Power REIT: A High Growth REIT
- PW has an asset portfolio consisting of 3 types of properties.
- The company has shifted focus to cannabis properties and has been acquiring over 10 properties in the last few years.
- At current valuation, the company is trading at a small discount to fair value.
Recently, I came across Power REIT (NYSE:PW), a small cap diversified REIT that focuses on growing markets. Although the company's share price has risen significantly over the past year, I think that the company is making moves into the right markets. However, there are some risks regarding legalization and competition to take into account. Nonetheless, in my opinion the shares are undervalued by around 6%.
Source: Company website
As most readers will probably be unfamiliar with PW, I will start with giving some background of the company and its markets. PW is a holding company and has several wholly-owned subsidiaries. PW's history starts with the Pittsburgh & West Virginia Railroad. The P&WV Railroad was qualified as the first infrastructure REIT in the late 1960's. In the early 10's the company also decided to buy some land for solar panels. The company owns around 600 acres of land that is leased to solar projects with 107MW of utility scale. However, since 2019 the company has a new investment focus: agricultural real estate. The company is not focused on just any agricultural real estate, the company is focusing on Controlled Environment Agriculture (CEA). CEA is a method of growing plants by creating an optimized environment. The company owns CEAs that are focused on food or cannabis.
Currently the smallest market of the company, with around 12% of gross rent (of the properties owned at the end of the third quarter). The company has a total of 112 miles of railroad, which is leased to a subsidiary of Norfolk Southern Railway (NSC). The lease is for a term of 99 years and started in 1964. The tracks are leased on a triple net basis which means that all the costs are for the renter and that PW does not have to take care of ongoing costs related to the property, including insurance, maintenance and tax.
Source: Wheeling & Lake Eerie railroad
If we take a look at Norfolk Southern's revenue, debt and FCF. I think that even though it had some struggles in 2020, there is nothing to worry about and that they will be able to pay the rent for at least the coming years. In addition to this, NSC's Net Debt/EBITDA is currently at 2.49, which is in line with peers (only CNI's Net Debt/EBITDA is a lot lower at 1.8).
In my opinion railroads are good assets to have and NSC seems like a tenant with good financial metrics. In addition to this, it is very capital intensive to make new tracks. On average building tracks cost around $1 to $2 million per mile and is certainly not easy. Furthermore, you need to own the land and deal with getting permits. Which does not help if you want to build new railroads... but it does help when you own an existing one such as PW's railroad. However, in the past there has been some disagreements between NSC and PW. This has led to a lawsuit, which PW eventually lost. Given the fact that there are no rent escalators in the contract and that the contract is running for a total lease term of 99 years, this part of the business will be an underperformer.
At the moment the CEA properties are by far the most important for the portfolio. The company earns around $5.6 million from its CEA properties. Which means that its 74.1% of the gross total annual rent (of the properties owned at the end of third quarter). The majority of these properties are leased on a triple net basis, which as mentioned before means that PW does not have to take care of costs for ongoing operations. Although PW says it focuses on food and cannabis when selecting CEA properties. They're mainly focusing on cannabis properties. Cannabis REITs have been a real hit in the past year with both PW and Innovative Industrial Properties (IIPR) up by more than 70%.
This is with good reason. In 2020 5 new states allowed recreational weed: New Jersey, Vermont, Arizona, Montana and South Dakota (as well as medicinal), while Mississippi legalized medicinal cannabis use.
Source: Marijuana Business Daily
In addition to this, the retail cannabis market is expected to grow with a 31% CAGR. To be able to reach this, there need to be more supply. To get more supply we would need more space, space that PW is providing.
I think that, given the growing size of the market, the cannabis properties are a good strategic move and will lead to growing FFO. Taking into account the regulations for cannabis properties, this will limit the amount of properties. Therefore, I expect FFO from CEA properties to rise in the future.
Renewable energy market
Last but not least, the company also owns land with solar farms. At the moment the company owns around 600 acres of land, with an average lease term of over 20 years. The gross annual rents of the solar farms are around 13.8% of total rent (of the properties owned at the end of third quarter). Giving it a third place in the portfolio
Renewable energy is another market that is set to grow and in the past year shares of renewable energy REITs such as Hannon Armstrong Sustainable Infrastructure (HASI) and Brookfield Renewable Partners (BEP) saw their price surge, although at a lesser rate as cannabis REITs.
The reason behind this is quite clear. More and more governments (including the US government since Biden) are pushing for renewable energy such as solar, wind and hydro energy. Solar energy is expected to be the most important globally until at least 2024.
In addition to this, EIA and the US Energy Information Administration expect solar power to increase as a percentage of total energy generation. Although, I expect that solar panels will be more efficient in the future, meaning that the current ones need to be replaced and that all things equal we need less panels, there will still be a need for land for solar farms.
Based on the expected importance of renewable energy and the importance of solar as a renewable energy source I think that the demand for land for solar farms will rise at least in the short- to mid-term. However, at the moment PW has really long leases and it does not look like they are going to buy new solar farms any time soon. Therefore, they aren't entering any new rental contract any time soon and rental increases will not differ from the already agreed upon contract. Nevertheless, if demand increases, so will the value of the acres it currently owns.
How has the company been doing?
Since the change in focus to CEA properties in July 2019, the company has increased its FFO significantly. At the end of 2018 the company had a FFO of $1.04 million, while it had FFO of $1.59 million for the nine months ended in September. If the company's Q4 is as good as the first nine months, there is a good chance that the company almost doubled its FFO since shifting its focus to CEA properties.
During this period the company acquired over 10 properties in the CEA space. Which led to their current portfolio of 21 properties as per 30th of September 2020.
To fund the acquisitions the company decided to, among other things, issue new shares. Something that is very common when REITs try to aggressively grow. However, this is only non-dilutive when shares are trading at a premium to NAV. To give you an oversimplified example:
Trading at a premium before capital raise:
A company has $1 billion in assets that are leased to tenants. The company earns $75 million in net rent and there are 10 million shares. In this example the company has a NAV per share of $100, FFO per share of $7.5 and the shares are trading for $200.
- Shares outstanding: 10 million shares
- NAV/share $100
- FFO/share $7.5
- Share price $200
After capital raise:
The company decides to issue 5 million new shares at market price to fund acquisition. The company would get 5 million x $200 which is $1 billion. The company uses this to buy new properties. After the acquisitions the company has $2 billion in assets, net rent of $150 million, and 15 million shares outstanding, while the company's FFO per share increased to $10, and NAV per share increased to ~$133. However, the premium has decreased to approximately 50%.
- Shares outstanding: 15 million shares
- NAV/share $133
- FFO/share $10
- Share price: $200
Therefore, by issuing shares at a premium the company can reduce the premium and buy more properties and increase rent income. Obviously, this is a very simplified example but as I mentioned before it is not uncommon for REITs to do this.
The debt levels of PW have also increased over the years but remain within relatively safe levels. The company has a debt/equity ratio of 1.6 and a net debt/EBITDA of 4.2. This is a lot worse than IIPR, but IIPR has size advantages and more cash on hand. However, the average net debt/EBITDA for the REIT industry was 6.1. Which is why I am not worried about PW's debt levels at the moment.
The last thing I want to talk about before I move into the risks and valuation of the company is the dividend. REITs are by law required to pay out 90% of their taxable income as dividends. However, due to a legal case with NSC, the company had an uncollectible settlement account of approximately ~18 million, which led to a NOL. This means that they can offset their tax income for the coming years, and are therefore not required to pay a dividend.
At the moment I see two main risks to PW. The first one is the progress of the legalization of cannabis in the USA and the second one is increased competition. Although both are related to each other they provide risks at different stages of the company.
First of all is the legalization of cannabis. As mentioned before, a bunch of new states has legalized recreational and medicinal use of cannabis in 2020. At the moment there are still 8 states in which it is completely illegal to have anything cannabis related on you, and 6 which only allow CBD oil. If there will be no change on cannabis laws on a federal and state law, this will limit the opportunities for new properties for PW. As I briefly touched upon before, there are certain rules and regulations on where you can grow cannabis. I see the likeliness of this risk as low, as Biden is not opposed to cannabis and there is growing support to use it (at least) as a medicine. Furthermore, I view the impact of it as moderate to high. The reason for this is that if there will be no more legalization, there will be less new competitors joining the market. Therefore, although it will hinder the amount of properties available, it will keep the rates of these properties a tad higher.
In case cannabis gets legalized, I expect a lot more competitors joining the market. At the moment there is still a stigma around cannabis. If it gets completely legalized I see this stigma disappearing. This would lead to lower cap rates and makes it harder for PW to grow as fast as new properties will bring in less money. At the same time it will increase the value of current properties, as there will be more demand. I currently view the likeliness of this risk as moderate. The reason for this, is that there is an increasing support for cannabis and the fact that Biden is not opposed to cannabis, could lead to the legalization of cannabis. The impact of this on PW would be moderate to high. According to Gurufocus PW's weighted average cost of capital (WACC) is 3.51%. If cap rates decrease and the company cannot lower its WACC, it will earn less on new properties. Therefore, depending on the WACC the impact will be moderate to high.
To determine the value we will take a look at the Price/FFO per share. This is basically the PE ratio of a REIT. To value PW we will use the P/FFO of both PW and its closest competitor, IIPR. At current share price PW has a P/FFO of 61 and IIPR has a P/FFO of 25.2. This would make it sound like PW is very overvalued. However, it is a lot more complicated than that. Based on size and growth rate, PW should trade at a higher P/FFO than IIPR. However, even if we look at the average P/FFO over the past year PW is trading at the higher end of the spectrum. If it would return to its average of the past year it would trade at a P/FFO of 42.1. If we would use the estimated FFO of 2020 of $1.32 per share, the company should trade at a share price $55.57. However, I do think this is a bit too high. I would say that based on the risks and the probability of lower cap rates a P/FFO of between 28 and 30 would be right. This would imply a share price of $36.96 to $39.60, an upside of at least 6.3%. However, do note that I like to be a bit more conservative in my estimations.
PW is a very diversified REIT, having 3 different types of assets. The main focus of the company is CEA cannabis properties. At the moment the company is doing a fine job and growing very fast, and the cannabis market is estimated to grow with a CAGR of 31%, giving ample room to grow. However, the company has had some problems with a lawsuit with NSC, which means it currently does not pay a dividend and new investors should take into account that this is not likely to change soon.
Furthermore, there are some risks to the company. If the legalization of cannabis comes to a halt, this will limit new property options for the company. If it does get legalized, there is a chance that cap rates will decrease significantly due to more competition, which will make growing at the same rate a lot harder. Nevertheless, at current valuations I think that the company is undervalued by at least 6.3%, providing some margin of safety.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PW over the next 72 hours. 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.
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