It's Early Days For Medalist Diversified REIT. Here's Why I Am Watching This 16%-Yielding Company

Summary

  • Medalist Diversified REIT just recently listed in November and currently owns three properties (with three additional pending acquisitions).
  • Positive attributes include a strong management team, diversified business model, and market location.
  • Concerns that should be monitored to judge progress as the company matures include portfolio composition, lack of staggered leases, moderately high levels of leverage, and dividend coverage.
  • I am taking a wait and see approach. This is an undercovered name just starting out, and its growth initiatives have the potential to present a compelling value proposition for the stock.

Overview

Medalist Diversified REIT (NASDAQ:MDRR) is an externally-managed REIT that just went public in November 2018. The REIT's target investments are retail, hotel, multifamily, and flex industrial properties in secondary and tertiary markets. These markets are located across the American southeast. MDRR's focus states include Virginia, North Carolina, South Carolina, Georgia, Florida, and Alabama. The company currently owns two retail shopping centers and one hotel property, and it has purchase and sales agreements for three additional properties (1 retail, 1 hotel, and 1 flex industrial). MDRR is a little-covered name and has a market cap of around $20 million, making it one of the smallest publicly-traded REITs. Additionally, MDRR pays a $.175 dividend per share quarterly, making for a $.70 annual dividend. As a result of the recent drop in MDRR's stock price since it went public, the company is now sporting a 16% dividend yield.

Thesis

MDRR's core strengths include its experienced management team, unique and diversified business model, and focus on high-growth American markets. However, these positive qualities may be overshadowed by the company's retail exposure, lack of staggered lease expirations, moderately high levels of leverage, and lack of dividend coverage. MDRR's growth initiatives, which include its value-add investments and future acquisitions, present an opportunity for the company to overcome the challenges that have plagued the company's stock price since its IPO.

Strong Management Team

MDRR's two managers include Thomas Messier, CEO, and William Elliott, COO. Both individuals have a combined more than 50 years of experience in commercial real estate and capital markets. Both managers grew up in the South, went to college at SEC schools, and their past careers have centered around the southeastern region. Management focuses on its circle of competence by investing in the geographic region it has the most knowledge and experience.

Complementing management's focus on its circle of competence is a track record of solid shareholder return from previous investment ventures. Management started two private equity funds, Medalist Fund I and Medalist Fund II. Medalist Fund I liquidated in 2018 and provided 8% annualized cash distributions to investors, while Medalist Fund II has paid 7.5% annualized cash distributions from Q1 2016 through Q2 2019. Management has noted that a large portion of the REIT's capital was raised from investors in their previous funds, illustrating management's ability to retain investors.

Unique and Diversified Business Model

Most publicly-traded REITs solely focus on investing one real estate sector. Investing in one sector involves elevated risk, given that the REITs' performance is subject to how that one asset class performs. MDRR's diversified business model allows for the REIT to take advantage of potential investment opportunities across multiple real estate sectors, not just one. Additionally, the company's performance is not subject to the whims of one sector. In the event of an economic downturn, MDRR's more stable and resilient properties will be able to hedge against potential underperformance in their more economically vulnerable sectors.

High Yielding Secondary and Tertiary Markets

Not only is the southeastern United States the geographic region where management has the most experience in living and working, but it is also the most attractive region in the country to own real estate. 18-hour cities with warm climates and a low cost of living are being fueled by an influx of millennials and baby boomers. As population growth continues to be strong for the southeast, more businesses are relocating there from expensive primary markets with high costs of living and doing business. Long-term economic and demographic trends should bode well for the southeastern economies, driving demand for real estate there.

Additionally, one of MDRR's distinguishing factors when compared with other REITs is its acquisition of under-capitalized, higher-yielding properties. The average cap rates on the properties targeted by MDRR range from 7% to 9%, which is very high compared to other publicly-traded REITs given the low cap rate environment. By investing in lower-priced, higher-cap-rate properties, MDRR achieves higher returns and insulates itself from competition from larger REITs with a greater access to and lower cost of capital.

Value-add Potential

MDRR's management has identified areas of its portfolio where it has the potential to increase value, either through increasing occupancy or renovations. MDRR's initiatives have already increased value in its two retail properties by increasing their occupancy since their acquisition, thereby increasing rental income.

Property Franklin Square Hanover Square
Occupancy at purchase 68% 91%
Occupancy as of Q2 2019 92.40% 96.70%

Source - SEC 10-Q Filing

Similarly, the company also recently completed a renovation of its Greensboro Hampton Inn Property. While disruptions that resulted from the property renovations have temporarily decreased hotel revenues, management expects the recent renovations to increase gross income in the range of $300-325k annually. Likewise, with the company's pending acquisition of the Best Western Hotel by Clemson University, it anticipates that better management of the property can drive stronger operating results there.

Hotel Location

Hotel real estate is one of the most economically vulnerable property types in the case of a recession, given that people are more likely to cut back on travel expenses. Additionally, Airbnb is perceived to have the greatest impact on economy hotels, which are the type of hotels owned by MDRR. On the other hand, I consider Medalist's hotels to have a niche appeal that will limit the negative impact a recession or Airbnb could have on the hotel industry. The Hampton Inn property is located just three miles from the Piedmont Triad International Airport, which has seen steady growth in the last several years. Likewise, the Best Western Hotel is located just .5 miles from Clemson University's campus. The strong location of Medalist's hotels is illustrated by these key demand drivers, which should sustain customer interest in them long-term. While Medalist currently has two hotels that I believe can perform well, the key question is whether it will be able to replicate strong performance in its total hotel portfolio as it expands.

Potential Concerns

I recognize that MDRR has many positive qualities with its ambitious management team, diverse real estate holdings, high yield properties in strong markets, and value-add potential. However, the company also has several potential risks that I am watching to see how they will impact performance going forward. These include the company's potentially economically vulnerable assets that may have greater risk as a consequence of e-commerce and an economic slowdown, lack of staggered lease terms, moderately high levels of leverage, and lack of current dividend coverage.

Property Sector Concentration in Retail

Of the six properties Medalist expects to have in its portfolio in the coming weeks (three currently under purchase and sales agreements), half consist of retail shopping centers. Management has touted its focus on workforce, necessity-based retail real estate as "Amazon-lite." While malls and department stores have been most vulnerable to rising online sales, neighborhood shopping centers have also struggled amidst this trend and do not have a particularly promising outlook. For this reason, management has been able to acquire shopping centers at such high cap rates (above 8%). I am encouraged that Medalist has been able to increase occupancy at the two retail properties it currently owns. However, I would like to see a greater focus on experiential tenants more resistant to e-commerce going forward, such as restaurants.

Additionally, the bifurcation of retail performance based on quality has been widely reported. Generally, higher-quality retail has outperformed lower-quality retail. According to the company's most recent 10-K filing, MDRR's two current retail properties have average effective rents per square foot of $11.98 (Franklin Square) and $14.71 (Hanover Square), both below the national average. Given the limited public operating history of MDRR's properties available, it is unknown how these numbers have been trending over the past several years. However, this will be a key metric to watch going forward.

Lack of Staggered Lease Expirations

In addition to having a high retail concentration, the lack of staggered lease terminations at MDRR's two retail properties poses a risk that they could lose a significant revenue stream if they do not release with the expiring tenants. In 2022, the Franklin Square and Hanover Square properties are set to have 35% and 78%, respectively, of the aggregate annual rents from lease expirations.

Franklin Square Property

Hanover Square Property

Source - 10-K Filing

It is completely possible that a significant portion of the company's revenue will not disappear in a short time span. It could release with the current tenants or quickly find new tenants in the event they are vacated, though the latter could potentially lead to significant capex investments to redevelop its properties for new tenants. Even if they are vacated, the overall impact on the company's total revenue may be minimal if it expands its total property count a significant amount. This is not a near-term concern for the company. What impact it will have on it will depend on future circumstances, though it is something to take note of for the future.

Moderately High Levels of Leverage

As part of the company's financing of its acquisitions, it has primarily used funds from mortgage loans and stock issuances. The company's market leverage ratio for its portfolio is a maximum of 80%. As of its Q2 SEC filing, which includes the three properties it currently owns, the debt/gross assets ratio was 73%. Per the 8-K filings regarding the company's purchase and sales agreements for its next three pending acquisitions, this ratio will not change much. These higher leverage ratios inevitably result in higher interest expense payments and greater risk during a recession. Additionally, the majority of its debt is currently interest only, and the company has not yet paid down the principal on most of its debt yet.

Dividend Coverage

The big wild card for the future performance of the company's stock price is dividend coverage. When the company went public at $10 per share, it established a reasonable 7% dividend yield. Since the recent decline in the company's stock price, that yield has spiked to around 16%. As illustrated by the chart below, the current dividend is not covered, as the company is not yet AFFO positive.

FY 2018 6/30/2019
AFFO (780,532) (568,630)
Dividend payments (1,213,840) (787,582)

Source - SEC Filings

However, the company has also had to raise significant equity to purchase new properties since going public, just recently increased occupancy of its two retail properties, and completed renovations to its Hampton Inn Hotel. Taking out capex spending for its most recent quarter (three-month period), the company would have been cash flow positive. Thus, it is evident that the company has been making progress towards achieving profitability. Once the company's three current properties and three additional properties under purchase and sales agreements stabilize, management aims for the dividend to be approximately 83% covered. Long-term, management has stated its goal of having the dividend fully covered by the end of 2020, which will be contingent on the acquisition of additional properties. Earnings growth will be the key driver to boost the company's floundering stock price. Though the current stats on dividend coverage are not desirable, this must be viewed in the context that the company just started operating a couple years ago and has not yet stabilized its properties.

Conclusion

Medalist Diversified REIT's struggling stock price and lack of profitability have overshadowed its current and future growth initiatives. With stabilizing properties and a strong acquisition pipeline that focuses on a diverse range of high-yielding properties throughout the Southeast, Medalist is a company worth watching. The potential value proposition of the stock at current prices has prompted me to take a small position in the company, though I am taking a wait-and-see approach. Whether or not I maintain or potentially increase my position is contingent on progress regarding the diversity of the company's portfolio composition (would like to see multifamily acquisitions and more flex industrial), AFFO growth, and leasing activity at its shopping centers.

This article was written by

Alex Mansour profile picture
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Alex Mansour is an undergraduate college student. Writing for Seeking Alpha since 2019, I cover primarily the equity real estate investment trust (REITs) space. I invest across all sectors of real estate, focusing on companies with strong earnings growth and trading at discounts to fair value. Relative to other analysts, my coverage emphasizes smaller and underfollowed companies that receive less attention from the mainstream, resulting in discounted valuations. While a long-term investor, I will recycle capital from companies that have reached or exceeded their fair value into more undervalued companies.  

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Disclosure: I am/we are long MDRR. 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.

Additional disclosure: Over the course of the last week, I have received a lot of information for this article by watching a webinar, which is public on YouTube. Additionally, the company hosted a conference call through RedChip on August 22, where the CEO gave a presentation and answered investors' questions. On August 26, I interviewed the CEO. While some of the information I obtained from the latter two exchanges are included in the article, the full depth of the conference call and interview are not public.

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