While CapLease (NYSE:LSE) has a diverse portfolio throughout the contiguous U.S., its property acquisition strategy is quite focused. The company almost exclusively picks up properties with single tenants who have high credit ratings, and most involve long-term leases. This type of operation provides low risk and stable long-term income, which allows CapLease to match it with loans and profit from the surplus revenues over debt service. Essentially, CapLease's rental agreements lead to slightly smaller income in exchange for stability. Additionally, it's long-term contracts facilitate occupancy, which has been continuously high and currently rests at 96%.
On March 27, 2010, CapLease announced a five-year rental renewal with Nestle for a 1,045,153 square foot property at a rate of $4.40/square foot/annum, increasing by 3% annually. Yielding $4.598 million in rent for the first year, this is much lower rent than was secured by its previous contract in which they were getting $6.301 million for the same property. As there was a paucity of demand for this type of property, Nestle had the bargaining power to negotiate a lower rate. CapLease has a $117 million loan associated with the mortgage on this property and that of two others currently being leased by Nestle. This loan has an effective financing rate of 5.7% as of the 2010 annual report, which bears an annual cost of $6.669 million. The current leases with Nestle on the other two properties expire in December 2012, and renewals have not yet been announced. With the reduced rental rates obtained on the renewal and the impending expiry of these other rental agreements, CapLease may have trouble covering the $117 million mortgage loan that comes due in August 2012. Since lower rental rates correspond to a lower value of the property, CapLease may have trouble obtaining a sufficient mortgage loan to replace the expiring one.
The need to cover this mortgage loan may have been a contributing factor that caused the company to consider a new preferred stock offering. On April 16,2012, CapLease announced an offering of 2,000,000 shares of 8.375% Series B Cumulative Redeemable Preferred at $25.00 per share. Expected proceeds of $48.3 million are to be used for general corporate purposes and the funding of future acquisitions. At 8.375% this is an expensive source of money, but it can be used to pay off some of the debt on the Nestle properties such that a new loan can be negotiated. The smaller debt after partial repayment will be better aligned with the value of the properties, so banks will be less averse to providing a new loan at favorable terms.
The Nestle mortgage loan is one of few debt maturities for CapLease as most of its loans are long term, extending as far as 2031. CapLease has an estimated EBITDA/debt interest ratio of 1.6, which is well below the sector average of 3.3, but its debt is deceptively well serviced. While CapLease is a highly leveraged company, its debt is well managed. Long-term fixed rate loans are matched with long-term stable rental income, which covers debt interest and provides continuous cash flow. 88% of CapLease's portfolio is financed on a long-term fixed rate basis.
In addition to cleanly servicing debt, LSE is making efforts to reduce leverage through amortization. In 2011 leverage was reduced to 66% (from 72% in 2010) by amortization along with targeted debt repayments. Through amortization CapLease is slowly (over many years) transforming the company from leverage heavy to equity heavy. Even during the hard financial times of 2009, CapLease was making opportunistic decisions to reduce debt. On Feb. 5, 2009, CapLease repurchased $8.74 million of its own 7.5% Convertible Notes at a cost of $3.27 million, netting a savings of $5.4 million. As debt is reduced and the benefits of amortization are realized, the spread between interest and income expands and CapLease can translate this into increased dividends. Annual dividend on the common has increased in each of the past two years.
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CapLease has some new adversities to deal with between newly issued, expensive, debt and declining rental income from Nestle, but it has a strong foundation to work from and seems to be moving in the right direction. The significantly reduced debt, along with its structure for servicing debt, make this company far more stable than it would seem prima facie. With an estimated price/FFO ratio of 6.6, and trading well below its book value of $4.69 per share, CapLease is currently underpriced.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 2nd Market Capital and its affiliated accounts are long LSE and LSE.A.