Last week I wrote an article on American Realty Capital Properties' (NASDAQ:ARCP) new IPO and, as mentioned, I was not impressed with the lack of diversification and valuation within the 63 asset portfolio. As I wrote, there were 60 bank branches leased to Citizens Financial Group (OTCQB:CFIN), 2 closed bank branches, and 1 Home Depot (NYSE:HD) leased distribution facility. The total offering was priced at $12.50 per share with net proceeds of $69.75 million.
Today I read over an add-on offering for ARCP where the new net-lease REIT is proposing to raise additional equity of around $18.687 million (after fees). At first glance, I was glad to see some diversification within the proposed new portfolio that could provide the investor base with increased safety relative to the income stream. As mentioned in the last article, the 60 bank branches were leased to just one financial institution with around 6.9 years of average remaining lease term.
Upon further review of the latest (9-22-11) S-11, I noticed the proposed additional assets being considered:
7 Advance Auto Parts (NYSE:AAP) stores for around $5,925,000 at an 8.74% cap with an average lease term of 8.2 years (all in Michigan).
21 Dollar General (NYSE:DG) stores for around $ 10,500,000 at an 9.38% cap with an average lease term of 7.6 years (in Missouri, Oklahoma, Illinois, and Arkansas).
1 Walgreen (NYSE:WAG) store for around $ 3,778,000 at an 9.15% cap rate with an average lease term of 20 years. (in Eastpointe, Michigan)
So this “proposed” diversification strategy will increase the 63 asset portfolio (IPO group) to a 92 asset portfolio capitalized by a new IPO and a modestly crafted follow-up offering totaling around $85 million (in combined equity raised). Sounds good, BUT….
Unlike Warren Buffett, I like diversification as I think it is a splendid predictor of future performance. Most of the best equity REITs maintain industry high occupancy levels due to strong diversification fundamentals. Many of the larger net-lease REIT platforms have evolved into strategic investment banks that are designed to be risk-managed and well-diversified like mutual funds. The diversification model has become extremely sophisticated as the investors are most sensitive to asset protection and all are seeking sustainable income with high margins of safety.
I do like the new tenant names mentioned in ARCP’s S-11. All of the retailers listed are “necessity-driven” models at or near investment grade (DG is rated by S&P has BB+) credit. However, here is what I do not like:
- Real Estate in Michigan C-
- Advance Auto Leases with 8.2 years remaining. The new (organic) stores have 15-year leases and I do not consider an 8.74% cap rate a bargain with 8.2 years remaining. C-
- Dollar General Lease with 7.6 years remaining. The new (organic) stores have 15-year leases and I do not consider a 9.38% cap rate a bargain with 7.6 years remaining. C-
- Walgreen’s is a good tenant but there are plenty of new stores with 25-year leases outside of Michigan. C-
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. And what do you do with a vacant Dollar General (DG) when the leases expire in 7.6 years?
In summary, I do not see value in this new REIT. As an investor, you make money when you buy and I do not see the “buy low, sell high” opportunity here. I see this new REIT being formed with a diverse mix of legacy assets with a high level of concentration with a once troubled bank tenant (with 6.9 average lease years remaining). I do not see the value in the IPO assets nor do I see the value in the proposed add-on assets. Diversification is extremely important to the “margin of safety” investor; however, the ARCP management team needs to consider the other diversification factors such as geography (not Michigan please). The Seeking Alpha article above summarized some of the “best in class” net-lease REITs and ARCP’s big brother, American Realty Capital Trust Inc.(a non-traded REIT) was included. Also, included in the article were several exceptional net-lease funds such as Realty Income (NYSE:O) and Cole Capital (non-traded). One common denominator for Realty Income and Cole is the innovative “margin of safety” investment strategies that are well-defined and extremely well-executed. ARCP’s 7% dividend sounds good on paper but an investor should always “peel back the onion” and understand the true meaning of the assets and the metrics that are driving the value creation strategies. Show me some “meaningful” diversification and I will show you a better grade on your next report card. And remember to do your homework and you will sleep well at night!