# What's The Probability That This Dark Horse REIT Wins?

## Summary

In any “dark horse” race, the odds for Lexington to outperform were high, but I was convinced that there were “probability distributions” that could lead Lexington to grow.

I was predicting that Lexington would be ahead of the game by now.

Clearly Lexington has the cash flow to pay out a higher dividend but instead the company has opted to prudently retain cash to reinvest and pay down debt.

It’s an endurance contest where the winners and losers are separated because they pick stocks with above-average appreciation potential and safe and growing dividends, and buy them at attractive prices.

When most people hear the word "statistics," they think of either sports-related numbers or the college class they took and barely passed. While statistics can be thought about in these terms, there is more to the relationship and the methodology of data research.

First off, and to be honest, I barely passed statistics. It was the toughest business school class that I took and if it weren't for a great instructor (Thank you Dr. Tarbert) and few smart friends, I would have likely taken the course again in summer school. In statistical terms, I had a 1 out of 100 chance of passing my college stat class so I suppose that means I'm a "long shot."

My daughter is dealing with that pain and suffering too. She is a freshman at UNC-Chapel Hill and I was discussing her studies over the weekend when we both broke out in a cold sweat just thinking about the word "probability." My daughter asked me if I ever used "stat" in my REIT research and I answered, "Uhm, yeah, I guess." I went on to say, "in theory I don't really count marbles but I do study data in an effort to predict the best REITs that will outperform over time."

In fact, I actually do use considerable data when I research a particular company. As many of my readers know, I'm a value investor and the root of my research is to determine a company's value through a methodical analysis of the security in order to determine the presence and size of the margin of safety.

I'm sure Ben Graham was an A+ student in his stat class at Columbia University. In fact, it's very clear that there is a lot in common with stat and eliminating investment risk. As you recall, Graham used methods to greatly minimize risk by filtering out disadvantageous securities from the outset. Much of the "margin of safety" concept is more of an all-purpose risk minimization tool in which one can proceed with a fair degree of certainty (or probability) that, regardless of day-to-day price fluctuations, one's principal is likely to be secure.

The Dark Horse Rides

Late last year I wrote an article (only available as a SA Pro article) on my "dark horse" REIT pick for 2014. Lexington Realty Trust (NYSE:LXP) was selected because of my statistical-based research that suggested that this mid-cap REIT could emerge from the crowded Triple Net REIT playing field and succeed. As in any "dark horse" race, the odds for Lexington to outperform were high, but I was convinced that there were "probability distributions" (The basic idea is to look at the results of an experiment, and look at how the results are grouped) that could lead Lexington to "grow by 45% in 2014."

For the first few months of 2014 my "dark horse" was riding high. From December 23rd (the day of my article) through March 4th (2014), Lexington shares grew by 13%. However, the other horses were also charging ahead: Realty Income (NYSE:O), American Realty Capital Properties (ARCP), and National Retail Properties (NYSE:NNN) all grew shares by around 17% (in the same period).

Then my "dark horse" started to slow down considerably. From March 4th through today, Lexington shares fell by around 6%; but Realty Income and National Retail also slid by 5%. American Realty Capital Properties dropped by over 10%.

Comparatively, I was predicting that Lexington would be ahead of the game by now. With the first quarter of the race finished, I was predicting that Lexington would have been a few steps ahead, instead of in the middle of the pack. Of course, one of the early surprises has been American Realty Capital, up only 4% since January 1st.

Let's Examine the Stats

Lexington has Total Assets of approximately \$3.55 billion and a Total Capitalization of \$4.72 billion - still considered small compared with the big horses: Realty Income, American Realty Capital Properties, and W.P. Carey (NYSE:WPC).

As of Q4-13 Lexington owned 227 properties that consisted of 115 office buildings, 59 industrial buildings, 26 retail/specialty buildings, 15 multi-tenant buildings, and 5 land parcels.

Lexington's largest tenant (based on ABR) is FedEx (NYSE:FDX) with around 3.3% total exposure. Here is a snapshot of the top 10 tenants:

Lexington has a large percentage (46%) of tenants that are investment grade rated and that provides the REIT with more predictable cash flows and steady and stable returns.

Lexington has a balanced lease rollover schedule with minimal expirations. Here is a snapshot of the company's lease expiration schedule based on cash rentals.

Why Should This Horse Pick Up Speed?

Because Lexington is smaller than the big horses (O, ARCP, and WPC) the company should be able to move faster. One way that Lexington can generate solid growth is by recycling non-core and under-performing assets. That initiative allows Lexington to produce funds for deleveraging and accretive acquisitions to maximize value. Over the last several years, Lexington has consistently used proceeds from dispositions to recycle capital into higher quality properties or pay down secured debt.

In the fourth quarter, Lexington produced strong execution on the investment front with total volume of \$428.9 million, consisting of \$19.9 million invested in active build-to-suit projects, \$362.2 million in acquisitions, \$39.4 million in financing and the completion of a build-to-suit project totaling \$7.4 million.

Lexington placed one build-to-suit project for a commitment of \$12.8 million during the fourth quarter. Subsequent to quarter end Lexington completed the \$42.6 million industrial build-to-suit for Easton Bell Sports, purchased a newly constructed office property subject to a 19 year lease for \$13.9 million and entered into a forward commitment to acquire a build-to-suit office property for \$40 million. Will Elgin, Lexington's CEO, commented on the recent earnings call:

We are building our pipeline for 2014 and 2015, and at this point we believe build-to-suit funding will total about \$200 million to \$225 million in 2014 based on current transaction activity. In addition, we believe we have an additional \$100 million to \$125 million of good prospects that we are working on for purchase. Accordingly our current forecast for 2014 property investment activity is \$300 million to \$350 million.

In addition to solid acquisition growth, Lexington should also be able to move ahead of the pack by continuing to improve cash flow. By reducing debt service payments (2014-2015 balloon maturities total \$368.23 million at a weighted-average rate of 5.4% with a current pay rate of 8.8%) Lexington should be able to increase revenues with a potential savings of between \$.07 to \$.09 per share.

Last June S&P assigned a BB+ corporate credit rating to Lexington. The credit analyst said that the company's ratings incorporate the "fair business profile," which is due to its diversified portfolio of net-leases properties, healthy tenant credit quality and improved portfolio-weighted average lease term. S&P said that it may raise the ratings upon an increase in the portfolios weighted average lease term and increased occupancy. (Source: SNL Financial)

Reviewing Lexington's balance sheet we can see continued deleveraging credit metric improvements. Since commencing in January 2008, Lexington has consolidated leverage reduction by over \$1 billion. Here is a snapshot of the evolution:

In the fourth quarter of 2013 Lexington completed \$213.5 million of mortgage financing secured by a New York City land purchase with a term of 13 years and fixed rate of 4.66%. Lexington also drew \$87 million under its five year term loan and swapped into a current fixed rate of 2.64%. Subsequent to quarter Lexington drew the remaining \$99 million of availability on this loan facility and swapped into a current fixed rate of 2.51% using the proceeds to fully retire the amount outstanding on the revolving credit facility.

Although Lexington increased secured debt in the fourth quarter, the company's objective remains to lower secured debt to 20% or less of gross assets. Lexington expects to continue to retire mortgages as they mature and unencumbered assets with the goal of having about 65% to 70% of assets unencumbered. Here's a snapshot of the company's debt and preferred composition:

Drilling Down to Probability

As evidenced below, Lexington remains a "dark horse" in Mr. Market's play book. The company has the lowest Price to Funds from Operations (P/FFO) multiple in the Triple Net REIT sector.

In addition, Lexington has a low P/FFO multiple when comparing to other sector REITs (i.e. Industrial and Office):

In terms of occupancy, Lexington reported year-end (2013) occupancy of 97.6% trending higher, indicating strong operating performance and predictable cash flows.

On March 18th Lexington announced that it declared a regular common share dividend for the quarter ending March 31, 2014 of \$0.165 per common share payable on or about April 15, 2014 to common shareholders of record as of March 31, 2014. Over the last 3 years Lexington has increased its annual dividend by an average of 12%. Lexington has increased its dividend by 65% over the last 4 years.

That's better than most REITs, especially when you consider the fact that Lexington has maintained a conservative payout ratio (of 58.9%). Clearly Lexington has the cash flow to payout a higher dividend but instead the company has opted to prudently retain cash to reinvest and pay down debt. Needless to say, a low payout ratio improves growth prospects over time.

Meanwhile the current dividend yield of 6.06% remains attractive. It's not the highest in the sector but it's essentially sacrificing some of the dividend for the opportunity for increased growth. If my horse is going to get close to returning 40% in 2014, it should turbo-charge the engine by prudently controlling risk.

Lexington suggests FFO per share guidance of \$1.11 to \$1.15 in 2014. Assuming the top end of the forecast and my prediction that LXP has been trading (for the last few years) below the peer group (of 9.1x), I'm betting that the shares could hit \$15.00 year-end (1.15 x 13). Actually, I'm not too bad off since shares are up around 5% from my previous article (LXP was trading at \$10.17).

However, assume that I'm wrong (it won't be the first time, I promise) and Mr. Market does not see the excitement in my "dark horse." Perhaps he ignores the attractive 2013 growth and the pipeline for 2014. Maybe he pays no attention to Lexington's improved balance sheet or refinancing savings. Maybe the asset recycling initiatives are less important. Maybe my "dark horse" gets no credit for the conservative payout ratio. Then what?

Well, I'm still a winner. Remember, Lexington is a Net Lease REIT. I own the stock for durable dividends. I purchased my shares at a cost of \$10.16 with a going-in yield of around 6.5%. I have already beaten the market since my total return YTD is over 10%. I would love to hit this ball out of the park but I know that the odds are not in my favor. Because I completed the necessary due diligence before making an investment in Lexington, I feel a certain satisfaction that my mission is accomplished: protecting principal at ALL costs.

But maybe Lexington does pull away from the pack? Based on my statistical research, there is that probability. However, there is a greater likelihood that I will increase my wealth over a period of years because I have invested in a company with consistent profit margins.

It may happen in 2014 or later, but one should recognize that investing is not a sprint. It's an endurance contest where the winners and losers are separated because they pick stocks with above-average appreciation potential and safe and growing dividends, and buy them at attractive prices. Simply said, winning is nothing more than investing with a "margin of safety."

Finally, I want to wish my daughter (Lauren) luck next week with her stat exam. She doesn't need much luck because she has that "necessary trace of wisdom" but hopefully luck is hereditary (because I have plenty of it).