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Spirit Realty Capital: Despite A 50% Run-Up This Year, Shares Have Room To Rise Another 15%

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About: Spirit Realty Capital, Inc. (SRC)
by: Cashflow Capitalist
Cashflow Capitalist
Long-term horizon, dividend investing, dividend growth investing, REITs
Summary

Spirit Realty Capital is a net lease REIT that has recently completed a transformation, becoming a much higher quality and better capitalized company.

The market has been in the process of repricing the stock this year, lifting shares by nearly 50% year to date.

However, shares are still nearly 30% cheaper than those of its closest peers.

Some discount may be warranted due to the lack of track record, but I see another 15% upside before the repricing is finished.

The simplified, pure-play triple net lease REIT is still a good buy.

Investment Thesis

Spirit Realty Capital (SRC) is a net lease real estate investment trust that has undergone a transformation in recent years. The old SRC had an asset portfolio of middling average quality, with a number of troubled ShopKo properties. But since the spin-off and subsequent sale of these lower-quality and/or higher-risk properties, the new SRC has emerged like the proverbial phoenix with a strong portfolio, relatively low debt, and ample cash-flow coverage of the dividend.

It owns 1,623 properties leased to 260 tenants in 31 separate industries in 48 states. Largely due to the sale of its lower-quality properties, SRC's current portfolio is 99.6% occupied with a weighted average remaining lease term of 9.9 years. Roughly 41% of annual base rent comes from investment-grade tenants.

Despite the stock's incredible 49% run-up this year, SRC is still trading at a meaningful discount to its closest peers and appears poised to continue the upward climb by another ~15%.

Image Source

The Opportunity

Fundamentally, the catalyst I see for a continued rise in the stock price relates to valuation. Now that SRC has transformed into a much higher quality REIT with ample capacity for growth and coverage of the dividend, it does not make sense that the valuation multiple would be significantly lower than peers.

Given the lack of successful track record and unknown future dividend growth rate, it would make sense for there to be some discount to peers, but not a big one. With that in mind, let's take a look at SRC's current price to 2019 FFO compared to that of its closest peers:

Spirit Realty Capital: 15.8x P/FFO (midpoint of 2019 guidance)

National Retail Properties (NNN): 20.2x P/FFO

Essential Properties Realty Trust (EPRT): 22.5x P/FFO

Store Capital Corp. (STOR): 21.4x P/FFO

Agree Realty Corp. (ADC): 24.7x P/FFO

SRC's valuation is over 28% lower than the average of its four closest publicly traded peers. However, let's assume some extra risk and uncertainty still associated with SRC resulting in a lower fair value multiple than its peers. Let's be conservative and assume a fair value (relative to peers) of 18.5x. If that is a fair assumption, then SRC is still ~15% undervalued.

This is reflected in the difference of dividend yields:

ChartData by YCharts

If you're wondering whether SRC has a lower tenant quality to correspond with its lower valuation, it doesn't. Most of its top 15 tenants can be found in the list of top tenants of its peers.

Source: Q3 Earnings Slide Show

Like NNN, SRC is focusing on car washes, convenience stores, fast food, and fitness centers. These make up some of its largest tenant industries by percentage of rent.

Source: Q3 Earnings Slide Show

Same-store sales for the third quarter rose 1%, with grocery, medical office, and quick service restaurants (fast food) the strongest tenant categories.

The vast majority of leases have rent escalations built in, determined either contractually or by the inflation rate.

Source: Q3 Earnings Slide Show

In addition, 42% of leases are secured with master lease agreements and 51% of tenants provide unit-level financials (e.g. store sales numbers). With SRC's new-found focus on publicly traded tenants, it also has corporate financial information for most of its tenants.

Rent coverage for reporting tenants comes in at 2.6x, slightly lower than EPRT's 2.9x and STOR's 2.7x.

Debt And Cost of Capital

YCharts puts SRC's debt to capital at ~38% (though the company reports 35.2%), and the company reports debt to assets of ~34% as of the end of Q3. In any case, it's clear that the company has substantially lowered its debt and put itself in a position to grow again through its recent transformation.

ChartData by YCharts

And the debt it has issued recently has been very inexpensive. SRC has an investment grade credit rating (BBB from S&P & Fitch, Baa3 from Moody's), and it took advantage of the drop in rates this year. During the most recent quarter, it issued $300 million of 7-year notes at a 3.2% interest rate and $500 million of 10-year notes at a 3.4% rate. The company used these new notes, in part, to eliminate all floating rate debt and extend its weighted average debt maturity to 7.1 years.

And yet, even while paying off debt, lowering its debt to capital ratio, and funding $277 million of acquisitions in Q3 (average per property of $3.5 million), SRC still enjoys a huge amount of liquidity. Combining cash and its credit facility, SRC has nearly $1.2 billion in liquidity available for growth, which is a big reason why it recently raised its acquisition guidance for FY 2019 to ~$1.2 billion.

Plus, despite the current 4.4x leverage ratio (debt-to-EBITDA), the company's target is 5-5.4x, which gives the company room to strategically lever up. With rates so low, SRC can enjoy a sizable gap between cost of capital and the initial cap rates of acquisitions. By my calculation, SRC goes into Q4 with a weighted cash cost of capital of 4.64%. Meanwhile, SRC targets properties at a cap rate of 7%, but in the most recent quarter the average acquisition cap rate was 6.84%. That amounts to a 2+ point spread that will widen as debt to capital increases.

However, the effective cost of capital will be even lower than that, considering (1) SRC's higher-than-ordinary cash position from the sale of its spun-off master trust and (2) the ability to increase leverage.

Conclusion

Spirit's management team has done a good job at turning this company around, and there seems to be more improvements to come as the cost of capital continues falling and the portfolio quality continues firming.

Free cash flow per share has exploded in recent quarters, providing copious coverage of the dividend and some ability to partially self-fund growth. The dividend takes up 75.2% of guided 2019 AFFO.

ChartData by YCharts

Assuming a 4% annual dividend growth rate (in line with peers), buying shares at the current 4.77% dividend yield would result in a yield-on-cost after ten years of 7.06%. This just barely meets my target of at least 7% 10-year YoC for ultra-safe investments, which I consider most triple-net lease REITs.

Combining the 4.77% yield, 5% estimated FFO growth, and 3% multiple expansion, total return over the next five years should come in around 12.7% per year. That's not bad at all at a time when the market continues to hit new all-time highs week after week despite earnings softness.

Disclosure: I am/we are long SRC. 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.