Note: The following article was published exclusively for subscribers on June 2, 2016. Since its original publication, I initiated a position in EPR-E. My average cost is $33.61, which leads to a 6.7% yield on cost. Based on the last price of $35.60, this position also has a 5.9% unrealized gain.
EPR Properties (NYSE:EPR) is a triple net lease REIT emphasizing entertainment and education properties. The REIT traded at much higher yields for dividends, FFO, and AFFO compared to the most stable triple net lease REITs like Realty Income Corporation (NYSE:O) and National Retail Properties (NYSE:NNN). I highlighted the REIT back in January when shares sold off after management announced their intention to issue new common equity and pay down debt. I felt the market was absurd to punish EPR for the activities because the decision was improving their financial flexibility and would make it easier for them to negotiate on new deals that would be immediately accretive to the REIT. Unfortunately, at the time I didn't have the hours available to do the necessary due diligence to make an investment.
In March I highlighted the correlations for the REIT which demonstrated that despite the higher yield, it was trading in correlation with O and NNN rather than with the cheaper REITs. This fit with my opinion of the REIT being a "high quality" REIT. However, it remains strange that the REIT was rallying when the market was falling because the tenants of the physical properties are heavily reliant on consumers having disposable income.
The following slide from the investor presentation breaks down the portfolio:
The company has been very successful growing the portfolio and lately has fairly substantial growth in the recreation and education segments. I like this portfolio for a couple of reasons. The first is that I believe the underlying fundamentals are fairly strong. To go a little deeper on the fundamentals, it is necessary to know more about the properties than the general segment. The following excerpt from the latest 10-Q gives a deeper insight:
The red, yellow, and green boxes were added to correlate the segments with the colors used in the first slide. I want to draw attention to the education segment for a moment. I believe our school systems are weak, and there will be demand for better education services. I don't foresee that segment of the economy getting slaughtered in the near term. The biggest threat to it could be the advent of better technology for delivering education through an online platform. While technological advancements are a substantial threat to the traditional college system, the education platform for younger students should be materially less exposed, since schools also function as daycare services.
The entertainment segment is stacked with movie theatres. I would consider this to be a little more speculative, but the company has been effectively diversifying over the last few years to reduce the emphasis. Again there is a material threat from technological advancements if companies like Netflix (NASDAQ:NFLX) are able to move more content onto their system and diminish the importance of theatres.
The recreation segment should be dramatically less exposed to technological advancements and I'm fairly comfortable with this strategy.
Compared to REITs like O and NNN, this is clearly a more speculative portfolio and investors should demand a higher yield for investing. Using prices from 06/01/2016, the annualized dividend yield (using last declared dividend of $.32 per month) was 5.4%.
Building New Properties
It is worth pointing out that EPR is building some new properties rather than strictly buying existing properties. Normally I would consider building new construction to be more speculative as opposed to buying existing construction with a lease immediately in place. However, EPR has an answer to this by having the properties leased out well before construction is complete. Remember that EPR will need to finance this new construction and it won't start contributing to FFO until construction is complete so investors should expect growth in FFO and AFFO per share.
If the company increases the amount invested in new construction relative to the portfolio, the financing could temporarily lower the level of FFO/AFFO per share unless they finance with debt and capitalize the interest expense.
The Price Problem
EPR was a great buy when I first highlighted it, but shares have ran up substantially since then as the market recognized that this triple net lease REIT was running a very intelligent portfolio at attractive capitalization rates. Based on the growth in their share price I wouldn't be too surprised if management announced a plan to issue new common equity and use it to pay down further loans. The announcement would probably cause shares to underperform the triple net lease REIT sector for a day or two before bouncing back. Such an event should be seen positively because it would give management flexibility to grow the portfolio and the higher share price should make it easier to finance properties that would be immediately accretive.
Investors will want to keep an eye out for that announcement.
A Better Angle
When I see a company I like but don't see a price I want to pay on the common shares, I look for alternative ways to invest in the company. There are currently three outstanding series of preferred stock for EPR. They are EPR-C, EPR-E, and EPR-F. Some brokerages may list them as EPR.PRC, EPR.PRE, and EPR.PRF or they may use EPR/PRC, EPR/PRE, and EPR/PRF. Schwab uses the last of these formats. NASDAQ uses the middle format. Google uses the first format. I will be using the same format as Google so my names will have a dash in them.
EPR-F is a fairly standard preferred share for a triple net lease REIT. It carries a dividend rate on par value of 6.625%, trades above par value, and becomes callable on 10/12/2017. The last price was around $26.49. The current yield is 6.25% but the yield to call will be materially weaker due to the amortization of the $1.49 premium. This is very normal for preferred shares of a high quality triple net lease REIT. The same situation is demonstrated with preferred shares for both Realty Income Corporation and National Retail Properties.
EPR-C and EPR-E
These securities are complex. It will take a few paragraphs and tables to demonstrate how they work. I will touch lightly on the unique factors first, then demonstrate pricing history, then go into precise calculations.
Both EPR-C and EPR-E are listed as "callable". Technically, they can be called in some situations. However, it would be inaccurate to believe that the call can happen at par value or that it is automatically available after the "call date" passes. The nature of the call is a forced conversion into common shares, but the required common share price for a forced conversion still hasn't been reached (as of 06/02/2016).
These preferred shares are convertible and the market is only moderately efficient at pricing in the impact of the embedded call option. The market is usually efficient enough to prevent an arbitrage trade from opening up in the preferred shares of EPR, but that doesn't mean much. The different series of preferred shares don't offset each other well enough to create excellent hedges so pair trading is dramatically more difficult even if the case for risk adjusted returns is materially stronger in one security than another.
The following chart demonstrates the price history over the last year on EPR, EPR-C, EPR-E, and EPR-F. It does not incorporate dividends. The dividend yield on these securities is different, but the difference is not huge.
The common stock of EPR is dramatically more volatile. That shouldn't be a surprise. EPR-F is the least volatile, and that also shouldn't be a surprise since investors at this point should assume that there is a high probability of it being called in late 2017 or early 2018 unless interest rates materially higher or the market loses faith in EPR. The interesting thing is the disconnection between EPR-C and EPR-E. Both of these securities have built in convertible options. While EPR took off the value of EPR-C followed much closer than EPR-E. This leads to a scenario where I believe EPR-E is materially underpriced. As I am writing this article on 06/02/2016, I opened a limit order to buy EPR-E. I worked on this idea for most of 06/01/2016 and 06/02/2016 before deciding to put in the order.
The conversion ratio for EPR-C and EPR-E are not static values which may further confuse many investors. The ratio was set in the prospectus but the ratio becomes more favorable for the preferred shareholder each time that the common stock of EPR pays out a dividend in excess of a given value for each quarter.
For EPR-C the threshold is a quarterly dividend level exceeding $.6875 on the common stock.
For EPR-E the threshold is a quarterly dividend level exceeding $.84 on the common stock.
For reference, the current monthly dividend is $.32 on the common stock which translates into $.96 per quarter. Both EPR-C and EPR-E are gaining stronger conversion ratios with each passing year.
The following chart demonstrates the conversion ratio at the end of each the last several fiscal years.
This means that a share of EPR-C can demand 37.58% of one common share as of the end of 2015.
Prices Where Forced Conversion Can Happen
The rules for EPR-C indicate:
" The Company may, at its option, cause the Series C preferred shares to be automatically converted into that number of common shares that are issuable at the then prevailing conversion rate. The Company may exercise its conversion right only if, at certain times, the closing price of the Company's common shares equals or exceeds 135% of the then prevailing conversion price of the Series C preferred shares."
The similar rule on EPR-E requires 150% rather than 135%.
That could confuse most investors. The "conversion price" is calculated using the conversion rate from above combined with the $25 liquidation value listed on the shares.
The calculations for EPR-C as of the end of 2015 are $25/.3758 = $89.81.
The calculations for EPR-E as of the end of 2015 are $25/.4573 = $82.
The following chart breaks down the common prices necessary for the company to have access to their call option (which is a forced conversion):
The common price to trigger the company's ability to call is simply a function of the static value of $25 divided by the conversion ratio. Therefore, when the conversion ratio increases (due to a large common dividend) the necessary common price decreases. When the denominator increases, the number decreases. The numerator is always $25.
When investors look at it that way, it may seem like there are two contradicting stories. On one hand the investor wants the conversion ratio to increase because it means their investment can be exchanged for a larger number of common shares. On the other hand, they may not like that the necessary price for the company to be able to force conversion is getting lower each year. Allow me to simplify this by calculating the effective call prices at the end of each year:
That isn't a typo. The two changes offset each other when it comes to calculating the call value. Because they offset the effective call price built into the shares is simply 135% of the $25 liquidation value for EPR-C and 150% of the $25 liquidation value for EPR-E.
If the dividend is maintained for the common stock the conversion ratio would continue to increase year after year. The increase in the conversion ratio means more shares of common stock per share of preferred stock. If the common share price is maintained while the conversion ratio increases, that should push the preferred share price higher. Essentially, if the common price and dividend are maintained there should be a very gradual price gain for the preferred shares due to the growth in the conversion ratio.
Implied Favorable Conversions and Annualized Yields
The following chart breaks down the recent prices with the resulting conversion values and the annualized current dividend yield:
EPR-C at $27.60 would only have needed common shares to appreciate by about $2.28 for investors to be able to buy the preferred shares, convert them, and sell the common shares at a profit absent trading costs. Since having the option to convert always has value, investors should expect that the preferred share price would move up if the common moves up. For EPR-E the common price necessary for immediate conversion to be favorable is higher than the current price by about $5.11. EPR-E should be able to participate in price appreciation if the common stock continues to climb.
Why I Like EPR-E
EPR-E offers a current yield of 6.45% which is the highest in the group. While the E series trades at a huge premium to liquidation value, it still trades at a discount to the effective call price of $37.5. Finding a high current yield on the preferred shares of a high quality triple net lease REIT trading below the call value is very difficult. The market's demand for high quality preferred shares is demonstrated by valuing EPR-F at $26.49. The F series has a fairly material risk of being called at $25 plus accrued dividends in late 2017 or early 2018. That gives an investor less than 2 years of collecting the annualized dividend of $1.65 and about half of that would go to covering the premium paid for the shares. The resulting realized yield would come in around 2% to 4% depending on the call date.
How much more attractive would those shares of EPR-F be if the call price was a premium to the current price rather than a material discount? The expected capital gain from a forced conversion that would value EPR-E at about $37.50 would be around $2.60, more than a year's worth of dividends. In a nutshell, investors in EPR-E get a higher current yield and if shares are called they get gains exceeding a year's worth of dividends. EPR-F on the other hand can see a capital loss of on the call that would offset almost a year of dividends.
Since EPR-F is very similar to the preferred series from Realty Income Corporation and National Retail Properties, I believe the market is demonstrating a much better understanding of the security in pricing shares. Remember that the preferred shares for O and NNN trade at roughly similar valuations and yields to call.
Yield to Call and Yield to Worst
While the "yield to call" is almost always the "yield to worst" for the preferred shares of a high quality triple net lease REIT, the yield to call for EPR-E cannot be calculated precisely because the actual date where shares would be callable depends on the average closing prices on the common stock. What we do know is that the expected conversion price on the EPR-E shares in a call would be equal to about $37.50 so any yield to call calculation for EPR-E would have to include a capital gain at the end rather than a capital loss. As a result, the "yield to worst" must be the yield that does not include the capital gain. Therefore, the "yield to worst" is equal to the current yield.
The same argument can be made for EPR-C. The reason I picked EPR-E over EPR-C is because the current yield (and thus the yield to worst) is materially higher. Because it creates more of the yield through the current dividend rather than through an expectation to eventually be converted at a higher price, it offers greater price stability and less risk.
I don't know where the share price of EPR will be a few months from now, but I'm very comfortable that the REIT won't be going out of business. The properties include some fairly aggressive exposures but the balance sheet is extremely strong. Take a look at the capital structure:
This structure puts about 64% of the financial structure in common stock. The leverage in their operations is fairly low and that gives me some extra comfort in buying into the preferred shares.
EPR Properties is a great triple net lease REIT with a conservative structure that balances the aggressive nature of their largest segment. The REIT has been moving towards properties that I consider more conservative which reduces the amount of risk in the investment. The rapid growth in the common shares put them at a price beyond what I'm comfortable paying but the market didn't grow the valuation of EPR-E in the same way. While the valuation of EPR-E did grow over the last few months, it still offers a materially higher yield than the common shares while demonstrating less price volatility. An investor wanting those attributes might settle for buying EPR-F but an expectation for those shares to be called implies a significant capital loss should be expected to offset almost a year of dividends. On the other hand the shares of EPR-E are trading at a material discount to their effective call value while offering a higher current yield than any of the alternatives.
The substantial rise in EPR and EPR-C suggests that the value of the embedded call option should be rising but the market does not fully reflect it. Shares of EPR are up about 23% over the last calendar year while EPR-E is only up about 2.77%. A year ago that embedded call option wasn't very significant, but now it is. Despite the increase in the value of this embedded call the price (and thus yield) remains fairly similar to where it was a year ago.
The biggest argument against EPR-E would have to be the premium over liquidation value. Since liquidation value is not equal to call value, I don't put much weight on that. If I was worried about liquidation, I wouldn't be trying to buy them at all.
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Disclosure: I am/we are long EPR-E.
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.
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