With so many REITs enjoying success in the current environment, the demand for properties is quite high, resulting in bidding wars and reduced cap-rates. Yet, a tiny little company, Whitestone REIT (WSR), still has a pipeline of acquisitions with cap-rates around 8%-9%. How is this possible? To answer this question we will first look at the background of the company, and then, in more detail, the specifics of Whitestone's recent and planned acquisitions.
Whitestone markets and operates Community Centered Properties (a term trademarked by WSR), which are centrally located in culturally diverse areas in major cities, such as Houston, Phoenix, Dallas, San Antonio and Chicago. It was founded in 1998 and publicly traded since August of 2010, during which it was initially offered at $12.00 per share. It has grown to a still-small market cap of $161mm, with $40mm of acquisitions currently under contract.
These $40mm purchases include multiple properties, each with cap-rates ranging around 8%-9%, based on their going-in average occupancy of 85%. Management sees upside potential, with expectations to be able to raise occupancy a bit higher once these properties kick in. Each of these is projected to close during 3Q12 and more acquisitions are anticipated going forward from its substantial pipeline. WSR is able to get these high cap-rates due to its practice of acquiring properties in foreclosure and/or under financial distress. A proactive approach allows WSR to purchase many of these properties before they even go to market, thus evading bidding wars. In fact, one of its acquisition criterions is to purchase well-below replacement cost.
The assets themselves are of fairly high quality, and are centrally located in major cities. However, some of these properties were overlooked by other REITs due to the very small spaces allocated to each tenant. As such, a company needs to have the capacity to handle a vast number of small square footage leases of varying quality properties. When combined with the short average lease term, it becomes extremely management-intensive to maintain occupancy and rates.
Considering its strong second quarter performance, accretive acquisitions, and a whopping 8.3% dividend, it seems strange that WSR trades at an FFO multiple of only 12.7. Potential reasons for this are investor concerns over its G&A expenses and dividend payout ratio.
Based on WSR's 2Q12 balance sheet, general and administrative expenses take up 16.95% of its revenue for the quarter. While this number seems outrageously high, we must dig deeper to ascertain the nature of it. Three different aspects contribute to this abnormally high expense ratio, and two of them are temporary.
1) Due diligence costs on its acquisitions. With currently in place acquisitions summing to 25% of the company's entire market capitalization and more already being looked into, we can conclude that at least a portion of the G&A is from these costs.
2) Among the aforementioned $40mm of acquisitions, the management that will run them has largely been pre-hired. As such, upon becoming operational, we can expect the increased revenue without expenses of additional employees to run these buildings. Therefore, as a percentage of revenue G&A costs will decline.
3) The multi-tenant and short-term nature of its leases does and will continue to require extra management hours to ensure continued occupancy and rates.
Since two of the roots of the extreme G&A are temporary, it seems probable that this number will drop significantly for future quarters. Investors should worry about such balance sheet anomalies as for many companies it is the result of egregious salaries, but with Whitestone these expenses appear clean. In fact, its top executives, the CEO, CFO, and COO are only salaried $334K, $154K and $183K, respectively.
Dividend payout ratio
Extrapolating WSR's 2Q FFO, it has a payout ratio of 129%. Consequently, many investors are concerned about the sustainability of the current dividend level. In response to voiced concerns, management declared in its second quarter conference call that it is "absolutely confident with the dividend level" and that it is "very sustainable". This confidence is backed up by the anticipation of bolstered FFO as its new properties become operational. To get an idea of how much increase to expect, we need simply to compare the magnitude of its $40mm in acquisitions soon to become operational to the overall tiny size of the company. Given the high cap-rate of these new properties, the sustainability of its current dividend level seems plausible.
While these concerns remain valid, the market price has remained low because of them. As the growing pains of rapid expansion subside, Whitestone REIT will show potential for excellent returns and provide a superb dividend while we wait.
Additional Disclosure: 2nd Market Capital and its affiliated accounts are long WSR.
Disclaimer: This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.
Disclosure: I am long WSR.