Lessons Learned - Part IV: Management Matters

Includes: GNL, VER
by: Brad Thomas

Management matters across the board, and no matter the business setting.

When you lay down with dogs, you wake up with fleas.

Many of you know that part of my job as a financial writer is to dig deep inside a company’s inner workings.

This is my fourth "lessons learned" article. To recap the others:

  1. Lessons Learned Series: In The School Of Hard Knocks, I Took Night Classes
  2. Lessons Learned Series: Diversification Is The Next Best Thing To A Crystal Ball
  3. Lessons Learned Series: Location, Location, Location

Here's a lesson I probably don't have to tell you. No doubt, you've already learned it on your own the hard way.

Management matters.

It's a fact we learn about from almost the second we get our first jobs as kids. Who is in charge can and does determine a lot… including how worthwhile even the most mediocre position may end up being.

Take the teenager working dinner shifts three nights a week at the family restaurant down the road and around the corner. She's only been there a few months, yet you know she knows that management matters.

If you asked her about it (and she felt free to give you her candid opinion), she would fill you in on the inside scoop. Such as how, during most Tuesday nights, the manager on the floor is Chris, a tall guy in his 30s who truly looks like he could step off of a Where's Waldo page.

All he's missing is the striped shirt and hat.

Chris is a nice enough guy, she'll admit. But he's a stickler for the rules with no imagination whatsoever. If corporate says to jump, he doesn't even bother asking how high. He just starts jumping.

The way he sees it, if corporate had meant for him to know how high he should launch himself into the air, it would have told him. The man has no business imagination whatsoever, which means that things run smoothly back in the kitchen and out on the restaurant floor…

Until they don't. The moment that something comes around that corporate couldn't or didn't predict, things fall apart.

Photo Source

Step Up for Inspection, Manager #2

Another of this teenager's managers, Dan - a general no-nonsense type - tends to work on Friday and Saturday nights. In his case, he analyzes each situation as it comes along and makes a decision from there.

He's not as interactive with the employees as Chris is, and everyone knows he's not their buddy. He's their boss. So, they can make jokes with him about annoying customer interactions, and he'll ask them how they're doing as he makes his rounds.

He'll even accept feedback, including complaints. But, at the end of the day, what he says goes.

The teen in question and her fellow employees don't always agree with what Dan concludes. As such, there definitely are some snippy comments made behind his back.

Now, faced with those two managerial choices, which one do you think the teenager prefers to work for? Which one would you prefer?

And, more importantly, which one do you think makes the business run more smoothly?

Either way, like I said at the very beginning… Management matters.

Photo Source

Who to Thank and Who to Blame

Management matters across the board, and no matter the business setting. It matters to low-level restaurant employees like servers, fry cooks, and busboys.

It matters to the workers sitting at desks inside their corporate America assigned 125-foot cubicle spaces.

And, it matters to the REIT investor who buys up shares because of the company's impressive (hopefully growing) dividend or rising valuations on display.

That impressive dividend and rising valuation are thanks to management. Make no mistake of it.

This isn't to knock non-management members. It's not a slam against the little guys and gals. Businesses are built on their backs, after all.

Their backs - and management's vision, as well as the ability to implement that vision in a way their employees can make sense of and take pride in. That right there is an essential equation with so many parts and pieces to it, not to mention possibilities.

Both good and bad.

That's why you really want to know who you're getting into bed with… before you get into bed with them. Otherwise, you learn exactly why they say: "When you lay down with dogs, you wake up with fleas."

How Far I'll Go

I learned this lesson the same way as you and the same as our teenaged friend from before. It's an educational experience I've taken to heart and applied to my business writing every chance I get.

This means that I listen in on what they say and how they say it during their quarterly announcement conference calls… I make time to talk to them directly on the phone when I can… and I'll even sit down face to face with management if the opportunity presents itself.

Which, for the record, it does often enough. For instance, I'll be attending RECon and the MoneyShow in a few days, with quite a few CEO interviews already lined up.

And let me tell you: There really is nothing quite like sitting down face to face with a person when you want to get to the bottom of what they believe.

You get not only their words, as you would with a written statement from their office. Not only their intonations, as with a phone conversation. Even video chat can't quite compare to looking someone straight in the eye.

That's how far I'll go to study management of the REIT portfolio plays I'm proud to recommend - or warn against, as is the case below.

It's worth every effort. Believe me.

Note: All of our CEO interviews (in video format) will be aired on our "iREIT on Alpha" Marketplace service.

An Overly Managed REIT We're Avoiding

Many of you know that part of my job as a financial writer is to dig deep inside a company's inner workings. As explained above, this includes very closely analyzing management structure. And, that in turn means that I must pay close attention to its balance sheet and income statements.

Specifically, I tune into the company's dividend record and its payout ratio. Whenever I see a dividend that is not being covered by profits, I get concerned…

One case in point is Global Net Lease (GNL). While most net lease REITs are enjoying steady earnings, or funds from operations (FFO), growth - thanks in large part to their low cost of capital - and rising corporate profits, this one is stuck in quicksand, as it were.

In Q4-18, the company's core FFO per share slipped $0.01 from $0.51 to $.50, and NOI declined from $66.8 million to $63.3 million… primarily as a result of resolving outstanding litigation for $7.4 million.

GNL is set to release Q1-19 earnings on May 9, and, looking forward to that, I'm not concerned as much about its one-time slippage than I am the lack of proper FFO growth. Analysts (there are three, as per the F.A.S.T. Graph chart below) expect its adjusted funds from operations (AFFO) per share to decline by over 5% in 2019.

And, while the sample set is small, it appears that the company's muted growth is due to its cost of capital disadvantage.


Source: FAST Graph

Furthermore, GNL's payout ratio (its dividend per share divided by its AFFO per share) appears to be getting even tighter: 107% based on the estimates for 2019. This means there's little room for error should the company face sudden vacancies or capital expenditure requirements.

As viewed below, in almost every quarter, GNL has paid out more dividends than it's generated in profits (using AFFO data):


Source: GNL Investor Presentation

Therefore, in my opinion, the challenge before it is twofold.

First, the company must acquire new deals accretively, which simply means it must generate positive spreads on acquisitions so that its weighted average cost of capital (WACC) is lower than its cap rates.

In 2018, for instance, the company closed on $478 million worth of properties with a weighted-average cap rate of 7.70%.


Source: GNL Investor Presentation

To arrive at GNL's WACC, we used the following:


Source: Author

Using this basic, "back of the napkin" approach, you can see that GNL's investment spreads are modest at 50 basis points. Compare that with Realty Income (O) and most other net lease REITs though, which are generating spreads of 150 bps or higher, and that number looks downright dingy.

In addition, Realty Income has superior assets and isn't plagued with legacy lower-quality properties, as the ones that are owned by GNL.

Another important difference is that GNL has to pay its external manager, AR Global Investments, LLC. That business is subject to possible conflicts of interest, including significant ones created by the compensation arrangements it operates off of with its various investment programs - GNL included.

Keep in mind that one of my biggest "lessons learned" as a REIT analyst and investor is in making management accountable. And, one of the great things about investing in publicly-traded REITs is that management must disclose financial information to investors and report on material business developments and risks on a timely basis. This means they're governed by the SEC and must provide investors with additional visibility into their finances and operations.

As a relevant refresher course, I once wrote on and invested in a company known as American Realty Capital, which was the subject of an accounting "mishap" that led to executives being removed and criminal charges being filed. The company was subsequently re-branded as VEREIT (VER) and is now in the process of settling litigation activities that cost investors millions of dollars.

That was definitely a lesson learned that has since made me extremely cautious on the subject. If a company is externally managed, I want to know all about its executives and the executives over at its affiliate.

That's why I went and searched the AR Global website to find its management team… and couldn't locate any bios. In fact, this is what I found on its leadership page:


Source: AR Global website

It also appears that the company remains at the same address as the former American Realty Capital company in New York City.

Keep in mind that GNL has limited rights to terminate its advisor. Moreover, the initial term of its advisory agreement doesn't expire until June 1, 2035, and is automatically renewed for consecutive five-year terms after that unless notice of termination is provided by either party a full year in advance.

This means the advisor can generate fees from GNL for at least another 16 years.

As it stands now - and the next year, and the next year… - the advisory agreement requires GNL to pay a base management fee of $18 million per annum ($4.5 million per quarter). That's on top of a variable base management fee, both of which are payable in cash, and incentive-based compensation, which is payable in cash and shares if hurdles are met.

In addition, GNL's service provider and property manager are entitled to payments, which are calculated as a percentage of gross revenue. And, in addition to even that, its advisor receives outperformance awards based on whether it achieves certain levels of total returns to shareholders.

When you consider all of those external management fees being paid out, you get a sense of the dangerous potential for a dividend cut. Tallied up, they amount to around $5 million per quarter. Since GNL's common shareholders received $39.1 million in dividend payments last quarter (since AFFO was $37.1 million), it essentially had to pull $2 million out of a hat to fund dividends during the latest quarter.

And, that's just not good. Not good for management. Not good for Global Net Lease.

Not good for you.

Note: Some of you may want to know my official position with regard to Global Net Lease's 7.25% Series A cumulative redeemable preferred stock (GNL.PA).

I know that others here on Seeking Alpha are recommending this high-yielding name, but I am not. There are plenty of other opportunities in the preferred landscape, and we will be writing an updated preferred REIT pick article later this week… at which time GNL.PA will not be on it.

Author's note: Brad Thomas is a Wall Street writer, and that means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, 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.

Disclosure: I am/we are long O. 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.