Summary
- Following Bed Bath & Beyond's default, investors are concerned that more large retailers will face financial strain in 2023.
- Retail REITs like Alpine Income Properties carry elevated risk exposure due to high concentration in "Big Box" retail properties.
- While PINE's price-to-FFO valuation may seem low, the REIT has a higher debt with riskier properties than most REITs.
- Using retail capitalization rates to value PINE's assets, the REIT appears to be trading substantially above its net asset value.
- I believe PINE is overvalued and may decline this year as risks grow within the retail CRE segment.
Following the default and impending bankruptcy of Bed Bath & Beyond ( BBBY ), risk within the retail segment appears to be on the rise. Numerous companies such as Kohl's ( KSS ), AMC Entertainment ( AMC ), Best Buy ( BBY ), and others appear to be at an elevated risk of financial strain this year. As retail companies struggle to compete with online counterparts, most are seeing a growing long-term pressure on profit margins. With real retail sales trending lower , I believe many retail companies will need to close stores to reduce exposure, particularly if consumer sentiment remains weak in 2023.
The retail industry is undergoing immense change. Since online shopping (or video streaming, etc.) is viewed as cheaper and more convenient, many traditional department stores are wading at the edge of extinction. Traditional malls went first, but I believe the trend is accelerating to strip malls. The long-term secular trend against department stores appears to be accelerating, so even if the US avoids a recession, retailers may not.
Certain stocks carry relatively high exposure to this risk factor. One notable example is the REIT Alpine Income Property Trust ( PINE ). Alpine is a triple net-lease REIT (tenants pay all expenses) focused entirely on retail. The company's top tenants include Walgreens ( WBA ), Dick's Sporting Goods ( DKS ), Dollar Tree ( DLTR ), and Lowe's ( LOW ). PINE has seen a rise in popularity among income investors due to its low valuation and high dividend yield. The stock currently trades at a forward "P/FFO" of 11.6X with a forward yield of 5.4%. Both metrics are around 20% better than the sector average, suggesting PINE is a possible value opportunity. Despite challenges in the retail sector, PINE's sales per share have risen substantially since its 2019 inception. Of course, many of its tenants are not investment-grade rated, so potential challenges in the retail space this year could undoubtedly harm PINE's valuation.
What is PINE Worth Today?
Alpine is interesting as the REIT is younger and has grown rapidly since its inception through acquisitions. The company purchased many of its assets from its external manager CTO Realty Growth ( CTO ). Externally managed REITs carry certain risks since their managers are not necessarily entirely aligned with shareholders. While investors should always be cautious with externally managed REITs, I see no specific red flags in PINE.
To assess PINE's value today, we must consider the total value of its properties based on its capitalization rate. According to the company, the firm's assets have an implied capitalization rate of 7.1% . Last year, according to CBRE , "neighborhood" retail properties carried an average cap rate of 6.8%, while "power-center" (big-box) retail had an 8% average cap rate. The company owns both properties, with a bias toward larger retail spaces . CBRE's capitalization rate data also lagged greatly as capitalization rates are likely to rise by at least 1% due to the sharp increase in real interest rates last year (or at least back to pre-2020 levels). Thus, as I am offering a predictive valuation of PINE, I would use a capitalization rate of 8.1% - in-line with the rise in borrowing costs and the associated decline in commercial property sales .
Alpine's sales and operating income have reached a plateau over the past two quarters (Q3 and Q2) as its acquisition binge ends, so I will use those metrics to estimate its property value. The company earned a net operating income (operating income plus depreciation) of ~$16.8M during Q2 and Q3 of 2022, or $33.6M annualized. Dividing that figure by the 8.1% capitalization rate, Alpine's estimated property value is ~$415M. The REIT ended Q3 with $22.9M in other tangible assets and $298M in total liabilities. Adding its assets and subtracting liabilities, we arrive at an estimated net asset value of $140M, nearly 50% below its current market capitalization of $270M.
Of course, that is a predictive valuation based on my view that capitalization rates for retail spaces should rise by at least 1% below the early 2022 minimums. Using the company's 7.1% capitalization rate, its estimated property value rises to $473M. Accounting for liabilities and tangible assets, its estimated NAV increases to $199M, approximately 25% below its current market capitalization. Even if we further improve the assumptions regarding the company, it isn't easy to justify its valuation today following its rally over the past two months. Of course, many REITs trade permanently at a premium to their NAV due to attractiveness to investors. Currently, PINE is valued as if its properties carry a 6% capitalization rate. That cap rate is more-typical of REITs, so, understandably, investors place a premium on PINE since pure-play retailers (with higher cap-rate assets) are uncommon.
The Bottom Line
Technological pressures (e-commerce competition), weak consumer sentiment, and labor shortages weigh precisely on "big box" retail assets. While 54% of Alpine's rent comes from investment-grade tenants, nearly half are not investment-grade, and around 21% are not rated. In my opinion, the REIT has relatively high exposure to the negative long-term and short-term trends impacting the retail space. Today, only high-class shopping areas that offer an exciting experience to customers (which cannot be found online) are thriving; as Alpine does not appear to own many such properties, I believe it carries elevated exposure to the challenges facing retail properties .
PINE may appear cheap to many investors since its price-to-FFO is atypically low and its dividend is slightly high. However, PINE's debt is somewhat higher than its equity as the company uses debt financing to grow without diluting shares. Alpine's portfolio is also fairly riskier than most REITs and carries higher capitalization rates, so investors should not necessarily compare its valuation directly to higher-quality REITs. Lastly, PINE should sell at a discount due to its externally managed status. The fact is that it is easier for CTO to sell undesirable properties to Alpine (since it controls it) than to other commercial buyers. Even if Alpine's portfolio is sensible today, externally managed REITs carry higher agency risks.
PINE is trading 40% above its tangible book value and has generally done so since its inception. PINE is a young REIT, so its book value is also a relatively close measure to its NAV since its properties have hardly depreciated. Overall, I am bearish on PINE and believe it is materially overvalued today by around 25% based on its NAV estimate. Further, a rise in capitalization rates (which I expect due to the sharp increase in interest rates last year) could cause its NAV estimate to fall significantly below the target level.
For further details see:
Alpine Income Property: Overvalued After Accounting For Risk Exposure