ARCP: Take Some REIT Risk And Always Double-Down On A Soft 16

Aug. 7.12 | About: VEREIT Inc. (VER)

One of my first mistakes in blackjack was when I was dealt 16 and I refused a third card. The guy sitting next to me was in shock almost and said something about a "soft 16". I lost the hand but I still don't know what he meant by soft 16.

After losing my chips I went back to my room and read over my "Blackjack for Dummies" book and then I learned that the Ace in Blackjack can be played either as a 11 count card or a 1 count card. So I had 16 or 6. In hindsight, I learned that the 16 was a losing proposition since I could have taken at least one hit on the hand before busting. As I learned, taking a hit would have been the correct play (in most circumstances) based on basic blackjack strategy.

Of course, the statistically determined action is always based on the player's hand and the dealer up card. If you have been dealt a soft 16 (for example, Ace-5) you should neither surrender nor stand. You'd better double is the dealer has 4, 5, or 6 face up. If not, then hit.

American Realty Capital Properties: Double Down but Consider the Risks

Yesterday I wrote an article on American Realty Capital Trust (ARCT), the second largest triple-net sector REIT that owns around 486 properties located in 43 states. ARCT owns properties leased to high-quality tenants and the average lease duration for the portfolio is around 12.5 years. Because of the extraordinary tenant quality, I consider ARCT to be somewhat of a bond-replacement alternative in which the current dividend yield is 6.42 percent.

ARCT offers a fairly straight forward value proposition in that the overall portfolio lease fundamentals and relatively low debt ratios provide investors with a low-risk fixed-income alternative (see recent article on ARCT here). In blackjack terminology, ARCT would be the equivalent of 2 face cards (a score of 20) - darn close to perfection.

Unlike ARCT, American Realty Capital Properties (ARCP) offers a differentiated strategy unmatched across the REIT sector: seeking to acquire single-tenant, freestanding commercial real estate that is net leased on a medium-term basis (generally three to eight years), primarily to investment grade and other credit-worthy corporate tenants. In contrast, ARCT focuses on single-tenant, freestanding commercial real estate that is net leased on a long term basis (generally 10 to 25 years), primarily to investment grade corporate tenants.

So although ARCP invests in the same properties that ARCT also owns, the two companies represent distinctly different investment platforms - one with low-risk and the other with medium risk. Figuratively speaking, ARCP is like a "soft 16" and an investor should take a closer look and decide if he or she wants another card.

ARCP - How do the Cards Stack Up?

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. Today the portfolio is comprised of over two million square feet (includes 22 properties under contract described in the company's S-11 filed May 25, 2012, several have since closed).

The portfolio has an average lease term of 7.1 years with occupancy of 100 percent and 99 percent of the tenants are investment-grade rated. Here is a snapshot of the progress during the past ten months (note, the company went public around eleven months ago):

Click to enlarge

In addition the once non-diverse portfolio (two tenants) has expanded to include a variety of new tenants and sectors. For example, ARCP has 20 Dollar General (DG) stores, two Walgreens (WAG), six Advance Auto Parts (AAP), and six FedEx (FDX) distribution facilities. One of the most recent transactions was a John Deere facility that is around 522,960 square feet that was purchased a cap rate of around 8.5 percent. Also, in July ARCP announced that it closed on a Mrs. Baird's distribution facility located in Dallas, Texas with 75,050 rentable square feet, at a purchase price of approximately $6.2 million. The Mrs. Baird's distribution facility is 100 percent leased to and guaranteed by Bimbo Bakeries USA, Inc., a wholly owned subsidiary of Grupo Bimbo SAB de CV. The net lease has a 15-year term, with approximately five years remaining. Here is a snapshot of the latest portfolio properties:

At IPO (September 7, 2011), ARCP's portfolio was comprised of just three tenants - Citizens Bank (74.6 percent of annual rent), Community Bank (.4 percent of annual rent) and Home Depot (25 percent of annual rent). Since the IPO, ARCP has reduced its exposure with Citizen's Bank from 75 percent to 37 percent. In addition, ARCP has diversified its revenue by adding eight new credit tenants.

Since its IPO, nearly one year ago, ARCP has doubled the size of its portfolio while increasing its percentage of rents derived from investment grade tenants to 99. As of the latest quarter (Q2-12), ARCP's assets totaled $201.17 million.

Click to enlarge

ARCP's growth oriented, value proposition relies on "vintage rents." These rents are generally well below current market rents, having been set approximately 10 to 15 years earlier, when market rents were considerably lower. A fair market, long-term lease renewal has the potential to generate earnings growth and significant value appreciation in the underlying asset.

No other natural competitor or institutional buyer exists in this space, which is why ARCP's seasoned management team has experienced tremendous success in purchasing assets at spreads 300 to 400 basis points wider than the long-term lease market (at 9% to 10% cap rates). This unique investment strategy allows ARCP to pay a considerably higher dividend rate compared to ARCT: $0.89 per share for ARCP vs. $0.70 per share for ARCT.

ARCP - How Does the Dealer Stack Up?

ARCP is managed by a legal affiliate of American Realty Capital (ARC), which has 65 professional and support personnel. According to the S-11, ARC's management team has been responsible for sourcing, structuring, and acquiring over 2,900 net leased properties representing ~45m sf at a purchase price of over $6.0 billion.

ARCP's senior management also has "skin in the game." In fact, industry analysts have praised ARCP's senior management for their considerable level of ownership in ARCP, collectively owning 1.6m shares, or approximately 14% of the currently outstanding common shares, purchased with cash in conjunction with the initial public offering (NYSEARCA:IPO), as well as at the market since the IPO.

Moreover, ARCP's management received incentive-based compensation in the form of manager stock, which vests over time. Distributions payable under those shares are subordinated to common shareholders if ARCP doesn't meet performance thresholds. In my opinion, this aligns management's interests with those of ARCP's shareholders.

ARCP: Surrender or Stand?

ARCP is not for every investor. Unlike ARCT, there is risk in the ARCP investment alternative and the primary risks are as follows:

Lease Expiration Risk the primary risk. The average lease term is around 7 years and the more time that the portfolio matures, the greater risk of lease termination (and revenue reduction). However, ARCP's strategy of acquiring properties with below-market vintage rents could also present investors with an opportunity.

Because ARCP buys properties at or below replacement cost, there is a unique opportunity to release sites to tenants that pay higher rent. In fact, this medium risk proposition could provide investors with significant asset appreciation going forward. So in short, this is a medium risk, high return proposition.

Leverage is another risk. ARCP has a debt to market capitalization of around 45.48 percent. This higher leverage does not concern mean as much as the lease roll-over risk - especially since the portfolio consists of 99 percent investment-grade rated tenants. In addition, the leverage is significantly less than the mortgage REITs like Annaly Capital Management (NLY), Cypress Sharpridge Investments (CYS), Colony Financial (CLNY), and Apollo Commercial Real Estate Finance (ARI).

Lack of Diversification is another risk; however, I am much more satisfied with the "margin of safety" fundamentals today than I was eleven months ago when the portfolio consisted of just three tenants. ARCP has done an excellent job spreading tenant, industry, and geographic risks. Here is snapshot of the company's geographic diversification:

Click to enlarge

ARCP has a current market capitalization of $119.7 million and the current stock price is $10.72 per share (52-week high was $12.96 on September 8, 2011). The current dividend is 8.3 percent and the yield is attractive compared with its triple-net peer group that includes Realty Income (O), National Retail Properties (NNN), Agree Realty (ADC), American Realty Capital Properties , and Lexington Realty Trust (LXP).

Click to enlarge

The advantages to the investment opportunity include (A) medium-term leased properties are attractive, given the risk-return profile; (B) Rents derived primarily from investment grade, corporate tenants provide stable shareholder dividends, (C) Growth in earnings and asset values is facilitated by the opportunity to mark to market rents upon lease expiration, and (D) Significant management ownership allows for true alignment of interests.

The disadvantages to the equity selection include medium term lease rollover risk, higher leverage risk, and lack of diversification.

In summary, I consider ARCP to be somewhat of a hedge play in that the principal (asset quality) appears to sound - especially given the company's track record for acquiring properties below replacement cost. Alternatively, the leverage and diversification risk is moderate and these fundamentals are more aligned with a mortgage REIT investment.

The (blackjack) book says always hit soft 16 and even double down when the dealer has a 4, 5, or 6 face up. I like my odds with ARCP and I think that it is unlikely that my cards will go bust - at least for the near future (or at least during the next 5 years or so). The dividend looks attractive and with contractual rent bumps there should be strong support for capital to appreciate.

If the risk keeps you up at night, you could always move up the credit curve (and move down the dividend curve) and focus on some safer triple-net REITs like ARCT, NNN, or O. Remember that the wild card is ARCP's lease expirations and I suggest you stay close to the vest with that card (lease renewal dates) - and in the mean time - keep stacking up the dividends.

Click to enlarge

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.