Summary
- I attempt to assess Modiv's dividend safety.
- In terms of the portfolio and balance sheet, MDV doesn't have many red flags.
- The big problem with MDV remains its high cost of equity.
- MDV's preferred stock remains more attractive today, despite a lower yield and less upside potential.
Modiv Inc. ( MDV ) is a micro-cap net lease real estate investment trust ("REIT") that has only existed as a public company for about a year. The timing of its debut on the public market wasn't great, as the REIT has shed over a quarter of its value since its IPO.
But bad timing doesn't necessarily make it a bad REIT - or a bad investment going forward.
What will make it a good or bad investment going forward are fundamental factors like cost of capital, skilled management, and strong underwriting and property selection criteria.
Back in August 2022, I made the case for avoiding MDV because, though I liked management's decision to dispose of office properties and recycle the proceeds into industrial properties, the REIT suffers from a prohibitively high cost of capital.
The debt isn't really the problem. As we'll discuss below, the problem for MDV is its high cost of common equity and preferred equity.
Capital recycling can only get you so far as a net lease REIT. Without the ability to raise capital for accretive acquisitions, a net lease REIT's AFFO per share growth will be severely stunted. This could result in a self-reinforcing cycle wherein the REIT is cheap because of low growth, and it can't increase its growth rate because its stock is cheap.
Don't get me wrong. Some net lease REITs suffer a cost of equity disadvantage but still manage to find accretive acquisitions. Spirit Realty Capital ( SRC ) is an example of this. See, for instance, this article comparing SRC to high-yield peer Alpine Income Property Trust ( PINE ).
But SRC's AFFO yield (a proxy for cost of equity) is about 8.5%. MDV's AFFO yield is 10.2%.
To state the reverse, SRC's price to AFFO is 11.8x, while MDV's price to AFFO is 9.8x. SRC has a cost of capital disadvantage. MDV has a cost of capital disability.
That said, MDV does offer a 9% dividend yield, which is enough of a return for many investors, assuming MDV's dividend is safe. As we saw recently with Gladstone Commercial Corporation ( GOOD ), another high-yielding net lease REIT, even longstanding dividends aren't immune to being cut . And MDV's dividend is not longstanding.
In what follows, I'll try to determine MDV's dividend safety and explain why I still prefer the Series A Cumulative Preferred Stock ( MDV.PA ), which yields only a little less than the common shares.
Modiv: How Safe Is The Dividend?
MDV is (I believe) the smallest net lease REIT as measured by number of properties, gross real estate value, and market capitalization.
The small net lease REIT came out of the gate with a very generous dividend policy, paying out a rather high share of its AFFO and on a monthly basis.
Since the beginning of 2020, MDV's management team, led by the five-year-tenured CEO Aaron Halfacre, has undergone a significant portfolio transformation from primarily office to primarily industrial properties.
When looking at MDV's top tenants, we find an eclectic group of medical office (Sutter Health), big box retail (Costco), investment grade industrial (3M), and a car dealership in Southern California (Kia of Carson).
For a very small REIT, MDV does have a fairly large degree of industrial diversification across its portfolio, if you ignore the fact that its top 5 tenants make up 43% of its base rent. Just one of those tenants defaulting on its leases with MDV would threaten the dividend (though I don't envision that happening anytime soon).
Until MDV's portfolio grows such that its top tenancy makes up a smaller share of total rent, its smaller size will add to its level of risk.
As previously stated, though, management has been doing yeoman's work of transforming the portfolio, mainly by recycling office properties into industrial properties over time.
This portfolio recycling has largely been accretive to both immediate and long-term AFFO per share, as MDV has managed to sell office properties at cap rates around the same as or less than the acquisition cap rates of its industrial properties.
For those familiar with industrial real estate, you are aware that there is a wide divergence in quality of building, location, and tenant across this subsector of commercial real estate. The prime located warehouses in last-mile areas of major cities occupied by investment grade tenants may sell for cap rates of 4% or less.
MDV's properties aren't those. They are generally in more rural or exurban areas and occupied by lower credit tenants, often sponsored by private equity firms. Generally speaking, private equity firms buy out industrial companies and then perform sale-leasebacks with investors like MDV in order to offload the real estate assets from their books and reinvest into the business (or to deleverage, or to pay distributions to themselves).
There's nothing wrong with doing sale-leaseback deals with private equity sponsored companies in itself. It all depends on how strong the underlying tenant is and what the PE sponsor plans to do to make the tenant/company stronger over time.
Fortunately for MDV, the REIT went into the fourth quarter of 2022 with a fairly strong balance sheet. No debt matures this year, and only $13.4 million in mortgage debt matures next year. After that, no debt matures until 2027.
MDV's debt maturity schedule plays a huge part in the REIT's level of dividend safety. Since there are no debt maturities to refinance this year and little for next year, the balance sheet poses very little risk of triggering the need for a dividend cut.
Given the $1.26 to $1.36 AFFO per share guidance for 2022, the $1.15 annual dividend represents a payout ratio of about 88%.
While MDV has not provided guidance for 2023 yet, I cannot imagine its 2023 AFFO per share could get much higher than $1.36, so the lowest I could see the payout ratio dropping this year would be around 85%.
While that payout ratio is not a red flag, it also doesn't leave much retained cash for acquisitions and growth. And though it's possible that MDV could find a source of new debt, that new loan would probably sport a 5% or 6% handle. Combining that with any common equity issuance at all would probably eliminate the possibility of accretively acquiring properties at a 7-7.5% cap rate, which is the cap rate range of MDV's most recent acquisitions.
So, external growth using newly raised capital is probably off the table for now.
What isn't off the table is more capital recycling. Management has stated their intent to continue disposing of office assets, and given that a quarter of their rent still came from office real estate at the end of Q3 2022, this capital recycling can probably continue for at least another few quarters.
There is one last point to mention on the dividend safety. While this does not directly affect the dividend, I believe it to be an implicit vote of confidence in the dividend as well as the company more broadly.
I am referring to insider buying. Admittedly, though, insider buying is a bit of a mixed signal. There have been a lot of insider buys in recent months, but almost all of them have been fairly small.
For instance, 20 shares at $11.77 each represents a total purchase value of about $235. The purchase of 222 shares at $11.78 apiece represents a total value of about $2,615.
Now, to be fair, the 30-day average daily trading volume of MDV is only about 15,000 shares, so maybe purchasing many times in small batches is strategic.
Or maybe executives and directors are required to own a certain dollar amount of the company and only buy as many shares as required to stay within that requirement.
In any case, insider buying can't be a bad sign. How good of a sign it is may be debatable.
The Safer Option: Preferred Stock
In a January 13th article , I pitched the preferred stock as another high-yielding way to tap into the portfolio cash flow stream of MDV without needing to own the more volatile and risky common shares.
MDV.PA offers a dividend yield of about 8.5% as well as upside to its $25 par value (as of this writing) of about 15%.
Though MDV's 9%-yielding dividend does appear to be safe for now, the slightly lower yielding preferred dividend is much safer.
Meanwhile, MDV may reasonably achieve a price to AFFO of about 12x in the year ahead, indicating upside potential of 20-25%. Comparatively, MDV.PA's upside to par value of about 15% is obviously less, but not enough less to make it the less appealing investment option, in my opinion.
Moreover, for me, owning MDV.PA is a convenient excuse for keeping track of the fundamentals of MDV, so if common shares do become more attractive in the future, I will likely know about it faster than I otherwise would and be able to buy MDV while it is still cheap.
For me, though, the risk that MDV falls into the self-perpetuating trap of a cheap stock causing low growth, which keeps the stock cheap, is too great to purchase shares of the common stock at this time.
For further details see:
Modiv: Gauging The Safety Of The 9%-Yielding Dividend