2023-04-24 06:30:00 ET
Summary
- Spirit Realty Capital, a Net-Lease REIT, is one of three non-office REITs paying a dividend yield between 7% and 10% at this writing.
- Not so long ago they were burned by bad tenants, leading to a substantial spinoff and a modest dividend cut.
- We will explore whether current market skepticism is justified or instead Spirit is rising like the Phoenix from the ashes.
Spirit Realty Capital ( SRC ) appeals to many REIT investors because of its relatively high dividend yield (7% today). But that yield also has challenged Spirit’s growth in recent years, because the high dividend reduced their ability to grow per share cash earnings by issuing stock.
When STORE Capital was bought out last summer, I considered SRC as a possible replacement. Instead, I went with Essential Properties Realty Trust ( EPRT ), whose growth story seems more secure to me. My article comparing the two discussed my reasoning.
The research for that article did make me less concerned about holding SRC. Then later in the year came my decision to emphasize stocks paying well-supported but large dividends as part of a defense against potential declines in earnings multiples. At that time I established a position in SRC.
Still, Spirit has some aspects that are not really in step with other REITs focused on single-tenant, triple-net leases. So I decided to take a deeper look. This follows my articles this year on Simon Property Group ( SPG ) , AvalonBay Communities ( AVB ), and EPR Properties ( EPR ), and National Retail Properties ( NNN ).
The Ashes
Spirit Realty has a long history and a short history. They adopted REIT status in 2005 and had an IPO in 2012.
My colleague Austin Rogers from High Yield Landlord just published an article that does a very nice job of describing the long history.
Problems with tenants developed. During 2017, the stock price plunged in response. Spirit ended up deciding to spin off quite a few properties in the course of a management transition.
The new team, led by CEO Jackson Hsieh, has been making the short history since then. Executing a spinoff of poor properties took a couple of years. The financial impacts only ended during 2019.
Since then Spirit Realty has been trying to rise from the ashes. And now we have the spike in interest rates and a weak stock market, bringing more impediments.
Spirit, Who Are You?
My challenge with Spirit since 2019 has been to discern who they want to be when they grow up. Most Net-Lease REITs have a clear focus. A few examples:
- Realty Income ( O ): Investment grade tenants
- National Retail ( NNN ): Solid, Middle-market retail tenants
- Essential Properties ( EPRT ): Middle-market service tenants
It was difficult to discern a theme for Spirit. It seemed as though anybody who could afford the high cap rates they needed was good enough. This in turn seemed quite scattered.
In reading their most recent 10-K, though, and remembering what they have shown us for years, it occurred to me that they don’t see it that way at all. The 10-K itself has a notably different flavor than many others, with lots of details intended to make their investment case.
The team is focused on their quantitative tools and especially their Property Ranking Model and Spirit Heat Map. They truly believe that these let them find and exploit market dislocations.
In short, they are a bunch of arrogant quants who believe that their intelligence and their models give them an edge. I should recognize the type, it appears in my mirror every morning.
The Spirit team may be right but the market has yet to buy their story. In my view part of the reason is that the history remains short. But the other part is that their approach is different, making their actions harder to place in context of other REITs in their sector.
Winning by Selling
This year Spirit greatly increased their rate of dispositions. It was 65% of Cash from Operations, or CfO, and more than 3% of gross assets.
Jackson Hsieh has been explicit about this increase in the 2022 earnings calls. Here from Q2 [emphasis mine]:
… asset recycling and dispositions will be a key part of our strategy going forward , providing an alternative source of accretive equity capital and critical market intelligence while allowing for portfolio shaping, strengthening relationships within the brokerage community and demonstrating the quality of our portfolio.
What impresses me is that Spirit is actively trying to sell properties that have appreciated in value. That same call discussed a sale at a 3.8% cap rate, which is amazing. Overall, they give other examples showing that selling high is part of their approach to increased dispositions.
At the end of the year Jackson Hsieh reported that
For the year, we sold 278 million of leased assets at a weighted average cash capitalization rate of 5.47%, representing a 118 basis points spread from capital deployment cap rate and generating a $94.2 million gain.
The total proceeds from dispositions was $323M, of which only $46M was from vacant properties. The total is large enough to provide good flexibility for acquisitions or if need be for reducing debt.
My view is that most Net-Lease REITs ought to dispose of more properties than they have done historically. It would improve both portfolio quality and financial stability.
The acquisition cap rate for the year averaged above 6.5%. It increased into the fourth quarter and Spirit expects to obtain above 7% for 2023.
The other big change this past year has been a shift toward more industrial properties of a certain type. Here is how their portfolio has evolved.
Spirit Realty Capital
The large growth in “Industrial” properties is obvious. Spirit describes this as a response to market conditions (Q4 2022 earnings call):
We think that the things that we're buying today in the industrial sector are just super mission-critical, especially [the] industrial outdoor storage facilities that we're buying. That doesn't mean that we're not going to do retail. We still like it. We obviously are very close to a handful of tenants and industries that we're particularly still bullish around.
But I think that the crack in the financing markets corporately have enabled us to be more competitive in this industrial space. That's why you're seeing it increase. The mortgage financing market has sort of made it more challenging for some of the real estate private equity players that compete against us in this sector. So I think we're going to continue to make progress this year. And obviously, as the markets begin to normalize and get more competitive again, we may have to shift away from industrial.
While it is great to see the willingness to follow the economics, to my eyes there are advantages here. This is their summary of the industrial properties.
Spirit Realty Capital
It seems to me there is a niche here for Spirit. The lower-cost industrial properties may prove to be a good focus for them. The other Net Lease REIT with an industrial emphasis is W. P. Carey ( WPC ). But W. P. Carey is three times larger and at the point that they have an increasing focus on larger properties and large portfolios.
What Spirit shares with W. P. Carey is a focus on properties that are critical to the businesses of their tenants. These are much more difficult for the tenant to walk away from than, for example, some logistics facilities.
Of course, this area could again be disrupted by schools of private-equity sharks. But not with the present capital markets. If Spirit establishes themselves as a better partner, they might prove able to stay active here even against some future increase in competition.
That said, there is no commitment from Spirit to sustain this direction. Again from Jackson Hsieh, “obviously, as the markets begin to normalize and get more competitive again, we may have to shift away from industrial.”
At the end of the day I believe what they say. This is not a management team making a strategic push into industrial. It is a bunch of quants who plan to exploit the edge their quantitative tools give them, wherever it may be.
Other Net Lease REITs that emphasize fewer sectors argue that sector-specific knowledge matters and would argue that Spirit’s approach is riskier. My view is that there is more than one way to skin a cat, to use a rather dated phrase.
Spirit brags about several aspects of their portfolio. Some of these are rent coverage, a high percentage of public ownership, and large corporate revenues.
The items that catch my attention are the 95% corporate level financial reporting, 50% unit-level financial reporting, and 45% fraction of properties with master leases. My preference would be for the last two of these to be larger, and they have not increased in the past three years.
That said, Spirit showed the reporting against the distribution of actual or shadow credit rating among their tenants in their 2019 annual 8-K (wish they still did). Both the master leases and the unit-level reporting are predominant for lower-rated tenants, as makes sense.
Spirit, Oh Your Beautiful Balance Sheet
In seeking an adjective to describe the balance sheet of Spirit, what I come up with is beautiful. Just look at this debt maturity ladder.
Spirit Realty Capital
There is nothing due until 2025 and that is just a term loan. After that, the senior unsecured notes are evenly staggered. Overall, the average interest rate is 3.73%.
On top of that only 2% of Spirit’s debt is floating rate. Many other REITs are seeing half or more of their increase in cash earnings eaten up by increased floating rates in 2023. Not Spirit.
If need be Spirit can wait years before working to add more senior unsecured debt. And if challenges arise, they have way more than $1B of liquidity.
Other REITs must be (or should be!) eating their hearts out over the Spirit balance sheet. No wonder Spirit carries a BBB credit rating.
The Cash Flows Changed for 2023
Here are the main elements of the cash flows for Spirit from 2019 forward. The left stacked bar for each year shows sources of cash. Moving vertically, green shows CfO, blue shows dispositions, red shows net cash from stock issuance, and gray shows new debt.
RP Drake
The stack of sources of cash through 2022 is common for a REIT using stock sales and new debt to expand their portfolio. The right bars of each pair show total dividends in purple and acquisitions in yellow. They have acquired a lot.
Spirit was not hugely affected by the pandemic. Their net deferred rent for 2020 was about $20M and their CfO dropped $25M (7%) from 2019 to 2020.
Dividends have been about 75% of CfO for the past two years. Though the dividend yield has been high, Spirit was making it work. FFO/sh is back above its value from 2019, though CfO/sh is not quite there yet.
But with the bear market of 2022, issuing shares no longer (at the moment) enables acquisitions that increase per share earnings. Jackson Hsieh was quite explicit about this in the earnings call:
Right now, where the stock price is, we're not planning to issue any more equity . [If] the equity price improves materially, and we see good acquisition opportunities that where the cap rate is at a place where we think the spreads are there, we could certainly get the ATM
(The ATM, or At The Market, capability lets Spirit issue stock at the market price.)
With that context (and using midpoint numbers), the projection for 2023 shows the guided $800M of acquisitions. These are supported by the CfO, the guided dispositions, with $422M of debt making up the difference.
Actual new debt may be a bit larger, as Spirit is likely to draw $500M in term-loan debt during the year. Using this much debt would incrementally increase Spirit’s leverage.
They are not the only one making that choice this year. It seems a good time to employ term-loan or revolver debt and wait to see where the capital markets go.
Ability to Grow Earnings
The actual earnings growth Spirit will achieve in 2023 is rather uncertain. Across 2022 there were changes in interest expenses and a decrease of some non-tenant income.
Spirit looks ahead based on annualized Q4 2022 results, which they argue represents the right comparison for forward expectations. They provide the bridge below for Adjusted Funds From Operations, or AFFO. (Differences for Net Lease REITs among AFFO, FFO, and CfO tend to be modest and over time their trends are the same.)
Here they see some growth from rent bumps (organic) and some growth from deploying capital. But note that the $0.10 per share increase in AFFO shows the impact of about half a year of portfolio activity.
Nearly all of the 2022 growth is included in the starting number. But most of the 2023 activity is not. The full contributions to AFFO/sh growth corresponding to the 2023 portfolio additions will be in the ballpark of $0.20 per share, or 5.5%. But this will be fully realized only by the end of 2024.
The gains just discussed are offset mostly by an unidentified reduction in NOI (of about $7M) and also by a very modest increase in cash G&A. The NOI reduction is another example of how real-world headwinds can significantly reduce growth rates below theoretical values in any given year. So they end up with guidance for the gain in AFFO of about 1% at the midpoint.
We can look theoretically for the ultimate impact of the 2023 activity as follows. First we associate a yield with both new investments and dispositions. (In effect, we assume that the interest costs and other costs go away on the sale and come back on the purchase, as discussed in this article .)
Here are the evaluations of those yields.
RP Drake
The Debt Ratio is taken to be 45% on the assumption that Spirit will get back to that eventually. This ignores some strange aspects of the debt in 2023. The interest rate is the (swapped) value for new debt that supports new acquisitions but the portfolio value for dispositions.
The acquisition cap rate is in the middle of the range suggested on the earnings call at 7.25% while the disposition cap rate is about 1.2% smaller, as it was in 2022. One ends up with an Investment Yield of 9.3% and a disposition yield of 7.2%.
We then work through to growth rates of CfO/share. A first part of that is the impact of rent escalators.
Spirit has this illustration of their escalators:
Spirit Realty Capital
They also report very small lost rent. When this growth is converted to the increase in CfO, it gives 1.4% as shown in this table, which we will use to work through the sources of growth.
RP Drake
The first line shaded orange shows the net growth in CfO from increasing rents. The next row shows the growth from investing retained earnings.
The retained earnings (26% of CfO) produce new CfO at the rate given by the Investment Yield. This gives another 2.4% of growth.
The capital recycling (rows shaded blue) is a bit more complex. The disposition volume, 51% of CfO, is entirely reinvested at the Investment Yield. That’s the easy part.
The sale of the fraction of the disposed properties that are not vacant decreases CfO according to the Disposition Yield. The value of this fraction used, 85%, is assumed to be the same as in 2022. The loss of CfO from properties that are now vacant occurred earlier, and so is not included.
One ends up with growth from the recycling of capital of 1.6%, on the third row shaded orange. Adding up all three sources of internal growth gets 5.5%, as shown in the line shaded green.
This result agrees with the value estimated above, based on the guidance for the impact of the full year of activity. But the agreement is not significant as these estimates are insufficiently accurate. What matters is only that the numbers are in the same ballpark.
The rows shaded gold show the impact of diluting the shareholders by 10%, issuing new shares. The Traded Yield on the Market, at 8.9%, is a bit below the Investment Yield of 9.3%.
But that difference is not enough to overcome the dilution by the share issuance. If one issues shares to buy more property as illustrated, one ends up in this calculation with incrementally less growth of CfO/sh.
This is the origin of Spirit’s insistence that they will not issue stock under current conditions. The contrast with what some other REITs say is notable.
So if conditions (such as cap rates) are stable and there are no headwinds, then Spirit should be able to grow CfO/share at more than 5% using their 2023 business model.
That would be really good for a REIT.
Headwinds?
The question is about the headwinds that reduce the rate of growth. Spirit’s acquisitions at high cap rates would seem likely to keep producing them.
Austin Rogers became concerned enough about tenant quality that he exited SRC and bought the Spirit preferred stock. His discussion and some related material in the comments on that article are worth contemplating.
I think the Spirit team would tell him that their quantitative tools are really superior, and that they expect to suffer a lot less than broad statistics might suggest. They also would tell him that the real estate has ample value so that they expect to be able to re-lease it or to sell it with good results no matter what.
What we can do is wait and see. Meanwhile, we can also look at the scope of what would be a problem.
Annual Revenues for Spirit run about $2.5B. About half that, $1.25B, makes it to CfO. The natural growth rate of CfO, of about 4%, produces about $50M, which is 2% of revenues. So the first 2% of revenue losses would cut CfO growth (and likely dividend growth) to zero.
We cannot say what Spirit would do if revenue losses grew larger than 2%. It would seem that some level of dividend cuts would be likely. To compensate fully for a next 2% loss of revenue would require a 14% dividend cut.
It is also worth remembering that Realty Income ( O ) and National Retail Properties ( NNN ) have never cut their dividend. Agree Realty ( ADC ) made one cut of 20% in 2010.
At the time Agree had very substantial tenant concentration, which they have moved away from since. For Spirit, the days when Shopko carried 30% of the total rent are long gone.
But even the Shopko debacle and spinoff only led to a 30% dividend cut. These Net Lease REITs pay remarkably stable dividends.
The average tenant for Spirit today pays 0.3% of total revenue. Only two tenants pay significantly more than 2% of the total, with the top one being Life Time Fitness at 4%.
On top of that the diversification of their tenants by industry is enormous, as you can see here:
Spirit Realty Capital
Now remember that it does not matter if tenants go through some challenging times, so long as they keep paying rent. To produce even a 4% drop in revenues would take some very hard times.
I don’t see that as plausible save perhaps in a redo of the Great Recession but you can make up your own mind. Realistically, in my view, events that slow cash earnings growth are far more likely than those that reduce earnings as such.
At least we are protected by a stellar balance sheet while we watch this play out.
Valuation and Takeaways
As yet, it seems that Spirit may be rising from the ashes like the phoenix. But the bird has yet to fly.
Valuation for Spirit seems uncertain to me. If they execute and if headwinds like failed tenants and interest-rate increases are minimal, cash-earnings growth of 5% or even more seems plausible.
But their track record on their unique approach remains short. And headwinds will occur.
Very few REITs have grown cash earnings above a 5% rate over the past 20 years. This is despite the opportunity the stock markets provided to add to growth by issuing stock.
Here I used FFO as a measure of earnings, because one can easily compare P/FFO ratios. CfO is a bit larger, but some of the cash earnings always get burned up by the headwinds. The current P/FFO for Spirit is just over 10x.
Using a recent “normal” discount rate of 10%, indefinite earnings growth at a 2% to 4% rate gets you a target P/FFO from about 13x to 17x. Using a 12% discount rate this goes to 10x to 13x.
Another way to put this is that SRC is now priced for a 2% growth rate and a 12% discount rate. That could represent the intermediate-term future but seems too harsh to me.
Looking at the other cases, 30% upside to fair value seems a reasonable estimate. And if things go well it could turn out to be twice that.
But for many investors potential upside will not be the main story. Another perspective is that SRC will pay you a 7% dividend with two positive features. It will have a reasonable shot at growing enough to keep up with moderate inflation. And it is unlikely to take more than a moderate cut in really bad times.
That seems to me a pretty good position to hold for a retiree wanting income that grows, which is why I hold it.
But for pure upside, I would pick something else.
For further details see:
Spirit Realty Capital: The Phoenix Rises (Rating Downgrade)