SRC - Realty Income: A Deep Dive Into The Spirit Realty Capital Deal

2023-11-01 12:31:36 ET

Summary

• Realty Income is the largest triple-net REIT in the US and is acquiring Spirit Realty Capital, making it the fourth largest REIT in the world.
• Realty Income has a strong history of dividend increases and a rock-solid dividend, with a 5-year dividend growth rate that surpasses the average REIT.
• The acquisition of Spirit Realty is expected to boost Realty Income's property portfolio, increase its base rent, and result in cost savings.

For those with only a passing knowledge of Realty Income ( O ), it is important to understand that the company has a long, successful history of growing through acquisitions. In fact, gobbling up other companies has made Realty the largest triple-net REIT in the United States, and is building it into the fourth largest REIT in the world.

Add to that a history of 122 dividend increases since the firm went public in 1994, along with 639 monthly dividends paid, and you have a rather impressive company.

Even so, the announcement that Realty is acquiring Spirit Realty Capital ( SRC ) sent the former company's stock down nearly 8% in a day. So, the obvious question for investors is whether this is a stock market overreaction or a portent of things to come.

Of course, an answer can only come with an in-depth analysis of both REITs.

Realty Income: Serving Up Monthly Dividends

Naysayers will point to Realty's rather low dividend growth rate as a negative. However, if you want a stock with a rock-solid dividend, you need look no further than Realty Income.

During the COVID-induced market collapse, Realty was the only retail net lease REIT and the only REIT listed in the S&P 500 that raised the dividend.

Furthermore, the company's 5-year dividend growth rate of 3.69% surpasses the 3.1% CAGR for dividends posted by the average REIT listed in the S&P 500. And with an AFFO payout ratio just below 77%, not even the biggest bear would claim that Realty's dividend isn't rock solid.

Even so, the dividend is but one facet of Realty's strength. During the Great Recession, O recorded the lowest operational and financial volatility of any A-rated S&P 500 REIT.

Realty is also well diversified from the perspective of the REIT's geographic footprint and in terms of its client base. The company has properties in the UK, Ireland, Spain, and Italy as well as all fifty states and Puerto Rico.

With over 13,100 properties and 1,303 clients in 85 industries, management touts that 91% of total rent is resilient to economic downturns and/or isolated from ecommerce competition. Add to that the fact that investment grade clients constitute 40% of rent, and that during the last earnings call, management noted that the REIT hit a 99% occupancy rate over the last three quarters.

Realty is among only seven S&P 500 REITs with two A3/A- ratings or better, along with being one of only two REITs among the S&P High-Yield Dividend Aristocrats Index with a credit rating of A- or better.

It is also important to note that Realty can borrow in Europe at rates that are significantly lower than those currently offered in the US. Additionally, 93% of Realty Income's debt is at a fixed rate, with well-laddered debt at a weighted average term-to-maturity of 6.7 years and zero debt payable in 2023.

Another source of strength lies in Realty's position as a triple-net lease REIT. This business model transfers the burden of paying the property's operating expenses, including real estate taxes, maintenance, and insurance costs to the tenants.

Furthermore, the REIT's leases tend to be long-term, with additional extension options. Coverage ratios are quite high, meaning tenants are solid companies and seldom request rent concessions, even during periods of macroeconomic malaise.

Nonetheless, bears often point to Realty Income's growth prospects as a negative. After all, the bigger the company, the more difficult it is to generate growth that translates into a surge in the share price.

Management counters that argument by noting that public net lease REITs comprise a mere 3% of the total addressable market in the US and less than 1% of the market in Europe.

What Spirit Realty Capital Brings To The Table

Spirit operates 2,064 properties in 49 states. The REIT derives 22% of its revenue from the top ten tenants, while 35% of its revenue comes from the top twenty tenants.

The company generates nearly $695 million in annual rents with a weighted average lease term of 10.3 years.

As of last quarter, Spirit reported a 99.8% occupancy rate. The company has maintained a 99%-plus occupancy rate since at least the second quarter of 2018.

The following chart provides a picture of the percentage concentration provided by the tenants in the top five industries.

Spirit only has a 2.9% exposure to office properties, and most of the REIT's tenants operate e-commerce resistant businesses.

While 90% of Spirit's tenant lease agreements carry escalation clauses, only 13% are directly linked to the Consumer Price Index. Nearly 78% of the remaining leases carry contractually fixed increases. Consequently, the overall value of the leases will not keep pace with the current levels of inflation, a weakness Spirit shares with Realty Income.

Spirit's debt is rated at the lower end of investment-grade. At the end of Q2, the company had $1.6 billion in liquidity, including cash and its credit facility.

The adjusted debt to annualized adjusted EBITDA is 5.3x.

Because Realty is assuming Spirit's debt, it is important to note that the latter company has a well-laddered, 100% fixed-rate debt with no maturities until 2025.

With an average remaining term to maturity of nearly five years and an average interest rate of 3.5%, the deal is not expected to have an adverse effect on Realty's balance sheet. Realty's leverage ratio should be around 5.5 times following the transaction.

Analyzing The Acquisition

Realty Income is acquiring Spirit Realty in an all-stock, leverage-neutral transaction. The deal is expected to close in the first quarter of 2024.

Under the terms of the agreement, Spirit investors will receive 0.762 newly issued Realty Income shares for each Spirit Realty share. At $37.34 per share, that constitutes a 15.4% premium to the stock's closing price prior to the announcement of the deal.

To get a handle on the price Realty is paying, since late 2020, except for three brief dips, Spirit has traded for over $40 a share.

The acquisition will boost Realty Income from the seventh largest to the fourth largest REIT in the S&P 500 by enterprise value. The REIT's property portfolio will grow from around 13,100 properties to nearly 15,200.

Realty's base rent will also jump from $3.8 billion to $4.5 billion.

Although there is a significant overlap in the two REIT's client bases, Realty's exposure to its 20 largest tenants will decline by 3.5%. Realty will also have lesser exposure to its current top industries, with the property portfolio moving away from retail and gaming while increasing exposure to service retail and industrial properties.

There will also be a shift in the geographic footprint of the REIT's property portfolio, as about a fifth of Spirit's rents stem from properties in Texas and Florida, markets in which Realty Income currently has less exposure.

Management guides for a 2.5% increase in adjusted funds from operations in the first year after the deal is finalized. It is also expected to result in approximately $50 million in annual general and administrative cost savings.

The following chart provides an overview of the client mix of the combined companies.

Is Realty A Buy, Sell, Or Hold?

While I view this deal in a favorable light, there are a few negatives to consider. Roughly half of Realty Income's tenants are not investment grade, and adding Spirit's clients to the mix will marginally weaken that metric .

Furthermore, although Realty has lessened its tenant concentration over the years, over half of Realty's net operating income is still centered on the top 20 tenants, with 6 tenants constituting over 3% of NOI. Therefore, any weakness in the REIT's top tenants could weigh on Realty Income's revenue.

Realty does not possess a moat, as the REIT's properties can be easily duplicated.

Realty is shouldering Spirit's existing debt, and with Spirit shareholders receiving 0.762 Realty Income shares for each Spirit common share owned, the deal is dilutive to current Realty shareholders.

One should also consider that over the last two decades, the relative performance of REITs has a strong negative correlation with interest-rate movements. Many investors view bonds and other interest-bearing instruments as risk-free, and this perception has some moving out of the Real Estate sector.

Furthermore, rising rates, especially when married with falling share valuations, reduce REITs ability to finance external growth. This is exacerbated by the fact that the bulk of both REIT's lease terms include very low annual rent increases, generally just 1%. This hamstrings internal growth for Realty Income, forcing the company to rely on acquisitions.

However, Realty's management team is particularly adept at executing deals, having notched nearly $35 billion in acquisitions over the past decade at average cap rates of around 6%.

I believe the Spirit acquisition is an example of how Realty's management team, bolstered by the size of the company, can execute on opportunities when the REIT sector is in the doldrums.

Spirit had become undervalued, with an implied cap rate of around 7.5%, and the REIT was trading near a 52-week low when Realty struck the deal. Rather than financing the acquisition with additional debt in a high interest rate environment, management moved to acquire Spirit in an all-stock deal with debt assumption.

The deal will result in greater diversification, both geographically and in terms of Realty's increased exposure to the industrial sector.

All in all, I consider the acquisition of Spirit Realty very positively. I also believe that the loss in share price presents a prime opportunity for patient investors.

Realty Income briefly traded at or slightly below the current share price at the peak of the COVID crisis and for about three months in 2018. Otherwise, you must go back to 2015 to find a time when the Realty traded below this valuation.

I'll add that the current yield of 6.65% is higher than witnessed during the darkest days of the COVID crisis. Aside from that downturn, and a brief period back in late 2013 and early 2014, we haven't witnessed Realty with much over a low 5% yield in the last decade.

For patient investors willing to ride out this storm, I rate Realty Income as a strong conviction BUY.

I view the current valuation and yield offered by Realty Income as a rare opportunity. I'll readily admit that I don't know whether it will take a few months, a year, or a half decade for Realty Income's share valuation to recover to the stock's historical norms, but I am confident that day will eventually come.

In the meantime, I'll be happy to collect Realty's dividend. I'll add that with a 6.65% yield, it will take very little price appreciation to match the market's average annual returns.

I am avidly adding to my rather small position in the stock whenever funds are available.

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