SRC - Realty Income: All-In After Spirit Realty Capital Merger

2023-11-03 00:35:55 ET

Summary

• Realty Income Corporation is set to acquire Spirit Realty Capital Inc., causing Spirit Realty Capital's stock price to surge 8%.
• Realty Income's stock price fell 6% due to the transaction risk, but the acquisition is expected to strengthen its core retail business and grow its industrial operations.
• The acquisition is seen as a positive move for Realty Income, with the potential for increased diversification and improved financial performance.

Realty Income Corporation ( O ) announced yesterday that it would acquire real estate investment trust Spirit Realty Capital Inc. ( SRC ) which caused the target’s stock price so surge 8%.

Realty Income’s stock price, on the other hand, fell 6%, as is often the case when the acquirer carries all the transaction risk. The $9.3 billion acquisition of Spirit Realty Capital is set to strengthen Realty Income’s core retail business, grow its industrial operations and is anticipated to result in AFFO per share accretion to the tune of 2.5%.

Taking into account that the Spirit Realty Capital transaction happens at a compelling FFO multiple, I think that passive income investors only have reasons to buy Realty Income after the merger announcement.

My Rating History

Realty Income’s Bellagio investment was a big deal because it marked a step forward in the trust’s evolution and diversified its FFO streams into gaming.

The acquisition of Spirit Realty Capital will further solidify the drive to enhance Realty Income’s diversification profile and make Realty Income the 4 ^th largest REIT (by enterprise value) in the S&P 500.

Since I rated Spirit Realty Capital highly , resulting in a Buy classification, and Realty Income is acquiring SRC at a compelling FFO multiple, I think a Strong Buy for Realty Income must be sustained.

Why Is Realty Income Acquiring Yet Another Multi-Billion Dollar Trust?

Realty Income has a history of making major acquisitions to acquire FFO growth. With its latest deal, the $9.3 billion all-stock transaction to acquire Spirit Realty Capital, Realty Income is strengthening its existing core retail operations, but it is also adding a considerable number of industrial properties to its growing real estate portfolio.

Realty Income’s background is in retail real estate, but the trust started to invest more heavily into industrial real estate in 2010 and has since grown its industrial operations to 13% of annualized contractual rent.

The acquisition of Spirit Realty Capital, which is anchored in retail, but also owns a considerable number of industrial properties, will help Realty Income incrementally diversify its real estate portfolio.

Spirit Realty Capital owned a total of 2,064 properties, and 257 of those fell into the industrial real estate category. Due to Spirit Realty Capital’s impressive lease rate of 99.8%, the transaction is anticipated to improve Realty Income’s pro-forma portfolio occupancy to 99.1%.

Realty Income has a higher percentage of investment grade-rated tenants than Spirit Realty Capital (40% vs. 19%), the weighted average lease term of SRC is much higher (10.3 years for SRC compared to 9.6 years for Realty Income.

Spirit Realty Capital’s industrial properties are worth $2.5 billion and is about evenly split between manufacturing and distribution facilities.

In total, Spirit Realty Capital’s industrial portion of the real estate portfolio produced $179 million in annualized base rent compared to $457 million in ABR of the retail portion.

Immediate Benefits Of The SRC Acquisition

Obviously, Realty Income expects synergy effects, a key reason for any merger deal: the trust plans to do away with $50 million in annual run-rate costs ($30 million excluding share-based compensation).

Realty Income estimates that transaction synergies will lead to a reduction in its G&A expense ratio (measured as a percentage of total revenues) from 3.9% pre-deal to 3.5% post-deal.

Most important of all, the transaction proposal presupposes immediate AFFO accretion potential of over 2.5% per share, and this is expected to be achieved without a change in the trust’s leverage structure.

Furthermore, as I already hinted at, it improves Realty Income’s portfolio diversification, leading to a higher degree of resilience and a higher weighted average lease term, and SRC’s industrial real estate will boost Realty Income’s non-core real estate holdings. Just like with the Bellagio deal, the transaction will strengthen those FFO streams that are classified as non-core.

Realty Income Is A Steal Below $50

I have pounded on the theme of valuation for quite a while and though I have been wrong on this (so far), I think that the market will eventually prove me right.

Realty Income has guided for $3.96 to $4.01 per share in AFFO (not account for organic and SRC deal-driven incremental FFO growth). With a stock price of $46.22, Realty Income is selling at a bargain AFFO multiple of 11.7x. Realty Income, not that long ago, sold for 20x AFFO.

Since Realty Income just announced that it will swallow up Spirit Realty Capital in an all-stock deal, it makes sense to compare the trust’s valuation to the valuation multiple of its acquisition target.

Spirit Realty Capital guided for $3.56 to $3.62 per share in AFFO and the trust’s stock trades at, post-deal announcement, at $34.89. The implied AFFO multiple for SRC is 9.7x which means Realty Income is buying SRC at a bargain price itself. For shareholders of Realty Income, both the deal price as well as the price of Realty Income itself are very attractive.

To provide yet another reference point, Kimco Realty Corporation ( KIM ) is selling, based on $1.56-1.57 per share, at 11.0x FFO. The AFFO premium that Realty Income used to trade at in the past has completely vanished, partially because of concerns over higher key interest rates, but also because of the deal announcement on Monday.

Why Realty Income Might See A Lower/Higher FFO Multiple

Realty Income will remain dependent on the retail section of its property portfolio and, thus, a recession is a risk and a headwind for the trust’s FFO performance.

Higher interest rates are also a headwind as they make real estate transactions, those that are not all-stock, more expensive. Higher rates also imply higher (re)financing costs for REITs that rely on floating-rate debt which may temporarily lower profit margins and stifle FFO potential.

In the long-term, I don’t think that higher or lower rates will either positively or negatively influence Realty Income’s real estate performance as Realty Income has delivered remarkably steady results over decades of real estate investing.

My Conclusion

I am a long term holder of Realty Income’s stock and consider the REIT to be a core holding in a passive income portfolio due to the stability and reliability of its dividend pay-out as well as long-term dividend growth history. Occasionally, if the opportunity presents itself, I am adding to Realty Income if the market appears to make a mistake in the pricing of the trust’s stock.

Barely two months ago, Realty Income announced a $1 billion investment in the Bellagio and the trust is not slowing down in terms of acquisitions. The $9.3 billion Spirit Realty Capital acquisition is set to incrementally boost Realty Income’s AFFO and make the trust the 4 ^th largest REIT by enterprise value in the S&P 500.

The transaction allows Realty Income to buy Spirit Realty Capital at a compelling AFFO multiple and will strengthen those parts of the portfolio (gaming, industrial) that have played a relatively minor role in the company’s growth strategy in the past.

I think the deal is a win-win for everybody, but particularly Realty Income shareholders that can now buy a high quality 6.6% yield at a bargain price. This is an all-in opportunity, Strong Buy.

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