STAG Has All Of The Ingredients Of Something Special

Summary

• I consider messaging a critical aspect to my job as a REIT analyst.
• Today I’m going to use the same messaging to convey the premium brand of STAG Industrial and why I remain a loyal shareholder in the Boston-based REIT.
• STAG is not engineering the yield to deceive investors, in fact, it’s quite the opposite.

I’m sure that when Warren Buffett’s company Berkshire Hathaway (BRK.A) acquired See’s Candy in 1972 he was thinking to himself, “your premium brand had better be delivering something special, or it's not going to get the business.”

Who knows, Buffett may have also been thinking about another premium brand, STORE Capital (STOR), after Berkshire Hathaway announced it had picked up 9.8% ownership in the Scottsdale-based REIT (for $377 million).

This is a timeless quote from the Oracle of Omaha that is relevant to the REIT sector, especially after the recent STOR announcement, and it suggests that Berkshire Hathaway just landed a superior REIT with the best dividend growth potential in the Net Lease sector.

Many of you know me for my humility, not for arrogance, so when I tell you that I was not surprised by the STOR news because I prompted an upgrade from a BUY to a STRONG BUY, don’t get angry. On May 17th, I wrote

STORE is forecasted to generate strong AFFO/share growth and when you combine that with a modest payout ratio, you can see that there is more inside of STORE. I am upgrading shares in STORE from a BUY to a STRONG BUY.

I consider messaging a critical aspect to my job as a REIT analyst, and I don’t take an upgrade from BUY to STRONG BUY lightly. As far as I’m concerned, the recent Berkshire Hathaway announcement is simply a validation that my messaging is correct.

So today, I’m going to use the same messaging to convey the premium brand of STAG Industrial (NYSE:STAG) and why I remain a loyal shareholder in the Boston-based REIT. Who knows, maybe Buffett is still shopping for a few good REITs and if STAG is not on the list, it should be.

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The Evolution of STAG

STAG Industrial is an Industrial REIT that went public in 2011 (the predecessor was STAG Capital Partners that formed in 2004), and since that time, the company has grown from 105 buildings to 324 buildings in 37 states, with approximately 63 million rentable square feet.

STAG’s portfolio consists of 254 warehouse/distribution buildings (88% of portfolio), 53 light manufacturing buildings (9% of portfolio) and 16 flex/office buildings (1.5% of portfolio). STAG has grown rapidly since the IPO. The company's stated goal of acquisitions is 25% annual portfolio growth, and it stated that its pipeline of potential acquisitions exceeds $1.9 billion. The portfolio has grown by 386% since the IPO:

STAG has found that primary (24.4%) and secondary markets (64.3%) have similar occupancy and rent growth experiences. Furthermore, secondary industrial property markets generally provide less rent volatility and equivalent occupancy compared to primary industrial property markets.

As illustrated below, historical primary and secondary market occupancy levels are very similar. "Super" primary markets historically operate at an occupancy level above primary and secondary markets:

Secondary market rent growth has performed in-line with Primary market rent growth over the past ten years. Super Primary market rent growth has displayed greater volatility over the past ten years compared to Primary and Secondary markets.

Data Does Not Support Conventional Wisdom

STAG intentionally invests in secondary markets due to the rationale that it enjoys low capital expenditures and lower tenant improvement costs (relative to other property types). Also, STAG's tenants tend to stay longer, since moving costs and business interruption costs are expensive relative to relocating a "critical function" facility.

As you can see below, STAG has a diversified geographic portfolio:

STAG’s #3 market is Greenville/Spartanburg, my hometown. Obviously, I know this market well and I drive-by many of STAG’s properties on a frequent basis. Here’s a snapshot of STAG’s GSP (Greenville/Spartanburg) portfolio:

A few days ago, BMW said it “will add 1,000 jobs and invest $600 million in its plant in Spartanburg, South Carolina. The investments will boost annual production to as many as 450,000 vehicles. The facility is already the company's largest final assembly plant in the world and had employed more than 9,000.”

Needless to say, the BMW announcement is also a big boost for STAG shareholders, in addition to BMW, many area companies are benefitting from the “BMW boom” including Michelin, and over 40 area automotive suppliers.

Greenville/Spartanburg is just one secondary market that STAG has a toe in. As noted above, STAG has around 64% invested in secondary markets, and the top 3 industries are automotive, air freight, and industrial equipment – all sectors that should benefit from President Trump’s Infrastructure plan.

Here’s a snapshot STAG’s automotive breakdown:

As you can see, STAG has significant exposure in the US automotive sector with OEM relationships with Ford, Fiat-Chrysler, GM, BMW, Toyota, Hyundai, and others. In addition to automotive, STAG also has considerable exposure in the air freight and logistics area:

As noted, many of the buildings owned by STAG are in secondary markets, but the notion that secondary markets perform poorly is a misconception. Here’s a snapshot of STAG’s top 10 tenants:

Keep in mind that the US industrial market is over $1 trillion in size, and as evidenced below, STAG’s share if that market is less than 1%.

STAG refers to its well-diversified model as a "virtual industrial park." It makes sense, since the REIT's portfolio of properties represent many of the different categories that you would see while driving through a large industrial park.

STAG has limited REIT competition in many of its core markets, as a majority of the peer group consists of private investors. Here's a breakdown of the company's portfolio based on tenant profile:

One misconception (or so-called myth) as it relates to STAG is the fact that it does not evaluate prospective deals carefully. While the company does invest in secondary markets, it does so by thoughtfully evaluating each acquisition through a structured probabilistic risk assessment model.

As illustrated below, the selectivity represents over 1,000 sites evaluated and 1/3rd of them being underwritten. Offers were made on around 20% (of the 1,000), and the company closed on around 3.3%.

In other words, STAG has maintained a very disciplined acquisition model in order to filter out the best opportunities. So it's not just that the company is investing in secondary markets, it's simply that STAG is investing in the BEST deals available in these secondary markets.

In 2016, acquired $472 million (22% growth) of industrial real estate at a weighted average Capitalization Rate of 7.9%

The Balance Sheet

As viewed below, STAG is much smaller than Prologis (PLD) and many of the other Industrial REITs:

STAG has continued to maintain a very strong and flexible balance sheet. In Q1-17, the company raised $69 million of gross proceeds from the ATM and raised an additional $135 million subsequent to quarter end.

At quarter end, STAG’s available liquidity was $383 million, and the net debt to run rate EBITDA was 5.3x and the fixed charge coverage ratio was 3.7x.

At quarter end, STAG had approximately $1.1 billion of debt outstanding with a weighted average maturity of 5.3 years and a weighted average interest rate of 3.7%.

All of the company’s debt is either fixed rate or has been swapped to fixed rate, except for the revolver. STAG is likely to refinance its $88 million of legacy secured debt (bears a weighted average interest rate of 6%) in August 2017.

STAG continues to demonstrate discipline in all phases of its business including acquisitions, asset management and balance sheet management. In Q1-17, STAG acquired 7 buildings for $99.8 million.

In Q1-17 STAG sold one building for $4.1 million:

Also, on November 14th, STAG sold a Southeast Portfolio of six industrial buildings located in Atlanta and Charlotte for Gross proceeds of $81 million ($51.61 PSF - 6.9% Capitalization Rate - Unlevered IRR of 15%). These assets were acquired individually at a weighted average Capitalization Rate of 9.2%.

STAG is looking to keep its leverage in the lower band of 5x to 5.5x, the lower end of 5x to 6x debt to EBITDA. I like the discipline I’m seeing on both sides of the capital stack.

The Latest Earnings Results

STAG’s primary focus is on the bottom line core FFO, and during Q1, the company grew core FFO by 27% compared to the first quarter of 2016. On a diluted per share basis, core FFO was $0.41, an increase of 5.1% compared to last year.

This represents STAG’s highest first quarter core FFO per share in the company's history. The growth in per share metrics coupled with growth and long-term cash flow remains a primary focus for STAG and is a central consideration in the decision-making processes.

On May 1, STAG’s Board of Directors approved a dividend increase to $1.41 per share annually.

STAG’s occupancy for the operating portfolio stands at 95.8% with an average lease term of 4.4 years. Cash NOI for the quarter grew by 14% from the prior year.

STAG’s tenant retention for the first quarter was 51%, lower than the long-term expectations of ~70%. The retention leases resulted in cash and GAAP rent increases of 13% and 24%, respectively. As Ben Butcher, CEO of STAG, explains:

High retention is generally a good thing for operating results but not always. If we were to add back to be no downtime leasing, i.e. where the building is already leased prior to the current tenants departure in the quarter, retention would have been 82%. The new leases for these incremental buildings had a cash roll up of 22.5%. For the full year 2017, we continue to expect retention to be in between 65% and 70%.

STAG’s Secret Sauce

As the dividend chart below illustrates, STAG has done a good job of growing its dividend:

…but more importantly, STAG has also done a terrific job of reducing its payout ratio:

As you can see, STAG’s current Payout Ratio is 83% and the company is forecasted to continue growing its dividend, while reducing its Payout Ratio. Now let’s take a look at STAG’s FFO/share growth forecast compared with the peers:

As you see, STAG is well-positioned to grow earnings while also reducing its Payout Ratio.

How does STAG’s dividend yield compare with the peer group?

Keep in mind that STAG is a pure play Industrial REIT and W.P. Carey (WPC), Lexington Property (LXP), Gramercy Property (GPT) and One Liberty (OLP) have office exposure. Now let’s examine the P/FFO multiple:

Again, as you can see, STAG is still trading at the low-end of the spectrum (comparing Industrial REITs). In other words, I still find STAG attractive compared with the pure play Industrial REIT peer set. Here’s how STAG has performed year-to-date:

No complaints from me at all, STAG is performing as expected, and I believe the company will continue to outperform the peers. Certainly, the shares are not as cheap as they were last year, but I still find the dividend yield attractive. Most importantly, STAG is not engineering the yield to deceive investors, in fact, it’s quite the opposite: STAG is demonstrating its premium brand is delivering something special! I’m maintaining a BUY on STAG.

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Brad Thomas is a Wall Street writer, and that means he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos and be assured that he will do his best to correct any errors if they are overlooked.

Finally, this article is free and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking. If you have not followed him, please take five seconds and click his name above (top of the page).

Disclosure: I am on the Advisory Board of NY Residential REIT, and I am also a shareholder and publisher on theMaven.

Sources: FAST Graphs and STAG Investor Presentation

REITs mentioned: (PSB), (FR), (TRNO), (DRE), (GPT), (EGP), (LPT), (MNR), (WPC), (OLP), (LXP), (GOOD), and (PLD).

Analyst’s Disclosure: I am/we are long APTS, ARI, BRX, BXMT, CCI, CCP, CHCT, CLDT, CONE, CORR, CUBE, DLR, DOC, EXR, FPI, GMRE, GPT, HASI, HTA, IRM, JCAP, KIM, LADR, LTC, LXP, O, OHI, PEB, PK, QTS, ROIC, SKT, SNR, SPG, STAG, STOR, STWD, TCO, UBA, WPC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.