Fears related to recent economic conditions in Europe have caused somewhat erratic market behavior in which stock prices are falling independently of company performance. This sort of event has a tendency to create opportunity as stock prices fall below their stabilized values. Using simple logical techniques, we can find that a particularly attractive opportunity is Agree Realty (ADC). At the heart of any deduction is a series of premises which logically lead to a necessary conclusion, the premises I will use relating to ADC are listed here and will be demonstrated below:
1) The European economic instability created market conditions which have led to price drops.
2) The price of ADC fell significantly more than that of its sector peers.
3) ADC was not more adversely affected by the external event (European economy).
4) The price drops in both the sector and in ADC were largely NOT due to individual company performance.
Conclusion: ADC has become underpriced relative to its normalized price and that of its sector peers.
Of course, any deduction is only as sound as its premises, so we shall explore their accuracy.
While it is a well-established trend that anticipation of a crisis leads to sell-offs and the resulting price declines, it is important to note the emotional nature of some market behavior. While panic can exacerbate these crashes it is also the source of opportunity for the equanimous investor.
Over the three months ending May 18th, Agree Realty dropped 13% while the overall shopping center sector dropped only 2.7%. To start the year, ADC's price fluctuated around $24.50-$25.00 until the decline which began in late February. Since then the stock has slowly and steadily gone down to its recent price of $20.70.
As a United States-based retail properties REIT whose tenants are also primarily based in the U.S., there is little reason to believe a European economic crisis would affect ADC any more than the rest of the sector. In fact, ADC has a vast majority of its leases expiring after 2016 which helps to mitigate damage if a crisis were to occur.
Any changes in average price of the sector can be attributed to a general market condition (most likely fears surrounding struggles in the EU in this case) as any movement due to individual company performance would be largely washed out by the averaging. Determining the nature of change for ADC requires deeper examination.
In hindsight, the company's biggest weakness was a lack of tenant diversification. Since 20% of its rental revenues came from Borders Inc., the subsequent bankruptcy filing from Borders on February 16th 2011 was a devastating blow. Consequent termination of rental agreements with ADC caused many properties to go unoccupied. Insufficient revenue forced Agree Realty to reduce the quarterly dividend from $0.51 in December of 2010 to $0.40 where it has remained. Since then, ADC has recovered significantly and taken steps to prevent recurrence.
Over the past 15 months, ADC has acquired many new properties distributed across different retail sectors and across the U.S. While this does not prevent an event like what happened with Borders from occurring, it mitigates damage by reducing the percentage of total real estate leased to any single tenant. Also, spreading its portfolio throughout various sectors reduces sensitivity to changes in any one retail sector. Agree Realty announced intent to continue diversifying through acquisitions and has sourced capital to facilitate this goal.
During the first quarter of this year ADC executed a secondary offering of 1,495,000 shares of common which sold at $24.75 per share. After underwriter fees net proceeds totaled $23.51 per share ($35,151,000 total) which is still significantly higher than the recent market price of $20.70. With a market capitalization of only $231.8mm this offering represents a large portion of the portfolio.
Despite the strong efforts to revitalize, ADC's earnings are still showing some residual effects from the Borders bankruptcy. FFO declined from $6.317mm in 1Q11 to $5.507mm in 1Q12 which was largely due to dispositions and the fact that revenue from some of its acquisitions has not yet kicked in. On the positive side, debt to market capitalization was reduced from 32% to 24% over the same period. Overall the quarterly earnings report is not stellar, but on track.
With continuous diversification, an equity offering at prices well over the recent market value and an on track, stable quarterly earnings report, what could have caused such a massive drop in share price? Thinly traded issues, such as ADC, tend to react with more volatility in chaotic market conditions as there is less volume and fewer market participants to balance out single occurrences. For anecdotal evidence, examine the chaotic trading activity in small cap REITS during last summer's European inspired sell-off.
These premises lead us to conclude that Agree Realty has dropped unjustifiably to an opportunistic acquisition price. In addition to potential for capital growth investing in ADC provides excellent income. An annual dividend of $1.60 yields 7.73% at its recent market price of $20.70. This dividend seems very stable as even at its currently reduced FFO it was well covered. With announced intent to maintain a payout ratio of 70%-80% we may see a dividend increase as the acquisitions contribute to earnings.
Disclosure: 2nd Market Capital and its affiliated accounts are long ADC.