SRC - Realty Income: I'm 'All In' After Spirit Deal

2023-11-01 07:00:00 ET

Summary

• Realty Income is acquiring Spirit Realty in a stock-for-stock deal valued at $9.3 billion.
• The merger will make Realty Income the largest triple net REIT and the fourth-largest REIT.
• The deal is expected to be over 2.5% accretive to Realty Income AFFO per share.

I wasn't surprised on Monday morning when I saw the news that Realty Income ( O ) was acquiring Spirit Realty ( SRC ) in a stock-for-stock deal valued at $9.3 billion, or $37.34 per share.

I have been suggesting such a merger could take place for a few years now. In January 2023 I explained :

"Spirit's property mix and tenant base would pair nicely with Realty Income and give them increased exposure to industrial properties. Currently Spirit is trading at a slight discount to its normal P/FFO multiple, and well below the sector's average normal P/FFO.

No one can predict the future, but Spirit does have high quality assets trading below the sector's average that fit very well with Realty Income's current portfolio."

That article was written it January 2023 when Spirit was trading at around $40.00 per share:

So again, I was not surprised to see the news on Monday, especially after seeing Spirit become extremely cheap with an implied cap rate of around 7.5%.

This seems to be a fair price to pay in this environment in which cost of capital has increased significantly over the last year or so.

In fact, when you look at the chart below, you can see that Realty Income pulled the trigger when Spirit was trading at a 52-week low:

I know some of the Spirit shareholders (of which I'm one) may not like the pricing on the deal in which SRC shareholders will receive 0.762 of newly-issued O shares for each SRC share owned.

However, I've been saying for years now that Spirit has really never gotten any traction with its current management team. You may recall that I was negative on Spirit back in October 2017 , even calling the REIT "spooky."

"I consider Spirit "spooky," and I'm continuing to maintain a Sell."

Now, to be fair, the new management team was able to spin off the "ugly ducklings" and invest in lower-yielding investment grade tenant assets. The problem though is that the company was never able to enjoy the cost of capital as Realty Income, so the investment spreads were "lackluster."

Spirit was hoping that it could become a mini-Realty Income - just like Agree Realty ( ADC ) - but it just didn't happen. So as they say, "if you can't beat 'em, join 'em,"

Yesterday I had quite a few comments on Seeking Alpha, complimenting my soothsayer skills. Readers commented things like:

You called it on the M&A. Congratulations.

Wow! That is very good prediction! Well done.

You certainly called this one.

You called this a couple of months back.

While I appreciate all of the kind words, I must say that I'm not a psychic.

It's fairly obvious to me that a REIT like Realty Income will keep doing what it does best, which is to continue to generate steady and reliable dividends for investors paid monthly.

Given the fact that Realty's cost of capital is elevated, it's harder to grow externally, so buying others at a decent multiple spread is the best game.

Back 13 years ago when I began writing on Seeking Alpha, the net lease sector was small, and many analysts weren't interested in covering the sector. However, as viewed below, the net lease sector has become a gigantic property category with a market capitalization of more than $117 billion.

The merger will make Realty Income the largest triple net REIT and fourth largest REIT ($63B EV), and the deal is anticipated to close in Q1-24.

Of course, it's subject to Spirit's shareholder approval that also includes a go-shop clause and is subject to a termination fee of ~$93 million within 45 days (~$170 million after 45 days).

I suspect there will be no competing bids, especially in the public sector. You may recall that Store Capital was taken out in a $15 billion deal by GIC (global institutional investor) in a partnership with Oak Street, a division of Blue Owl.

Because the proposed Spirit deal is a stock deal, no new capital is required (stock-for-stock with debt assumption).

This means that Realty Income doesn't need to raise any new capital, however there are refinancing headwinds given the higher rate environment today. Spirit's $4.1 billion of debt is at 3.48% which would be around 7% today.

Scale Has Its Advantages

As shown below, Realty Income is the undeniable leader in the net lease sector:

Realty Income anticipates approximately $50 million of G&A synergies, or approximately $30 million of synergies excluding stock-based compensation, representing approximately $0.03 per share.

Spirit's portfolio is complementary as it improves diversification and increases investment capacity across various categories. Spirit's portfolio comprises 51% non-discretionary and service retail assets and 26% industrial (77% total).

Fourteen of Spirit's top 20 clients overlap on a combined basis, allowing Realty Income to reinforce and deepen existing relationships with key clients.

By acquiring Spirit, Realty will diversify its top 20 list as its exposure to 18/20 tenants will decrease , while Cineworld will no longer be a top 20 tenant.

As I mentioned earlier, Realty Income's portfolio exposure to Industrial will grow to ~15% (13%); Spirit is ~26% Industrial.

The transaction is expected to be "over" 2.5% accretive to Realty Income AFFO per share. I highlighted the word "over" because typically Realty Income provides conservatism estimates and I suspect the accretion could be higher than 2.5%.

The fact that the deal is leverage neutral means that Realty will preserve its mid-5x debt/EBITDA cap and credit rating. Remember that Realty is one of only eight REITs with 'A' ratings from two major agencies.

Also, Realty benefits from Spirit's below-market debt with no maturities until 2025. As viewed below, the merger improves Realty Income's balance sheet:

Mr. Market Doesn't Get It

Yesterday Realty Income traded down by more than 7%:

This makes this cheap stock even cheaper…

As you can see, Realty now trades at $46.22 with a P/AFFO multiple of 11.6x and dividend yield of 6.7%

Shares are now cheaper than they were during the pandemic:

What could Mr. Market be missing?

Could Realty Income overpay for Spirit?

Spirit trades at a 52-week low and the deal is "at least" 2.5% accretive.

The deal generates north of a 100 basis point investment spread.

Realty Income does not need to raise capital.

Importantly, Realty Income becomes the 150th largest company in the S&P 500:

While I believe it's important not to ignore Mr. Market, I believe I should "do business with him, but only to the extent that it serves my interests".

Realty Income will soon represent approximately 10% of my investment portfolio (assuming SRC deal closes).

I'm adding more shares today which makes this position an overweight position.

As I pointed out, this is not a risk-free investment, however, I'm perfectly comfortable with the refinance headwinds.

Consider this new tranche a vote of confidence in the management team who has demonstrated that it can navigate various market conditions.

What's next?

• National Retail Properties ( NNN )
• NETSTREIT ( NTST )
• Four Corners ( FCPT )
• Broadstone ( BNL )

Realty Income is just getting started folks...

Get on the train before it leaves the station.

As always, thanks for reading and commenting.

Happy SWAN investing!

Note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.

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