Will This REIT Grow Too Big, Too Fast And Will It Last?

| About: VEREIT Inc. (VER)

On September 7, 2011 American Realty Capital Properties (ARCP) listed on NASDAQ by selling a total of 5,580,000 shares at an initial price of $12.50 per share (around $69.75 million in proceeds). At the time of the IPO, ARCP was paying out a dividend of 7% ($.875 per share) and the initial portfolio consisted of 63 single tenant properties with a weighted lease term of 9.6 years.

I began to research ARCP just a few days after the company's IPO and at the time my biggest concern was the high tenant concentration risk associated with 62 bank branches leased to one company, Citizens Financial Group. ARCP did include a token Home Depot building; however, the highly concentrated bank branch portfolio (with a weighted lease average of 6.9 years) was troubling. As I explained (in an article published on September 13, 2011):

The biggest issue that I have with the IPO is that the assets are highly concentrated with just two tenants, and one of the two tenants is a troubled bank with minimum lease term remaining. Furthermore, like many banks, branches are being reduced in size and, as a result, the "brick and mortar" model is becoming less important (to the banking model).

In another article (on September 23, 2011) I explained that ARCP's increased diversification efforts were not aimed on sound risk management practices but instead targeted as more of a "shotgun" approach - that is - like "blowing spit balls on a chalkboard and hoping that something will stick." As I explained:

Diversification is more than playing roulette where small bets are waged with a broad brush investment strategy. If that were the case, you could have diversified between Enron, Worldcom, and Global Crossing and gone broke. I believe investors would be better off considering REITs with more diverse, risk-adjusted lease terms and greater geographic balance. There are hundreds of single-tenant assets that can be acquired with leases of 15 years or longer.

Then nine months after ARCP's IPO I wrote a third article where I described a more bullish sentiment related to ARCP's improved diversification efforts. As I explained:

What a Difference Nine Months Makes. Since September 2011 (the IPO), ARCP has increased its asset base by 82 percent. In addition, ARCP has increased square footage by 163 percent and revenue by 100 percent.

I summed up my recommendation as follows:

ARCP is becoming a much better REIT model. Initially I was skeptical relative to management's decision to capitalize the portfolio with just two tenants - one highly concentrated with one financial institution. However, the 82 percent growth supported by strong cash flows, low operating costs, and experienced management has made an impact and I'm pleased to see the investment strategy become more balanced and risk-aligned.

Non-Traded REITs Added Fuel to the Fire

In an article in February (2013) I applauded ARCP for capitalizing on the acquisition of American Realty Capital Properties Trust III (ARCT3), a non-traded REIT that owned 659 high-quality properties, most (75%) investment grade rated. When I wrote that article I felt as though ARCP's diversification was beginning to unfold. As I explained:

ARCP is no longer a "Mickey Mouse" REIT and the discipline of the experienced management team will determine the company's destiny: to become a durable sleep well at night REIT. The growing high-quality tenant composition and continued revenue diversification will have an enduring impact that should allow the triple-net REIT to replicate the success of the stalwart peer group.

I provided this warning:

Remember investors. You are paying for management when you purchase shares in public companies. Unlike buying owned real estate, REITs are made up of management teams and usually the experience and track record for managing portfolio risk can be the difference between a good stock and a great one.

Then on March 5th I was ready to make a strong BUY recommendation, as I wrote:

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 a few weeks later, in a proposed hostile takeover, ARCP began casting a larger net in an attempt to acquire Cole Credit Property Trust III (CCPT3). In just eighteen months' time, ARCP had grown from an unknown bank branch landlord (with 62 banks) into a net lease monster looking to gobble up every net lease deal in site.

Although ARCP's offer (and counter-offer) was rejected by CCPT3 management, ARCP's management team, led by Nicholas Schorsch, made it clear that ARCP was not going to settle for anything but the biggest. Arguably, growth is good, except when it's at the expense of shareholders. As I explained:

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.

My argument was (and still is) that ARCP does not have the management capability to deliver sustainable occupancy performance. Because ARCP is externally managed, it shares resources with its external advisor and that means that there is not a focused core of competence related to managing portfolio level risk - perhaps a conflict of interest?

Are ARCP Shareholders Aligned with Management?

American Realty Capital Trust IV (ARCT4) has been burning the midnight oil to gobble up more net lease assets. The non-traded REIT has raised almost $1.6 billion in equity in the first four months of the year and yesterday the company announced it was buying around $1.45 billion of free-standing properties from GE Capital. The portfolio consists of a collection of restaurants with tenants including brands like Taco Bell, KFC and Burger King.

Not to be confused, ARCP announced separately that the company was acquiring 471 properties for around $807 million from the very same seller, GE Capital. The portfolio appears to be almost identical to the ARCP4 portfolio with many of the same well-known restaurant chains.

But wait, I have a few questions:

  1. I thought ARCP was focused on investment grade tenants and now the company is buying credits that were underwritten by GE Capital (it's commonly known that GE has one of the worst credit underwriting platforms around)?
  2. Why is ARCP and ARCT4 splitting up the portfolio? Investors of ARCP should question the incentives and understand what assets ARCP gets? (the medium term lease pitch is getting old since we all know that ARCP was trying to buy Cole - a long-term lease player - just a few weeks ago).
  3. What experience does ARCP have at managing fast food sites? (and underwriting fast food credits?)
  4. What's the cap rate associated with the GE portfolio?

In an article last week, one of the readers explained:

One key challenge for the non-public NNN REITs is that investment grade credits and the bond market generally remain "overheated," with the inevitable material rise in rates yet to materialize . Hence, NNN investors are faced with buying lesser quality assets at relatively low yields with the virtual yield requirements will increase over time. As a result, expect more moves like ARCP's purchase of the non-credit fast food TrustStreet portfolio from GE Capital. Achieving the higher cap rates required to cover dividends implies acceptance of weaker credits, shorter lease terms, and lesser real estate quality/greater residual risks. Bluntly, the only "value creation" for the NNN REITs for some time has been increasing scale and declining cap rates due in large part to sovereign intervention in debt capital markets. Dangerous to keep making a bet on those factors.

Does the CapLease Deal Make Any Cents?

Last week ARCP announced yet another transaction with the proposed purchase of CapLease, Inc. (NYSE:LSE). Dane Bowler did a great job at breaking down the pros and cons of the deal (see article here); however, I want to add two critical elements.

First, as Bowler explained, the CapLease portfolio consists of 64 properties and the largest tenant is the US Government (10% of revenue). Bowler explained that the "$9.0 acquisition price would represent a cap rate of 6.33. While there has been substantial cap rate compression among triple net property acquisitions, 6.33 is still slightly expensive."

I agree with Bowler that the cap rate appears rich; however, my bigger concern has to do with the government leases. These leases are not triple net meaning that they (the leases) are typically expenses that the landlord pays, in effect gross leases. In addition, ARCP does not have a management team that is experienced at this type of risk control.

However, ARCP has said that it would also include the CapLease management team and that the employees would integrate. That sounds good because ARCP does need to build out a management team.

But wait. CapLease is experienced at big boxes, not small fast food chains. What does all of this mean?

The same anonymous reader posted this comment (in an article) today:

The need to increase scale to find more cash flow in the face of declining fee income (i.e. less incidence of the insane fees associated with non-listed REIT fundraising activity) implies certain NNN REIT management teams generally may continue to favor aggressive moves for the sake of "scaling up" in lieu of long-term careful consideration of residual risk and lease-level value creation. Unclear what latest IAS/FAS Lease Accounting proposal will do to add to the uncertainty.

The Seeds of Destruction Are Sown in Good Times

ARCP is clearly aiming to become a dominant player in the Triple Net sector. In a recent article I explained:

I believe that over the course of the next few years the Triple Net REIT sector will become a significant category for small investors, large investors, and large corporations. What we are seeing today is just the tip of the iceberg and I suspect that analysts and investors will one day recognize the financially engineered model to be a core REIT sector with several dominating players.

I went on to explain:

Most investors are attracted to the Triple Net sector because of the minimum lease-up risk and reduced volatility.

But what happens when there is more lease-up risk? ARCP has a strategic model focused on medium term leases. For example, the legacy bank branches I mentioned at the beginning of this article had 6.9 years of lease term remaining and now the banks have around 5 years of lease term remaining. What happens then?

What about these new Taco Bell stores. Assuming that ARCP closes on the GE deal, what will happen when these leases begin to roll? Is there a management team capable of retaining the tenants?

As evidenced by the recent GE deal (mentioned above), ARCT4 has had to reach out further on the risk curve. Instead of buying higher-quality investment grade tenants, ARCT4 has pursued a more recent strategy of buying up the credit curve. So what happens next for ARCT4? Will ARCP acquire ARCT4? If so, does that mean that ARCP will be a consolidation of everything imaginable? Could ARCP be planting the seeds of destruction? Is bigger better?

Diversification or Diworsification?

I started this article arguing that ARCP's IPO lacked diversification. Later I warmed up to ARCP and recommended the shares. Then I warned that the proposed Cole deal could be driven more by ARCP's ego rather than its business fundamentals. Now what?

Diversification can be good, especially when it reduces risk without inhibiting returns. However, once it becomes "too diversified" the larger portfolio cannot achieve its desired level of return. That means that as you grow flexibility is reduced and it's difficult to achieve optimization. Warren Buffett described the diversification conundrum as follows:

The strategy (of portfolio concentration) we've adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it rises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.

I'm not arguing that ARCP has over-diversified (yet). I am simply making the case that there is no management team in place (or even with CapLease) that can manage the level of portfolio risk that is coming down the pipeline. I applaud Nicholas Schorsch for his highly successful track record at raising capital and aggregating assets. However, the invisible risk appears to be the capabilities of managing and retaining tenants in a significantly diversified net lease portfolio.

Finally, given the current market environment, I believe that Realty Income (NYSE:O) represents a far superior risk adjusted return today. Pound for pound, I like Realty Income because I know the company has an exceptional track record of managing risk and the management team is proven and battleship tested. I admire Nicholas Schorsch for his skills for being a "market timer"; however, I look for intelligent REITs based on "market performance." It's great to be able to aggregate assets and be a "market timer" however sleeping well at night has more to do with being a skilled operator. That's why I'm now Long O shares.

Note: I'm not advocating a SELL recommendation for ARCP investors. My concerns are driven more by the company's externally-managed platform and its conflicts of interest with ARCT4 and ARCT5. In my opinion, Realty Income represents a better buy today, given the risk-adjusted dividend yield compared with all of the other peer Triple Net REITs.

REITs mentioned: (NYSE:NNN), (NYSE:LXP), , (NYSE:WPC), (NYSE:ADC)

Disclosure: I am long O. 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.