2023-04-13 15:31:38 ET
Summary
- The rising interest rate environment has created yield opportunities for dividend investors.
- Spirit Realty has been aggressively increasing its industrial exposure.
- I discuss the implications of the company acquiring properties at comparable cap rates to its common stock.
- In spite of muted forward growth projections, the stock is a buy.
If one is looking for value in the net lease REIT sector but wants to avoid the distressed medical and cannabis sub-sectors, then Spirit Realty (SRC) fits the bill. Despite having transformed its portfolio in a significant manner over the past several years, SRC continues to trade at a notable discount to more popular peers. SRC does not have any debt maturing in the near term, helping to insulate it from the rising interest rate environment for now, but the low equity valuation will hold back growth rates. With the stock trading at a 7% yield, this is a name which can deliver strong returns in the event of a fall in interest rates and solid returns in the meantime. I reiterate my buy rating for SRC stock.
SRC's Stock Price
SRC stock trades at roughly the same level it did over the past decade, though I should note that it did complete the spinoff of Spirit SMTA in 2018 .
I last covered SRC in December where I rated the stock a buy on account of the attractive dividend yield. The stock has since fallen 7%, helping to increase the dividend yield and value proposition.
SRC Stock Key Metrics
SRC is a net lease REIT with a highly diversified portfolio with respect to tenants and sectors. The triple net leases mean that SRC's tenants are responsible for real estate taxes, insurance, and maintenance expenditures. That distinction means that SRC and other NNN REITs often have far higher free cash flow margins than typical REITs.
Over the past five years, SRC has made substantial changes to its portfolio, including reducing its retail exposure and increasing its industrial exposure.
That transformation has been deliberate - we can see that over the past few quarters, SRC has been very aggressive in targeting industrial acquisitions.
REIT investors know that the industrial REIT sector has been one of the more attractive, as these leases tend to carry higher annual lease escalators (in SRC's case, they tend to be in excess of 2% which compares favorably with the 1.6% average) and have had a recent history of capital appreciation from cap rate compression.
After facing credit issues with its then-largest tenant in Shopko which forced it to spin off those assets, SRC now has a rather standard portfolio from a credit quality perspective, with 19.5% investment grade tenants and 2.8x weighted average unit level coverage.
We should not ignore that point, as it is not entirely positive. We can see below that SRC has been acquiring properties in the 6.3% to 7.3% cap rate range over the past eight quarters.
This is important to note because SRC stock currently trades at an implied 7.3% cap rate. One can be forgiven for thinking that share repurchases would carry less risk than external acquisitions at a comparable valuation, as yours truly shares such sentiment. SRC is internally managed so this decision to acquire properties at a similar cap rate to the common stock is indicative of management's desire to further diversify its portfolio (perhaps towards the industrial sector). Perhaps management is hoping for the market to eventually reward the increasing industrial exposure with a higher valuation multiple. My personal view is that share repurchases should be prioritized instead, because first, I find it unlikely that the market will value SRC on a sum-of-the-parts basis and two, share repurchases are arguably a more direct catalyst for multiple expansion.
It can sometimes be difficult comparing portfolio quality in the NNN REIT sector. One of my preferred methods is comparing disposition activity to acquisition activity. SRC has disposed of $423.7 million in assets versus acquiring $2.8 billion in assets over the last eight quarters, for a ratio of around 15%. That ratio is lower than the 20+% typically seen at lower quality NNN REITs, but significantly higher than the mid-single-digit percentage typically seen at a higher quality peer like Realty Income ( O ) or Agree Realty ( ADC ).
As we can see above, many of the dispositions are from vacant properties and those are not included in the calculation of disposition cap rate. These NNN REIT landlords in general want to keep collecting rent, so fewer dispositions as a percentage of acquisitions can be an indication of stronger underwriting processes.
In general, many NNN REIT operators have taken advantage of the previous low interest rate environment by issuing stock to fund acquisitions, which has helped drive down leverage ratios. SRC is no different, as it ended the most recent quarter with a 5.6x debt to NOI ratio. I can see these names allowing leverage to creep up to as high as the 6.5x range if needed. It is worth noting that SRC has no debt maturities until 2025, thus it will not need to refinance debt at higher interest rates for several years.
After growing AFFO by 7.6% to $3.56 per share in 2022, management is now guiding for just 1% growth in 2023. We can see below that the growth calculation is made up of around 1% from annual lease escalators, 1.5% from external acquisitions (this number is depressed due to the likelihood that acquisitions will be funded primarily by retained cash flow), and held back by 1.5% impact from reserves.
On the conference call , management noted that the 1% reserve is quite typical but it should be noted that reserves have been much lower in recent years - perhaps the higher reserve is due to the higher interest rate environment and weaker economy. Management also noted that they expect acquisition cap rates to hover in "the 7.25% to 7.5% range" this year.
Is SRC Stock A Buy, Sell, or Hold?
At recent prices, SRC was trading at a 6.9% dividend yield and 11.6x forward FFO. That dividend yield is among the highest in the past decade - it should be noted that in the years prior to 2019, the stock traded at a sizable discount due to the aforementioned Shopko credit issues.
With there being no indication of credit issues at present, one must wonder how SRC trades at a 30% discount to Realty Income on the basis of FFO. O will definitely show stronger growth rates, but that may be mostly due to the lower cost of capital, which is something that SRC can not entirely control. More importantly, forward total returns for the two names are likely to be highly comparable as the higher dividend yield should more than offset the slightly faster growth rate at O. I can see the discount narrowing to around 15%, suggesting around 20% total returns for SRC stock over the next 12 months.
What are the key risks? Because growth rates are likely to remain muted due to the higher cost of capital, shareholders will need to be patient for a fall in interest rates or improvement in sentiment. SRC lacks the high annual growth rates of a tech stock, meaning that the 6.9% dividend yield might be all that shareholders can hope for while they wait. Inclusive of around 1% to 2% growth, that might not be enough to keep up with the S&P 500 index, as I emphasize that the bulk of potential alpha must come from multiple expansion. There is always the possibility that there is a credit event just around the corner - perhaps the Shopko mistake was not a one-time issue but indicative of poor credit underwriting standards. If the higher interest rate environment persists, then SRC will eventually have to refinance maturing debt at higher interest rates, which will further pressure growth rates. Because I view it likely that valuations improve over time for this reliable dividend payer, I rate SRC a buy but caution that investors may need to be patient here.
For further details see:
Spirit Realty: 7% Yield From Net Lease Real Estate, Low Leverage