American Realty Capital Properties: Plenty Of Salsa, But Not Yet A SWAN

 |  About: VEREIT Inc. (VER), Includes: ADC, DG, EPR, MPW, NNN, O, WPC
by: Brad Thomas

In August (2012), I wrote an article (How Much Salsa Should I Put in My Intelligent REIT Portfolio?) that included around 25 REITs that an intelligent investor would own. In that portfolio - I refer to as the SALSA portfolio (also in my Intelligent REIT Investor newsletter) - I included a 1.67% interest in American Realty Capital Properties (ARCP). I did not include more than 1.67% then because ARCP was still a fairly new REIT and I wanted to see how the company would perform and more importantly, to witness a track record of dividend safety and reliability.

In another article last year, I explained that I wanted to watch ARCP grow from its highly concentrated IPO (September 7, 2011) portfolio of just three tenants (Citizens Bank, Community Bank, and Home Depot) to a more diverse triple-net REIT composition. I recommended ARCP then based upon the following:

The advantages to the investment opportunity include (A) medium-term leased properties are attractive, given the risk-return profile; (B) Rents derived primarily from investment grade, corporate tenants provide stable shareholder dividends, (C) Growth in earnings and asset values is facilitated by the opportunity to mark to market rents upon lease expiration, and (D) Significant management ownership allows for true alignment of interests.

Then in March (2013) I was ready to dive deeper into ARCP and I recommended (in an article) that investors "load up the truck" on ARCP shares:

Load Up The Truck. I expect to see ARCP shares to climb to $15.00 by year-end and that represents an incredible opportunity to achieve significant capital principal appreciation and enjoy a magnificent dividend of 6.8%. It's no mirage.

Then in late March (2013) ARCP made headlines after the company made a hostile attempt to acquire Cole Credit Property Trust III (CCPT3) for around $9 billion. If successful, ARCP would've been the largest triple-net REIT beating out Realty Income (NYSE:O). When I heard of ARCP's hostile bid to acquire CCPT3, my biggest concern was that ARCP was using shareholder resources to wage an attack on Cole Holdings (the advisor). In an article, I even called ARCP's CEO, Nicholas Schorsch, a "bully" because I was distraught over the "playground" tactics that ARCP was using to gain advantage using disruption as the weapon of choice. As I wrote:

ARCP is no longer a slam dunk REIT. The management team is pursuing a disruptive investment strategy that is not investor-aligned and the "bullying" tactics are not advantageous to ARCP investors. I'm certain that the logic will prevail when the bully retreats from its conflictive agenda and Cole moves forward with the completion of its merger.

Some would argue that I went overboard for calling Schorsch (who I also consider a friend) a bully for trying to dismantle Cole Holdings; however, I feel an obligation to expose the risks of ARCP (and all REITs) and specifically the "ego-driven" management team. After all, REITs are incredible investments and it's important to remember that the value proposition is not just the "brick and mortar" component but also the management team that makes them so attractive (or in the case of ARCP so unattractive).

It's Time to Bury the Hatchet

So now CCPT3 and Cole Holdings are moving down the road to become a publicly listed REIT and that means that COLE (the new ticker) will soon be a massive diversified REIT with over 1,014 properties in 47 states. As mentioned previously, I do not feel as though ARCP was ready to acquire CCPT3 and hopefully the drama that unfolded in March and April has led to a much needed maturity event for ARCP. Sometimes we all go through failures in our lives, and maybe, in hindsight, the failure of ARCP (to acquire CCPT3) may lead to greater successes later…

Although ARCP is not the largest publicly traded net lease REIT today, the company is the fourth largest one (based on square footage). As of Q1-13 ARCP owns 702 properties in 45 states and Puerto Rico.

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As an aggressive consolidator of net leased properties, ARCP has diversified (from its IPO) from a REIT with highly concentrated exposure (RBS Citizens Financial accounted for 62.9% of ARCP's revenues) into a well-diversified REIT.

ARCP has current assets of around $2.1 billion and a broad exposure of properties across the U.S. and Puerto Rico.

ARCP's rental revenues are divided among a variety of high-quality tenants. Dollar General Corp. (NYSE:DG) generates 11.4% of the company's revenues, while RBS Citizens Financial Group Inc. accounts for 10.6%. The REIT's aggressive acquisition strategy has resulted in a reduction to its top tenant exposure. Here is a snapshot of ARCP's to 25 tenants (84% are investment grade rated):

ARCP has one of the most high-quality portfolios in REIT-dom and all top 10 tenants are investment grade rated. Here is a snapshot of the Top 10 tenants:

ARCP has also continued to grow its portfolio by diversifying its industry composition. Although not as diverse as Realty Income with 46 industries, ARCP has grown its base from 2 industries (since the IPO) to over 20 distinct industries today.

ARCP has 52 different tenants (compared with 195 tenants for Realty Income):

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ARCP has 100% occupancy and only 4.35% of leases that mature in the next 5 years.

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Are The Fundamentals Safe?

ARCP has a unique investment strategy that consists of investing in both long-term and medium-term leases. This hedged strategy of owning both stable long-term leases and higher yielding medium-term leases is a key differentiator for ARCP's value proposition. As the largest "aggregator" of net lease properties in the U.S., ARCP (and its non-traded REIT team) has developed an integrated acquisition model that creates quantifiable economies of scale. That is, in my opinion, the secret sauce that has allowed the New York-based REIT to deliver such attractive results.

On the company's latest (Q1-13) earnings call, ARCP reaffirmed its previously published 2013 and 2014 earnings guidance. As Nick Schorsch explained:

We continue to project that our earnings growth will be approximately 16% between 2013 and 2014. Our company's pipeline of acquisitions and balance sheet strength suggest that ARCP is particularly well positioned for continued earnings growth.

Schorsch went on to say:

We intend to grow our asset base and base AFFO per share through both the execution of our organic acquisition program on which our earnings guidance is constructed, as well as through the pursuit of opportunities to buy large property portfolios and make strategic corporate acquisitions in the net lease sector. ARCP saw a 600% increase in revenue for the first quarter of 2013 (due to ARCT3) compared to our fourth quarter of 2012…

ARCP has significant dry powder as the company recently increased its unsecured credit facility to a maximum borrowing capacity of $2.5 billion (with a capacity of $1.45 billion). ARCP's net debt to EBITDA ratio is only 5.3x and very modest debt over enterprise value of under 26%.

As illustrated below, ARCP's AFFO per share is projected to grow by 16% from 2013 to 2014.

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ARCP Knows How to Pay Dividends

One of the most attractive things about ARCP is the company's dividend policy. Over the last 5 quarters, ARCP has increased its dividend every time. Here is a snapshot of ARCP's historical monthly dividends paid.

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ARCP pays monthly dividends (current yield is 5.26%) and here is a snapshot of the historical results since the company became public.

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While ARCP's dividend yield has fallen by 2.69 percentage points over the one-year period ending May 7, its yield of 5.32% is still 90 basis points higher than the single-tenant REIT index yield of 4.42%.

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I find it interesting when comparing ARCP's current dividend yield of 5.32% with Medical Properties Trust's (NYSE:MPW) dividend of 4.78%. Specifically, one can clearly see the "mispriced" risk of MPW - investing in lower quality tenants - while ARCP still pays out a risk-aligned dividend of 5.32%.

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ARCP pays the second highest dividend yield of the peer group that includes Realty Income, National Retail Properties (NYSE:NNN), WP Carey (NYSE:WPC), Agree Realty (NYSE:ADC), and EPR Properties (NYSE:EPR).

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ARCP shares have increased by 57% over the last year. ARCP has the second best total return performance as compared with the following peers:

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Here is a snapshot of ARCP's year-over-year share price growth:

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Clearly ARCP's operating fundamentals are exceptional as illustrated by the comparison with RMS, the S&P 500, and a few select peers:

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In summary, ARCP compares favorably to the seasoned Triple Net peers. Here is a comparative slide that illustrates the higher-quality portfolio and potential growth prospects for ARCP.

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What's the Biggest Risk for ARCP?

As I alluded to in a previous article, Nick Schorsch is one heck of a "financial engineer" and his mastery of raising blind pool capital for companies to eventually go public is extraordinary. He (and his company) has been instrumental in transforming the non-traded REIT industry into a more predictable and reliable sector.

One of the hardest things for me to digest for ARCP is the fact that the company is externally-managed and that simply means that the mindset of Schorsch (and his team) is to grow AUM (assets under management), not drive value. Without a doubt, the history books show that externally-managed publicly-traded REITs significantly underperform their peers. So why hasn't ARCP?

For one, it's awfully hard to screw up a net lease portfolio. There is simply very little asset management involved and as long as you do a good job buying assets, you should have no problem collecting rents and paying out dividends. As noted in the article above, ARCP has done an excellent job at aggregating high-quality properties so there is not much risk to mitigate today.

However, ARCP is still less than two years old and the REIT has not had to experience filling up vacant stores, yet. There will be a time when ARCP management will have to protect its investors from vacancy and the leasing risk associated with filling up dark stores.

Second, ARCP has one of the lowest G&A expense ratios in REIT-dom. With a .5% G&A to Gross Asset Value ratio, ARCP has one of the lowest G&A structures in the industry. Why?

As noted above, ARCP is externally managed and that means that it shares resources with its external advisor. Many functions (human capital, marketing, utilities, travel, etc.) are spread across the companies underneath the Schorsch umbrella and although some costs are investor-aligned, I feel as though there are considerable conflicts that spell one thing: RISK.

Take a look at this recent ARCT4 filing:

In light of this excess pipeline, the Company and ARC DNAV amended the existing investment opportunity allocation agreement to include ARCP (solely with respect to long duration net lease assets) and ARCT V. ARC previously implemented the asset allocation process among ARC-sponsored net lease REITs to ensure industry best practices and facilitate the orderly allocation by each ARC Fund of real estate assets evidenced by the excess pipeline. Each ARC Fund requires that every property acquisition or allocation be approved by a majority of its independent directors.

As I interpret this paragraph, ARCT4 is stating that it should now feed ALL of its acquisition deals to ARCT4 first since the company is sitting on a "boat load" of cash. I'm surprised Schorsch is trumpeting this success, especially since it's one of the biggest concerns expressed by the back offices of the broker-dealers. Based on some back-of-the-napkin calculations on ARCT4, the company is burning through roughly $250,000 each and every day to cover their distribution since they don't have a portfolio to support this massive investor base. They'll probably be forced to buy just about anything just to deploy the equity, which can pose even more significant problems down the road.

So ARCP can no longer pursue "long duration" leases since ARCT4 is sitting on enormous cash that it can't spend fast enough. But that only applies to "long duration" leases, right?

Didn't ARCP recently announce that the company was trying to buy Cole Credit Property Trust III (CCPT3) - a "long duration" model with a weighted average lease life of 12.7 year - in a hostile takeover attempt?

The funny thing is that ARCT5 is open and accepting new money, but ARCT4 stated that they will not buy property for ARCT5 until ARCT4 is fully allocated. So, right out of the box, ARCT4 will be behind the 8-ball on ARCT5 as well.

To me, that seems like a lot of mouths to feed….

Why can't ARCP internalize now? I found the answer in ARCP's Q-13 earnings call transcript. As Nicholas Schorsch said:

We have the ability to internalize, we will internalize at some point. The idea was that we would get to a point where we are over roughly $7 billion to $9 billion in that range, of total assets, so that we could actually drive some savings below the 40 basis points (G&A).

Schorsch went on to say:

It would be a mistake to internalize and then have out G&A go up, as you've seen with other companies and you could still see it with Realty Income and NNNN that their G&A kind of runs around 100 basis points of total assets.

Schorsch concludes the internalization comments:

So we kind of think mathematically it's kind of between that $7 (billion) to $9 billion, but I can't say that the board wouldn't consider it at $6 (billion) or $5.5 (billion). Because it's just something we talk about every quarter, and it was obvious to us that when there is synergistic value and there is savings, then that's the best road to take and internalize immediately.

ARCT4 once fully invested will own around $2.6 billion in assets and at some point, in the near future, the company will be looking to create a liquidity event. ARCT5 is now raising money and it should be following the same path as ARCT4. It's clear that ARCT4 and ARCT5 will be likely candidates for ARCP to "gobble up" and perhaps that is when ARCP will internalize.

In my opinion, ARCP is large enough today to internalize and I believe that the risks for external conflicts of interest outweigh the savings associated with ARCP's G&A costs. If I were an ARCP shareholder I would argue that ARCP has already achieved enough scale to move away from its conflictive externally managed structure. There are simply too many conflictive mouths to feed and I believe that ARCP will be a much better REIT when the management team becomes 100% focused on the time, energy, and competence associated with a pure internally managed REIT.

In closing, I do see value with ARCP's exceptionally well-aggregated portfolio. I also believe that there is more room for shares to run. Although ARCP does compete with the longer-term lease REITs (include ARCT4 and ARCT5), the company has limited competition with acquiring the medium term leases. For the short term, that will provide outsized returns.

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I believe that when ARCP internalizes management, the valuation (of the shares) will move closer to the peer group. I do not think that Mr. Market places the same premium on ARCP (as compared with the peers) and in my analysis, that is a perceived risk. I think it is critical that you have confidence in your management team, not just in aggregating assets, but also in managing risk.

Once ARCP internalizes its management, I will have more confidence in the most important thing: aligned shareholder interests. I applaud ARCP for its exceptional performance and after careful consideration, I am keeping ARCP in my SALSA portfolio. Once ARCT4 and ARCT5 are closed, I will consider ARCP for my blue chip Sleep Well at Night (SWAN) portfolio. It's critical to have an alignment of shareholder interests in order to be a SWAN.

Source: SNL Financial, FAST Graphs, ARCP Investor Presentation

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.