over $100 million annually. Office properties were never a core area for SRC with only 2.9% of base rent coming from office properties.

Ninety percent of SRC's tenant lease agreements carry escalation clauses to combat the effects of inflation over the long term. However, 77.6% of the leases carry contractually fixed increases, and only 13% are directly linked to the Consumer Price Index. So we can expect steady rent growth regardless of inflation, but will not see a large bump caused by inflation.

Strong Balance Sheet With No Near-Term Debt Maturities

SRC maintains an investment-grade "BBB" rated balance sheet with 100% fixed-rate debt and no maturities until 2025. The REIT ended Q2 with $1.6 billion in liquidity, comprising cash and availability under its credit facility.

Even those arguing for the "higher for longer" case project rates to begin dropping sometime in 2024, and the company's strong financial position will permit them to refinance on favorable terms.

Accretive Acquisitions To Boost Portfolio Income

During Q2 2022 , SRC made a total capital deployment of $169 million to acquire 11 properties and made enhancements to others at a cash cap rate of 8.03%. The company also disposed of 18 occupied properties for $41 million during the quarter at a cash cap rate of 6.27%.

Let me explain why this is a profitable move in simple terms.

High Cap Rate: When you buy a property with a high cap rate, it means you paid a relatively low price for it compared to the money you can make from it each year. It's like buying a house at a good sale price. You might be getting a lot of rent from the property compared to what you spent to buy it.

Low Cap Rate: On the other hand, when you buy a property with a low cap rate, it means you paid a higher price for it compared to the money it makes each year. It's like buying a house when it's not on sale, so you might not make as much profit right away.

So when you acquire more real estate assets at high cap rates (good deal for the buyer), you are basically making good deals in relation to how much rental income you can collect. And then turning around and selling other assets at low cap rates (good deals for a seller) makes you a net buyer of positive cash flows from your investments.

Thanks to its diversified tenant base across operationally resilient tenants, SRC has performed above expectations, and management has revised its AFFO guidance upward to $3.56-3.62/share. This provides adequate coverage for the company's newly raised $0.67 per share quarterly dividend at a ~74% payout ratio. This is the third annual raise since 2020, indicating the company's dividend stewardship amidst harsh quantitative tightening.

When asked about its record low valuation compared to industry peers, the CEO reiterated the focus on making accretive acquisitions without raising new capital to boost portfolio quality.

"It's a mystery sometimes why we're trading at this kind of multiple when the portfolio is so solid, so diverse. I think in time, we'll be able to close that gap. We are going to just keep doing what we say we're going to do, which is try and punch out solid acquisitions, fund ourselves accretively." - Jackson Hsieh, President and CEO.

The Selloff is Disconnected from Operating Fundamentals

SRC has experienced a steep selloff in recent months despite overall strength in its operations and liquidity levels.

At this time, SRC is the most discounted Net Lease REIT in comparison to peers while maintaining sector-leading payout and yield levels.

We invite the selloff as a buying opportunity to boost our income and wait for Mr. Market to realize the potential in this well-managed REIT.

• 6.00% Series A Cumulative Redeemable Preferred Stock ( SRC.PR.A ) .

SRC has one public preferred security SRC-A that currently trades post its call date and carries a BB+ rating from leading credit agencies.

During 1H 2023, SRC spent $5.1 million on preferred dividends compared to the $187.3 million common dividend expense. The $254 million AFFO for the period provided adequate coverage for these shareholder commitments.

Investors must note that amidst periods of Quantitative Tightening (2017-2019 & 2022-present), we have seen this preferred security reach deeply discounted territories. On the other hand, during dovish monetary policy (2019-2020) and (2020-2021), we have seen SRC-A trade significantly above par levels, indicating the value proposition from this fixed-income producer when purchased at discounts. Source .

SRC-A currently yields 7.5% and offers up to ~25% upside to par, providing a comfortable income stream to lock in while the markets stay fearful of the Federal Reserve.

Conclusion

As income investors, a bear market is a buyer's market. Our Investing Group buys quality companies with solid profitability and sustainable dividends at discounted prices, and our portfolio is well-diversified to protect our income levels through market turbulence. This is how we design a rate-agnostic portfolio - we collect healthy income now and continue to generate yields when yields are scarce.

We find in Spirit Realty Capital, Inc. a deeply discounted REIT with a solid balance sheet and excellent income prospects.

• No near-term debt maturities and ample liquidity levels

• High yields at a respectable payout ratio

• Cheapest valuation among peer Net Lease REITs

• Quality portfolio composition with negligible exposure to "risky" tenants and industries.

The safest dividend is one that was just raised, and with an 8% yield, Spirit Realty Capital, Inc. presents a solid bargain to buy and wait for the Fed to reverse its course on the monetary policy.

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