2023-04-05 07:00:00 ET
Summary
- We're reviewing Spirit Realty Capital, one of the less-covered names in the triple net-lease space, but an excellent company with good upside.
- Here are the latest results put in context for future expectations, and why this company seems, to me, likely to significantly outperform expectations.
- We provide insight into M&A, which we believe is highly likely.
This article was coproduced with Wolf Report.
In this article, we'll be revisiting Spirit Realty Capital ( SRC ), one of our previously highest-conviction buys in the entire net lease space. The company has seen pressure, as have all REITs, during the past few months since we last wrote about it.
As value investors, we are primarily seeking to own underappreciated/undervalued, above-average quality companies , typically sector leaders (or at least better than average) with yield. One of our primary requirements is that we can see a way to an 80%-100% RoR in 2-5 years' time and that this must be based on a conservative estimate , or stable 40-60% RoR if we're looking at an "income investment."
We believe this is possible in the case of SRC.
Revisiting Spirit Realty Capital and Its Upside
There's significant fundamental quality to be had when looking at SRC. The company is BBB rated with a good market cap, above $5.6B. It has good diversification, with top-quality tenants in its ABR.
Most of its square footage/ABR is aimed at distribution, not manufacturing or flex , and the company has an average lease length of more than 10 years, which is very good in the context of net lease. The average size of an SRC asset is just above 100k sqft.
SRC also isn't the same company as it was even only four years ago.
Diversification has gone down 3%, meaning that the top 10 tenants now make up less than 22.5% of the portfolio. The company's industrial exposure is up to 20%, from close to 8% back in 2017, and public exposure is up to 53.4% from 36.7% in 2017. Obviously, if you know my work, you know that I'm a fan of industrial exposure.
The company did have some lost rent during COVID-19 and even before COVID-19 - but it's now down to 0.0% as of the latest quarterly. There are so many good tenants here - from Walgreens ( WBA ) to things like Circle K, Dollar General, Advance Auto Parts, CVS ( CVS ), Home Depot ( HD ), and others. The top 20 tenants have less than 45% of the company's ABR as of the latest report.
The company isn't a massive sort of FFO grower - however, stability is what's on sale here at BBB. The next few years aren't likely to see SRC growing significantly in terms of FFO/AFFO. Current estimates are for about 1% growth, which is fairly close to nothing at this time - but the company's yield, which is well-covered, is now close to 7%, which makes this one of the highest yields in the net-lease space.
The current portfolio characteristics look like this as of 4Q22.
SRC IR
This is then combined with the company's significant underwriting approach, where SRC targets high-quality single-tenant mission-critical/essential real estate with a focus on good credit quality (among other things).
The company currently expects very little growth in and of itself going forward - 4 cents above the 4Q22 result as a midpoint, with most of the impact coming from G&A increases and unidentified reserves, which the company generalizes as overall lower NOI due to impacts that have not yet been identified.
The company also expects to dispose of around $225-$275M worth of assets, but overall expect a 2023E AFFO of $3.59 on the high end for the 2023 period.
The company's portfolio composition remains top-notch - over 20% industrial and 42% service-oriented retail, with ABR toppers like Lifetime Fitness at 4%, which actually is the highest exposure.
SRC IR
We have seen better portfolio compositions - but not many, and it's definitely not a common sight in this sector.
Also, something else that warrants highlighting here - and that's how much the company's portfolio composition has actually changed in less than five years. After the spin-off in 2018, the company's exposure was mainly to retail, which accounted for nearly 85% of the company's ABR, with a WALT of 9.6 years, while also having 5.6% office and almost no industrial exposure.
SRC has now lowered the office exposure to half , more than doubled the industrial exposure , and lowered retail to 68% , with most of it being service oriented.
It now includes tenants and assets such as these:
SRC IR
If you go through the numbers, you'll see that since 2020 the company has successfully monetized its non-core industrial assets, and managed an 85% RoR on the original investment, disposing at an average cap rate of 4.41% with gains on investments such as tenants like Sunny D, BE Aerospace, Shiloh Industries and so forth. Its strategy to provide quality industrial properties continues.
SRC IR
That isn't to say the company's retail portfolio isn't impressive, with clients such as Circle K, Home Depot, and other service - and sector tenants which themselves are solid businesses with a significant degree of recession resistance to their operations.
What remains of the company's retail assets are qualitative properties leased to sophisticated investors that generate more than $100M in revenue on average, and are located in strong markets.
Now 44.6% of the portfolio is covered by a master lease, and the company has unit-level reporting of 50.2%. This is not as good as, say, STORE Capital (which had it across the portfolio), but the company is slowly reaching a better level. While nothing removes risk completely, the fact that 64%-plus of the company's tenants are businesses with over $1B in revenues does provide some safeguard.
It's unlikely that we'll see swift fundamental deterioration on part of this company - especially given the structure of its leases, with almost half of the company's current leases expiring after 2032.
Also, occupancy?
99.9%.
Enough said there, we believe, about the company's fundamentals. 4Q wasn't a surprise in any way.
Here's the current geographical diversification, and the light exposure to the southwest and northwest is a pleasant factor as well.
SRC IR
Let's move to valuation and see what we have here.
Spirit Realty Capital Valuation - A lot to like
Spirit Realty Capital is generally undervalued. The company isn't a REIT sector leader in terms of returns - but it's at a very attractive valuation in terms of where its yield is at, and where the company is going in terms of earnings - especially due to its stability.
Generally speaking, you want to pick this company up close to 11x P/FFO. Today, it's valued at around 10.5x FFO normalized. That means that based on essentially a flat growth estimate, we should expect no more than an 11-12.5x P/FFO on a forward basis, which gives this company an upside of around 14-15% annualized, or 40%-48% total RoR until 2025E.
Again, not the best upside in the industry we've seen, but it's solid, and especially, it's safe.
And a 7% safe yield with a potential 40% RoR upside, which is the minimum I'm looking for, is an interesting play for certain investors - especially the more income-oriented among you.
S&P Global analysts following the company give SRC an average of $40 on the low side to $58 on the high side. $40 is too low and $58 is way too high, as we see it. The meager growth prospects mean that SRC definitely isn't worth 14-15x P/FFO as some REITs, or over 20x P/FFO, as in some cases.
It doesn't have A credit, it's not large or conservative enough for that. But the average of around $45/share from S&P Global, implying an upside of around 15% here, that's something we can get behind.
The current share price represents a Price/NAV of 0.92x, which is well below where we believe it should be - it should be at least at 1-1.1x, reflecting the REIT's asset quality.
What's more, this company is very forecastable. On a two-year forward perspective with a 20% margin of error, the analysts have a perfect forecast accuracy, either hitting the target or having the company outperform the targets.
Again, there's a lot to like about SRC.
SRC trades at an FFO multiple of no higher than 10.5x, and the upside we mentioned is based on a 12.5x forward P/FFO. Comps are valued at higher multiples. As before, the implied cap rate based on NAV still means that you're getting a far better "deal" than if you were investing in some of the larger net-lease REITs, but this also makes sense - because they're larger and even safer than SRC.
There's insider trading activity in SRC - with insider buys outpacing sells over the past few years, though, overall, this company is underfollowed not only here on the analyst side, but on the side of larger investors and funds as well. Not many buy Spirit Realty. We believe there's a reason for that.
The company's growth prospects are, shall we say, limited. You may get a decent reversal to a 12-13x P/FFO out of the company. Couple that with the yield, and you have market-beating RoR.
That's what we're looking for. If you're fully invested in Realty Income ( O ), if you want more net lease, and you want that higher yield but don't want to compromise on safety and want a really high portfolio quality - then look at SRC.
We believe it has a lot to offer you.
Thesis
- Spirit realty is an above-quality REIT business in the net-lease segment. It's a market outperformer that also has a higher yield than other companies in the subsector.
- It's not the best growth prospect that you'll end up seeing - but it's nonetheless a solid sort of "buy" at a cheap or good valuation. We see this good valuation, and this "buy" being possible at anything below $45/share.
- That means that at the current pricing of below $40/share, this company is worth adding to your portfolio - so that is exactly what we're doing.
Remember, we're all about:
- Buying undervalued - even if that undervaluation is slight and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
- If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.
- If the company doesn't go into overvaluation but hovers within a fair value, or goes back down to undervaluation, we buy more as time allows.
- We reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.
Here's our criteria and how the company fulfills them ( italicized ).
- This company is overall qualitative.
- This company is fundamentally safe/conservative and well run.
- This company pays a well-covered dividend.
- This company is currently cheap.
- This company has a realistic upside that is high enough, based on earnings growth or multiple expansion/reversion.
We went back and forth on calling this cheap or not, but in the end, we do believe SRC is priced well enough to be called "cheap" here.
M&A Note : We recently added SRC to out M&A list, recognizing that the company is positioned as a takeover target. Shares are trading at an AFFO yield of 9% which makes the company extremely attractive, especially to a consolidator like Realty Income (6.3% AFFO yield).
O has successfully integrated other large deal acquisitions, including Vereit ($11 billion), American Realty Capital Trust ($2.95 billion) and CIM Real Estate Finance ($894 million), so the company is a proven net lease aggregator. We believe that as soon as O's costs of capital improves (AFFO yield below 6%) it will pursue M&A, which should be highly accretive given the synergies of consolidation.
Author's 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.
For further details see:
Spirit's 7% Yield Not So Spooky