This article was coproduced with Nicholas Ward.
It’s easy to think of the net lease sector as being fairly homogeneous. The majority of the companies we cover in this space can look very similar, after all, with their generalized focus on single-tenant retail properties.
Yet they’re not all created equally. And thinking otherwise can be detrimental to the health of your portfolio.
It’s true that the triple-net lease space is known for its reliable dividends. So we’re not completely surprised to see investors expect that of every single real estate investment trust in this grouping.
Plus, we’re well aware that REIT investors are usually income-oriented investors. We love a high yield as much as the next investor.
However, it needs to be a bonus attached to a quality management team. Because ultimately, over the long term, management’s strength to consistently execute is what results in a safe and reliable dividend yield.
With that in mind, we wanted to look at our recent iREIT on Alpha interview with Christopher Volk. He’s president and CEO of Store Capital (NYSE:STOR), a net-lease REIT that’s anything but equal.
(Source)
More Than Willing to Store This REIT Up
Like many net-lease stocks, Store’s stock experienced significant weakness when the shutdowns began. And many investors dropped it like a hot potato.
However, we have a long-term relationship with Volk. And our own independent analysis kept us confident in his team’s ability to navigate the volatile economic environment.
As such, we were willing and able to buy into the dip.
iREIT purchased shares at $19.78 last March. And this March?
We’re looking at total returns in the 70% range since STOR is now back to $32.28. And, as a cherry on top of this dividend-paying sundae, it never cut its dividend along the way.
(Source: Koyfin)
So much of the confidence we have in STOR is derived from its unique business model. The company focuses heavily on unit-level fundamentals when building out its portfolio. It views each property as a profit center rather than a piece of real estate.
In our view, that mentality has allowed STOR to outperform in the past.
Store Capital is also known for its middle-market approach. That essentially means it focuses on smaller, non-investment grade tenants.
Concerned about that? That’s understandable.
However, Volk has spoken about this strategy many times. Ultimately, it boils down to the leverage the landlord has… such as the higher returns it can generate when negotiating leases.
Chatting With Store’s Volk
Volk highlighted that stance in our recent conversation. Investors don’t need to look further than the company’s name to get a sense of its priorities, he said.
“STORE stands for Single-Tenant Operational Real Estate,” he pointed out. In other words, “profit-center properties.” These are distinct from other property types because:
“… you can actually create long-term lease contracts that actually have superior risk profiles than the tenants that are underlying those contracts. The reason is because you're owning their profit centers. And the profit centers are integral to the businesses that they have.”
When making investments and negotiating leases, Store Capital ensures that it’s:
- In the dominant position
- Joining into symbiotic relations
So while it wants to ultimately call the shots, it wants to do so with companies that have the same commitment to quality as it has. They need to have proven cash flow metrics dependent on physical real estate.
They might not be investment grade, but they’re hardly the bottom of the barrel either.
Store also is highly selective with regard to the location and quality of the buildings it buys. These play a large role in its tenants’ success stories, something they understand very well.
That’s another reason why Store can typically lock in such favorable terms.
Volk Says this reaps rewards for him, his company, and its investors as well. “Over the last five or six years,” he told us, “we've sold $1.3 billion worth of real estate and made about $90 million over our costs.”
That wouldn’t have happened with less preferably placed properties.
It also helps how Store targets assets it can purchase at or below their replacement costs. That way, it can more easily liquidate holdings where leases don’t work out… still earn a profit… and then recycle those profits into better profit centers.
Store Capital-Style Success
Store’s success in recycling properties and constantly upgrading its holdings is part of why it’s been able to generate the above-average total-return metrics its shareholders have come to know and love since it went public in 2014.
Of course, its goal – and most other REITs’ – isn’t to trade in and out of real estate. Instead, it’s to foster long-term relationships that result in rising, reliable rent collection.
And this is where Store’s profit center focus and high degree of selectivity really come into play.
Volk says that having access to unit-level fundamentals is key to making proper, risk-adjusted, long-term decisions:
“In our case, we have profit and loss statements from virtually all the investments that we make. We know how senior we are with every single one of our tenants. We have 519 customers today, and we know exactly where we stand with those customers.”
Those profit/loss statements serve as the foundation of a healthy relationship.
Volk also highlighted some common misunderstandings in the net-lease sector:
“… REITs oftentimes focus so much on the assets and the real estate and what the net asset value is, but ultimately net asset value. It doesn't really pay people's returns. It doesn't pay a dividend. The returns are founded on seven fundamentals.”
In his view, the seven most important fundamentals for net-lease investors to focus on are:
(Source)
This helps them sort through their portfolio possibilities to find those with:
- High-quality equity
- High profit margins
- Reliable bottom-line growth
- Strong balance sheets
- Safe dividends that offer reliable dividend growth prospects
In short, exactly what we expect most conservative investors are looking for. And exactly what Store provides…
Along with a well-diversified portfolio and attractive valuation, especially when compared to its future growth prospects.
Retail Done Right
Some of the major concerns we’ve seen investors express throughout the pandemic period center around net lease REITs’ retail exposure. That’s especially true of theaters, gyms, and restaurants that have been hit hardest.
Which these companies just happen to offer.
Yet in Store’s case, we believe the recovery in rents – from about 73% rent collection in Q2 to around 93% today – shows that Store is bouncing back. It’s now in a place where its operations can support future investment. And its current dividend should provide peace of mind for its loyal and new investors alike.
During our interview, we asked Chris about Art Van. One of Store’s larger tenants, it filed for bankruptcy early on in last year’s drama.
So we wanted to know the impact this relationship had on its landlord’s bottom line and dividend sustainability. Yet, as he told us, Store’s top-10 tenants represent only 18% or so of its rents all told.
Volk further notes that this exposure is roughly half the size of many of its peers. Their top-10 tenants often make up 40%-50% of their portfolios.
This delineation isn’t by accident. Volk said that his company’s “business model is designed to deal with tenants that periodically underperform.”
Obviously, bankruptcy is never the plan. However, we’re pleased to see it properly prepared for the possibility.
That provides even more peace of mind going forward.
(Source)
The Dreaded “T” Word
Regarding Store’s theater exposure, Volk had several valid points he wanted to make.
For one thing, that has been falling. The company has been expanding its portfolio elsewhere and even divesting some of its theater assets.
Pre-pandemic, about 5% of its holdings were theaters. Today, that’s down to 3.8%. And he appeared confident about what’s left:
“The good news is that we know our theaters. We're in them at the right prices. The properties and the theaters were performing well at the property level.”
He even sounded bullish on the future of the theater industry, pointing out how 2019 was a record year for the box office. As more and more people become vaccinated, he thinks theaters will fill up again.
In his view, content producers are better able to monetize films when big-screen distribution is involved. As for the media/entertainment industry?
“The pandemic has given the studios the license to experiment and go directly to streaming and see how much revenue they can generate. But my guess is that they are going to fall short. If Disney could have released Mulan to theaters and then put it online, they probably would have collectively done a better job. Same thing with the Wonder Woman sequel, and so on.”
All told, he’s feeling good about valuation in 2021:
“At the midpoint of guidance, you're looking at an AFFO (adjusted funds from operations) growth rate of somewhere around 5.5, which is decent. But I expect that it's going to get better in 2022. Because you're going to be dealing with a tailwind.”
Volk even went so far as to turn his company’s relatively low rent collection figure into a positive:
“There are peers of ours who are collecting more than that, but we have just room to move up. The other thing that's interesting is that, because we're starting off at a higher lease rate, our yields on investment tend to be among the highest in the net lease space, irrespective of percentage of collections.”
And lastly, he touched on the continued recovery:
“We're going to take those yields and drive them further throughout 2021. And as we get into 2022, where we're going to basically be driving our payout ratio right back down to where it was in the low 70s percentage rate. And we'll be able to then work on normalizing performance... Normalizing performance is something where, if you're yielding a four, and you can generate 6% growth, then you can get to double-digits.”
With all of this in mind, we continue to feel confident about our Store positions.
In Conclusion…
Right now, STOR shares are trading with a 16.8x forward AFFO premium.
(Source: FAST Graphs)
Our biggest “concern” with investing in Store Capital is the stock’s multiple.
It’s currently above the company’s longer-term p/AFFO average in the 16x area – which is why we currently rate STOR as a “Hold” at iREIT.
However, we do feel very good about our long position in it. And we don’t have any plans to sell in the short term. Why would we when it has such strong operating profits and dividend growth expectations from here?
Store’s shares are trading slightly above our “bullish up to” threshold in the $30 area. And, with that in mind, we continue to track the stock closely.
We believe in management’s ability to generate those targeted double-digit annualized returns. In short, this company’s very high-quality nature makes us more than pleased at the idea of accumulating more shares.
Just when they’re trading at our fair value estimate.
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